Wednesday, 26 December 2012
Over the last few years, and at an increasing pace as of more recently, *unions have become more and more confident of their ability to effect change and taken much more aggressive activist positions* against the capitalist oppressors. The most recent examples range from California cities to Twinkies-maker Hostess Brands, and each time the stance from the unions appears to have been far more aggressive (and M.A.D. prone) than in the past. The question is why? Perhaps, as we tweeted following Hostess' liquidation:
Will the broke PBGC step in and fund Hostess' 18,000 workers suddenly vaporized pensions?
— zerohedge (@zerohedge) November 16, 2012
...It is the confidence of an all-powerful government at their back with the US Pension Benefit Guarantee Corporation, which is the backstop for private sector plans, providing cover. The problem is, as UBS explains, the *PBGC has a huge deficit and is cashflow negative*. This leads us to the uncomfortable expectation of further USD government support (bailout) or a more direct monetization by the Fed. PBGC could be impacted severely if a few large firms terminate their pensions. In this case, UBS expects PBGC to sell equities and buy long duration fixed income.
Via UBS' Boris Rjavinski and Matthias Rusinski: *Uncle Sam’s Little Nephew May Need a Big Bailout*
*PBGC’s deficit is over $34 billion and growing*
The Pension Benefit Guarantee Corporation’s (PBGC) 2012 Annual Report reveals significant deterioration in its finances. Our read is that there was very little good news in that report, as most of the PBGC’s key financial viability measures have worsened. Present value of accumulated future benefits jumped due to large declines in interest rates while losses from newly insolvent pensions and probable future insolvencies continued to grow. Specifically,
· The *$34.4 billion deficit* is the highest ever. It has *increased $8 billion, or 32%, in the past year* (Figure 6).· PBGC remained *cashflow negative*. Payouts to current pension recipients have outstripped the premium income collected from solvent pensions by $2.75 billion· The *70% funded ratio is the lowest since 2004 and is down from 75% a year ago* (Figure 7). PBGC’s own estimate of exposure to “reasonably possible terminations” is $322 billion, i.e. *about 2% of the current U.S. GDP*
The only major piece of good news was the 12.6% return on PBGC’s investment portfolio.
*Fannie, Freddie, PBGC…?*
The PBGC might become one of the first public entities to receive a bailout. When the government bailed out Fannie and Freddie it was not legally obligated to keep them afloat, as they were owned by private shareholders. Nonetheless, *virtually all investors thought the government would stand behind Fannie and Freddie*, and in 2008 they were proven correct. PBGC is a part of the Government. However, in the big picture sense, there is little difference. *PBGC, like Fannie and Freddie, is on sound financial footing as long as the US government backs it.* The advantage of injecting capital into PBGC is that it becomes more obviously solvent, instead of counting on government support in a crisis. However, its current charter does not allow use of taxpayer funds. Just like its distant cousin FDIC, PBGC’s liabilities are contingent. Taxpayers and legislators probably will not care about PBGC’s or FDIC’s obligations while they are “deep out of the money”. Unfortunately, with the $34 billion deficit that continues to grow, the *policy makers will have to start thinking about how to foot the pension protection agency bill*, when it comes due.
*Strong portfolio return cannot offset low rates and troubled pensions*
The 12.6% return in the PBGC investment portfolio in fiscal 2012 was undoubtedly very strong. The resulting *$9.8 billion net balance sheet contribution from investments was very significant*. That begs the question: why did the funded gap still worsen by $8 billion? One key to the answer lies a little over one mile away from the PBGC headquarters, at the Federal Reserve (Figure 8). As the 2012 annual report indicates, the *“actuarial charges due to changes in interest rates” increased $10.8 billion, as “interest factors” decreased by 103 bp.* We estimate that PBGC’s liabilities have an average duration of roughly 10.8 years.
*We have heard many complaints from private investors, including pensions, about the Fed lowering their liability discounting rates.* Operation Twist was joined by QE3 and soon to be followed by QE4. Chairman Bernanke has indicated several times that he is well aware of the pain caused by low yields, but feels convinced that the net benefit from economic recovery will outweigh the potentially short-term problems for pensions. Perhaps PBGC Director Josh Gotbaum will soon take a short walk along the red line in Figure 8 to plead his case with Chairman Bernanke.
*Future increases in busted pensions may make PBGC net seller of stocks, buyer of bonds *
The market impact from developments at PBGC may be muted in the near-term, but may grow in the future. It runs a very conservative investment portfolio with 2/3 allocated to fixed income. When the agency takes over assets of a busted pension, it is very likely to quickly bring them in line with PBGC’s own portfolio mix. *If PBGC has to take over large underfunded pensions, it will likely be a net seller of equities and buyer of bonds.* In 2012, PBGC realized roughly $1 billion in losses from taking over 155 terminated pensions with an average funded ratio of 50%. However, that number could have been easily over $10 billion had a single large airline bankruptcy restructuring in 2012 led to termination of its pension plans.
*PBGC is part pension, part insurer*
The PBGC’s mandate is to protect future incomes for participants in private sector defined benefit pensions. It is essentially a hybrid between a pension fund and an insurance company. *In its pension function, PBGC allocates its portfolio of investments to meet future payment obligations* to retirees. The *insurer side of PBGC collects premia from solvent insured plans and pays out “claims” in the form of current pension payouts*. It also must deal with how its capital position is affected by new “claims”, i.e. newly terminated plans and workers going into retirement. PBGC must also consider the capital impact from plans that likely will be taken over soon; in other words, the visible “new claims pipeline”.
*Ongoing cash bleed compounds deficit trouble*
Two key measures of pension solvency are the funding surplus or deficit and the funding ratio. In PBGC’s case, both of them indicate poor financial health. *The deficit is $34 billion (Figure 6 above) and the funded ratio is 70% (Figure 7 above).* If PBGC were a traditional corporate pension plan, it almost certainly would be classified as “at-risk”. The insurance side of PBGC also is quite important. Investors often use the ratio of premia to claims in assessing insurers. We apply a similar metric for PBGC: [premiums collected] / [ongoing pension payout]. Figure 9 shows that PBGC was net cashflow negative to the tune of $2.75 billion in 2012 with premiums barely covering 50% of “claim” payments. In fact, the last time premiums exceeded current payouts was in 1999. *An entity that has $80 billion in assets, a $34 billion long-term funding shortfall and a significant negative cashflow is not on a sustainable path. No kidding.* We doubt anyone expects the PBGC to make money. After all, its role is to mitigate the hits from dodgy pensions. However, the massive deficit and cash outflow put it at risk for a large bailout sooner rather than later.
Pension funding relief passed this summer by Congress does raise the insurance premia that pension sponsors have to pay to PBGC. However, *we doubt premium collections will double, which would be required to stop the cash bleed right now*. In addition, the new rules focus on high risk funds that have large deficits. Raising insurance premia for these funds could have a perverse effect. Their sponsors may become more likely to terminate the plans and dump them on PBGC, thereby compounding the problem.
*Pensions trouble spill over to PBGC within 1-to-2 years*
An interesting insight from Figure 6 and Figure 7 is that the PBGC funding gap seems to lag US corporate funding ratios by roughly 1-2 years. For instance, the private pension funding ratio troughed in 2002, while for PBGC the trough came in 2004. Corporate pensions took a huge hit in 2008 during the global credit crisis; for PBGC metrics worsened noticeably in 2009. Finally, *the big deterioration in PBGC’s funded ratio and deficit in 2012 may be a delayed reaction to the “pension Waterloo” of 2011.* While it is hard to put scientific rigor behind this “lag rule”, we think it does make sense. When corporate pensions take a large hit, it will take some time for companies to get through the reporting cycle. Thus, PBGC has to wait for updated numbers so it can identify new high-risk plans. *When a pension is terminated sponsors go through myriad steps*. They need to piece together a full picture of the damage, search for solutions to improve things, and finally come to reject all other options before shutting the plan and turning it over to PBGC.
*PBGC investment portfolio: good downside hedge but limited upside *
PBGC’s current investment portfolio composition is fairly conservative, with a strong tilt to long duration fixed income. Almost 67% of the portfolio is invested in publicly traded bonds, with the largest allocations to U.S. Treasuries and investment grade bonds. *Only 28% of the portfolio is in stocks*, with the rest split between some private equity/debt and cash. The 10-30bp decline in Treasury yields, outperformance by corporate and EM bonds, and some exposure to equities help explain the 12.6% return on assets in fiscal 2012. With its overweight of government and investment grade corporate bonds the PBGC investment portfolio should act as a good hedge in a risk-off environment. The investment portfolio by itself has limited upside if economic growth accelerates. Nonetheless, in an environment of strong growth and rising interest rates, the declining present value of liabilities should more than offset losses on investments. *Interestingly enough, almost 25% of the portfolio is invested in foreign (including emerging market) stocks and bonds*. These investments should help diversify portfolio risk, but may prove less liquid and more volatile at the time of stress.
*Long term solvency challenged under current framework*
We estimate the distribution of PBGC’s funding ratio for various horizons using a Monte Carlo model (Figure 10). We generally use ten years of monthly data to compute the covariance matrix of returns. We use exponential weightings to emphasize more recent observations. For investment grade fixed income we use current yields rather than historical data to project future returns. On the liability side, we project payments using both current data and the trend of average increases in payments over the past five years. We apply the same approach to forecast PBGC’s insurance premia increases.
While we clearly have to make a lot of assumptions, the model’s output should be fairly robust. The historical data are highly transparent, and it is fairly easy to map most of the components of PBGC’s investment portfolio to publicly available indices. In addition, PBGC’s portfolio is very highly diversified, which helps make Monte-Carlo distribution more stable.
The results are quite telling. *Thanks to the conservative asset portfolio heavily titled to fixed income, the projected funded ratio is more stable than for most pensions*. Stability can be a mixed blessing, as we see little chance that the PBGC will be fully funded in the next 10 years. The *downside “tail” scenario could still be painful*, as the red bars fall below 50% in later years.
*Clear and present danger from large pension bankruptcies *
*It may take only two or three more large pension bankruptcies to jeopardize PBGC solvency.* The American Airlines bankruptcy earlier this year served as a stark reminder that the agency is very exposed to a large underfunded pension going bust. American’s roughly $10 billion funding gap would send PBGC’s deficit soaring. Consequently, the agency pushed back very hard. The airline eventually agreed to freeze, rather than terminate, most of its pension plans. *There is no guarantee that PBGC will have the same success in the future.*
*2012 pension funding relief may lead to growing number of “zombie” pensions*
*We believe there is another latent threat to the long-term PBGC solvency. We label this peril the “death by a thousand cuts.”* As we have discussed in earlier publications, the pension funding relief passed as a part of the highway bill earlier this year has effectively allowed sponsors to cut their contributions to underfunded pensions by nearly 70%. We suspect that in many cases the sponsors’ contributions under the new rule will be lower than the pensions’ ongoing payments to retirees. *Again, plans with low initial funding ratios may continue to experience eroding assets, with the government powerless to do anything about it. *In some cases, this will become an irreversible path to insolvency, especially for smaller medium size funds that generally stay below the radar screen. One or two extra terminations of mid-size “zombie” pensions probably will not make a big difference to PBGC. However, the PBGC will have to grapple with this issue if the “zombie” numbers mushroom several years down the road.
*Future bailout candidate? Watch for a fiery policy debate if things continue to deteriorate *
*The issue of PBGC’s solvency is coming to the fore while debates on fiscal policy reach a fever pitch.* PBGC’s obligations ultimately fall on the federal government, even though its charter precludes the agency from tapping tax revenues directly. PBGC’s hefty deficit is likely to grow. The agency’s own estimate of loss exposure to “reasonably possible terminations” is $322 billion, i.e. about 2% of the GDP. In the game of over-under, we will take the over. *It is ironic, although not that surprising, that a long-term solution to PBGC’s solvency probably would come down to a combination of “revenue raising measures” and “entitlement cuts.”* In other words, insurance premia for plan sponsors would rise while the guaranteed portion of pension payments would fall. Without this sort of shift, we think the agency will need a federal bailout.
*Bottom line: market impact may be muted for now *
The market impact from developments at PBGC may be muted in the near-term, but we expect it to grow. *If PBGC takes over a large number of plans, it probably will be a significant seller of equities and buyer of bonds. *
We may also see PBGC exert its influence in the market indirectly, through its dialogue with private pensions. It may take a more active role in trying to make plan sponsors improve their funding ratios. *Many financially healthy plan sponsors are taking similar steps of their own accord.* Consequently, the demand for fixed income could rise, although we have found pensions’ moves very difficult to time.
Ultimately, a sound retirement income system in the U.S. is in the interest of a vast majority of population. Hence, *the main pension income insurer needs to be on sound financial footing*. However, just as with most other hot public policy topics, we expect a difficult and contentious debate on how to fund or support the PBGC.
That last paragraphs sums it up - its in the favor of the majority and so that will be justification for funding more monetization and implicit bailouts... 2013 may be the year to watch pension fund zombification.