SAFEGUARDING SOLVENCY

For the first time since 1993, the single-employer program sustained a net financial loss for the year. Increased losses from terminations of underfunded plans and the program's first investment loss since 1994 left the program with a reduced net surplus at year-end. The multiemployer program also recorded a significant financial loss for the year but remained financially sound, as well.

Financial Management

The net annual loss sustained by the single-employer program in 2001 resulted from terminations of underfunded plans, a loss on investments and actuarial charges. In the case of the multiemployer program, the net loss for the year was largely attributable to losses from future financial assistance.

The single-employer program's loss from equity investments was partially balanced by gains from fixed-income investments. As a result, the program reported a net investment loss of $843 million, nearly offset by premium revenue of $821 million. Nevertheless, at a time when many ongoing pension plans reported investment losses of 10% or more, the PBGC investment loss was only 3.3% of total assets invested. Consistent with the record size of plan terminations during the year, losses from plan terminations also increased. The combination of significant losses from terminations and negative returns on equity investments produced a net loss for the year of almost $2 billion, reducing the program's net surplus to about $7.7 billion. (Chart showing net position of PBGC single-employer plan insurance program going from deficit of about $2.7 billion in 1992 to surplus of about $7.7 billion in 2001.) Despite the loss, the current surplus continues to provide the insurance program with a cushion against future sizeable losses that are unforeseen and episodic in nature.

The multiemployer program reported a net loss of $151 million, due to an increased allowance for probable losses from nonrecoverable future financial assistance. However, with total assets of $807 million and liabilities totaling $691 million primarily for nonrecoverable future financial assistance, the multiemployer program remained financially sound with an end-of-year surplus of $116 million. (Chart showing net position of PBGC's multiemployer plan insurance program fluctuating between surplus of $169 million in 1992 and surplus of $116 million in 2001.) Investment income increased to $95 million, partially offsetting the loss from financial assistance. Premium income from insured multiemployer plans remained stable at about $24 million.

PBGC's financial statements have received their ninth consecutive unqualified opinion from the Corporation's auditors. The 2001 audit was again performed by PricewaterhouseCoopers LLP under the direction and oversight of PBGC's Inspector General.

Investment Program: The Corporation's investable assets consist of premium revenues accounted for in the Revolving Funds and assets from terminated plans and their sponsors accounted for in the Trust Funds. By law, PBGC is required to invest the Revolving Funds in fixed-income securities; current policy is to invest these funds only in Treasury securities. PBGC has more discretion in its management of the Trust Funds, which it invests primarily in high-quality equities. The asset allocation is designed to provide sound, long-term performance.

PBGC has structured its investment portfolio to improve its financial condition in a prudent manner. The Revolving Fund assets are invested to earn a competitive return and partially offset changes in its benefit liabilities. The Corporation's investment in equities provides overall portfolio diversification and a higher long-term expected return, within prudent levels of risk. PBGC uses institutional investment management firms to invest its assets subject to PBGC oversight. PBGC, with the advice of its Advisory Committee, continually reviews its investment strategy to ensure that it maintains an investment structure that is consistent with its long-term objectives and responsibilities.

As of September 30, 2001, the value of PBGC's total investments in the single-employer and multiemployer programs, including cash, was approximately $22 billion. The Revolving Fund's value was $14.4 billion and the Trust Fund's value was $7.6 billion. Cash and fixed-income securities represented 71 percent of the total assets invested at the end of the year, as compared to 61 percent at the end of 2000, while the equity allocation decreased to 28 percent from 38 percent of total assets invested. The current allocation to equities is the maximum currently allowable to PBGC, given legislative restrictions limiting equity investments to the Trust Funds. A very small portion of the invested portfolio remains in real estate and other financial instruments.
Table - Investment Profile

Results for fiscal year 2001 were mixed for capital market investments and PBGC's investment program. During the year, PBGC maintained its long-term, diversified asset allocation strategy and achieved a -3.3% return on total invested funds. PBGC's fixed-income program returned 13.8% while its equity program declined 27.9%. PBGC's five-year returns approximated their comparable market indices, meeting the Corporation's strategic performance goal. For the year, PBGC reported a gain of about $1.8 billion from fixed-income investments and a loss of $2.5 billion from equity investments.
Table - Investment Performance

Contract Management: A concerted effort between the Corporation's financial offices enabled PBGC to improve appreciably the timeliness of payments on vendors' bills, sharply reducing the late fees PBGC had been paying. Several elements comprised this group effort: a renewed emphasis on customer service principles resulted in a heightened responsiveness to PBGC's vendors; the new automated performance accounting system implemented during 1998 and enhanced during 2001 is providing much improved financial information, permitting better management of contracts and prompter payments on bills; and PBGC adopted a more-frequent payment schedule allowing faster payments on its bills. As a result, the amount of interest that PBGC paid due to late payment of invoices decreased by 78 percent, from about $133,000 in 2000 to less than $30,000 in 2001.

Of the contracts issued during 2001, PBGC awarded 90 percent through full and open competition. The remainder were sole-source contracts or set-asides for minority bids.

Single-Employer Program Exposure

PBGC's "expected claims" are dependent on two factors: the amount of underfunding in the pension plans that PBGC insures (i.e., exposure) and the likelihood that corporate sponsors of these underfunded plans encounter financial distress that results in bankruptcy and plan termination (i.e., the probability of claims).

Over the near term, expected claims result from underfunding in plans sponsored by financially weak firms. PBGC treats a plan sponsor as financially weak based upon factors such as whether the firm has a below-investment-grade bond rating. PBGC calculates the underfunding for plans of these financially weak companies using the best available data, including the annual confidential filings that companies with large underfunded plans are required to make to PBGC under Section 4010 of ERISA.

For purposes of its financial statements, PBGC classifies the underfunding of financially weak companies as "reasonably possible" exposure, as required under accounting principles generally accepted in the United States of America. The "reasonably possible" exposure as of September 30, 2001, as disclosed in Note 7 of the financial statements, was $11 billion (valued using data as of December 31, 2000), compared to $5 billion for fiscal year 2000.

Over the longer term, exposure and expected claims are more difficult to quantify either in terms of a single number or a limited range. Claims are sensitive to changes in interest rates and stock returns, overall economic conditions, the development of underfunding in some large plans, the performance of some particular industries and the bankruptcy of a few large companies. Large claims from a small number of terminations and volatility characterize the Corporation's historical claims experience and are likely to affect PBGC's potential future claims experience as well.

Methodology for Considering Long-Term Claims: No single underfunding number or range of numbers -- even the reasonably possible estimate -- is sufficient to evaluate PBGC's exposure and expected claims over the next 10 years. There is too much uncertainty about the future, both with respect to the performance of the economy and the performance of the companies that sponsor insured pension plans.

PBGC uses a stochastic model -- the Pension Insurance Modeling System (PIMS) -- to evaluate its exposure and expected claims.

PIMS portrays future underfunding under current funding rules as a function of a variety of economic parameters. The model recognizes that all companies have some chance of bankruptcy and that these probabilities can change significantly over time. The model also recognizes the uncertainty in key economic parameters (particularly interest rates and stock returns). The model simulates the flows of claims that could develop under thousands of combinations of economic parameters and bankruptcy rates. (For additional information on PIMS, see PBGC's Pension Insurance Data Book 1998, pages 10-17, which also can be viewed on PBGC's Web site at www.pbgc.gov/publications/databook/databk98.pdf.)

Under the model, median claims over the next 10 years will be about $850 million per year (expressed in today's dollars); that is, half of the scenarios show claims above $850 million per year, and half below. The mean level of claims (that is, the average claim) is much higher, more than $1,150 million per year. The mean is higher because there is a chance under some scenarios that claims could reach very high levels. For example, under the model there is a 10 percent chance that claims could exceed $2.5 billion per year.

PIMS projects PBGC's potential financial position by combining simulated claims with simulated premiums, expenses and investment returns. The mean outcome is an $8.4 billion surplus in 2011 (in present value terms). However, the model also shows the potential for significant downside outcomes. In particular, there is more than a 25 percent chance that the Corporation could return to a deficit in the next 10 years and a 10 percent chance that the deficit could exceed $14.0 billion in 2011 (in present value terms). These outcomes are most likely if the economy performs poorly, in which case PBGC may experience large claims amounts and investment losses. PBGC is continuing to analyze the best way to manage and reduce the risk of insolvency.

Loss Prevention

Under the Early Warning Program, PBGC monitors certain companies with underfunded pension plans to identify corporate transactions that could jeopardize pensions and to arrange suitable protections for those pensions and the pension insurance program. Following a comprehensive internal review of the program, during 2000 PBGC adopted new, more-exacting screening criteria for determining when to contact companies about pending transactions. The Corporation then issued detailed guidance to help plan sponsors and pension professionals understand the scope of the program's operation, anticipate when PBGC is likely to be concerned about a business transaction and foresee the types of pension protection PBGC may seek. The new guidance reduced the number of corporate contacts PBGC made with respect to companies not in bankruptcy who were undertaking corporate transactions. Over the past year, however, loss prevention activity increased in the area of bankruptcy with the dramatic increase in bankruptcy filings during the year. The Corporation's focus remains on achieving protection for pensions acceptable to both PBGC and companies sponsoring underfunded pension plans.

Litigation

Legal challenges to PBGC policies and positions continued in courts across the country. At the end of the year, PBGC had 78 active cases in state and federal courts and 426 bankruptcy cases.

Major cases in 2001 included:

White Consolidated Industries, Inc.: In a July 1999 ruling, affirmed in June 2000 by an appellate court, a district court found White liable for the unfunded benefits of six pension plans that White transferred to the Blaw Knox Corporation in 1985. PBGC took over the plans subsequent to the transfer because they ran out of money or would have been abandoned after Blaw Knox ceased business in 1994. PBGC sought to recover approximately $120 million, plus interest, for the plans' underfunding, alleging that a principal purpose of White's transaction was to evade its pension liabilities. In July 2000 PBGC and White reached an agreement settling the litigation and White's separate administrative appeal before PBGC challenging the Corporation's calculation of the unfunded benefit liabilities. The settlement contained two alternatives, the first of which called for White to resume sponsorship of the six pension plans and pay the plan participants their full plan benefits with a 5 percent increase, plus any benefits PBGC did not pay because of the legal limits on PBGC's guarantee. Under the second alternative, PBGC would keep the plans. White would then pay the plan participants the value of their unpaid nonguaranteed benefits with interest and pay PBGC $180 million plus interest less the amount White pays directly to participants. In October 2001 White informed PBGC that it was unable to carry out the first approach due to various economic forces. As a result, PBGC will remain trustee of the plans and White will make the payments as called for under the agreement.

Raytech Corporation: In 1986 Raymark Industries, Inc., formerly known as Raybestos-Manhattan, Inc., created Raytech Corporation as a wholly owned subsidiary. In doing so, Raytech acquired Raymark's profitable assets while leaving Raymark with asbestos-related liabilities and two pension plans that are underfunded by about $19 million. In 1999, while undergoing reorganization in bankruptcy, Raytech filed for a declaration that it was not liable for any minimum funding contributions to the Raymark pension plans after it ceased being a member of Raymark's controlled group. PBGC filed a counterclaim alleging that the spin-off of Raytech and Raymark was a scheme intended to defraud creditors and asking the court to order Raytech to maintain, administer and fund the plans. In December 1999, the bankruptcy court granted PBGC's motion for summary judgment and ordered Raytech to take full responsibility for the two pension plans. The court agreed with PBGC that the transactions that separated Raytech from Raymark were intended to defraud Raymark's creditors and that PBGC was entitled to relief under fraudulent conveyance law. In March 2001 the district court affirmed the bankruptcy court's grant of summary judgment in favor of PBGC. Raytech's appeal was pending before the appellate court at year-end.

Copperweld Steel Company: PBGC continued to pursue bankruptcy claims to recover amounts due PBGC and Copperweld's three terminated pension plans, which covered about 3,000 workers and retirees. The company's liquidation trustee contested whether PBGC's claims for unpaid minimum funding contributions in excess of $1 million are entitled to tax priority and whether the assumptions PBGC prescribes in its regulations appropriately measure PBGC's claims for unfunded benefit liabilities. In December 1997 the bankruptcy court ruled for the liquidation trustee's position on both issues. On PBGC's appeal, the district court affirmed the bankruptcy court's adverse decision, and in November 2000 the Sixth Circuit Court of Appeals affirmed the lower court rulings. In October 2001, the United States Supreme Court denied PBGC's request that it review the appellate ruling regarding valuation of PBGC's benefit liability claims. PBGC did not seek review of the appellate decision that PBGC's claim for unpaid minimum funding contributions is not entitled to tax priority.

Pineiro, Brooks, and Beaumont v. PBGC: In 1991 PBGC became trustee of three Pan American World Airways pension plans underfunded by $914 million. Three former Pan Am employees later filed suit asking a district court to replace PBGC with an independent trustee. In 1997 the court initially dismissed virtually all of the allegations as meritless, leaving open only an allegation concerning the timeliness of PBGC's notices of benefit determination to the Pan Am participants. The plaintiffs filed an amended complaint in January 1998 realleging PBGC delays in issuing benefit determinations as well as most of the dismissed allegations. In March 2000 the district court issued a new decision that denied PBGC's motion to dismiss and vacated significant parts of its 1997 ruling, allowing several of the plaintiffs' claims to continue while dismissing others. The court's decision focused on the technical legal issue of whether PBGC operates as a "trustee" or as a "statutory guarantor" when calculating guaranteed benefits. While a technical issue of statutory interpretation, the issue is fundamental to PBGC's operation because different standards of conduct, and different standards of judicial review, apply depending upon whether PBGC undertakes the duty as a fiduciary or as the federal guarantor.

Following its March 2000 decision, the district court permitted PBGC to file an immediate appeal of its ruling and stayed all further proceedings in the case pending that appeal. The court of appeals initially granted PBGC's motion to appeal but in October 2001, following briefing and oral arguments, the appellate court dismissed PBGC's appeal "for lack of appellate jurisdiction." The court did not decide the case on the merits but ruled only that deciding the appeal at this stage would not "materially advance the ultimate termination of the underlying litigation. ... No matter what we do on this appeal, it seems likely that this action will proceed." The appellate court therefore returned the case to the district court for further proceedings.

Despite the exceedingly poor condition of Pan Am's pension records and the difficulties caused by the company's protracted bankruptcy proceedings, PBGC has been paying benefits to Pan Am retirees continuously since taking over the plans. Every participant entitled to receive a guaranteed benefit has received that benefit, and PBGC has completed all benefit determinations for the 53,000 former Pan Am workers and retirees. The ultimate decision in this case will not increase or decrease the benefits payable to plan participants.

Air Line Pilots Association v. PBGC: Under a January 1993 agreement between Carl Icahn, Trans World Airlines, Inc., PBGC and the unions representing affected TWA employees, TWA's pension plans for pilots and employees were frozen, with no additional benefits earned or new participants added after the date of the agreement. Pichin Corporation, owned by Icahn, assumed funding responsibility for the plans, and Icahn acquired the right to unilaterally terminate the plans at any time after January 1, 1995. The agreement's confirmation by the bankruptcy court enabled TWA to emerge from bankruptcy reorganization later in 1993. In December 2000 Icahn exercised his right, terminating the plans as of January 1, 2001. PBGC took responsibility for the plans the same day. At the time, the plans covered a total of about 36,500 people, including more than 15,000 active TWA workers, and were underfunded by about $700 million.

Despite the fact that the Air Line Pilots Association (ALPA) was a party to the 1993 settlement agreement, ALPA and two individual pilots brought suit in district court in 2001 alleging that termination of the TWA Pilots Plan was unlawful and should be enjoined. In March PBGC filed a motion to dismiss the complaint on the basis that the termination was proper under ERISA and that the complaint is barred because the propriety of the termination was already decided when the bankruptcy court approved the 1993 settlement agreement. The plaintiffs filed their own motion for summary judgment, to which PBGC responded. The motions were pending before the district court at year-end.

Coleman v. PBGC: Six former employees of McLouth Steel Products Company brought this suit claiming entitlement to shutdown benefits under their terminated plan, which PBGC trusteed in 1996. McLouth had amended those benefits out of the plan in 1995 pursuant to an agreement with the Steelworkers' union and PBGC that sought to avoid the plan's termination. The employees now claim that the agreement and the amendment were illegal. They also challenge as a prohibited transaction the transfer of $12.7 million of plan assets to PBGC as plan trustee to finalize the termination of a predecessor plan. PBGC moved to dismiss the suit, but the district court denied that motion. The court also certified the suit as a class action but granted PBGC's motion to strike the demand for a jury trial and dismissed the employees' common law claim for misrepresentation. Discovery is ongoing in the case.

Information Systems and Security

PBGC made further progress in 2001 in enhancing the security of its existing information systems and data. The Corporation completed the last item on its information security action plan by adding encryption capability to its network infrastructure. Any information passing across PBGC's Wide Area Network, which connects PBGC headquarters to its field benefit administrators and custodian bank, is now encrypted for privacy. PBGC also updated its security plans, conducted system reviews and enhanced its annual security awareness training with training designed for new employees and system administrators and monthly awareness notices to all employees.

In January 2001, PBGC's Inspector General conducted a penetration test of PBGC's network security as a follow-up to earlier work done in 1999. The Inspector General found that PBGC had significantly improved its security against external and internal attacks or abuse. The Inspector General was unable to gain significant access to PBGC's systems in this round of testing.

PBGC has effectively hardened its systems against attack by virus and remains committed to actively protecting its systems. During the year, the Corporation's information security was tested through numerous attacks by "worms" and "viruses," which PBGC survived without damage.

As the year closed, PBGC successfully transferred its performance accounting system from an off-site Department of Commerce facility to an in-house client-server system. The Commerce Department had been operating the system under a special arrangement with PBGC. By moving the system (which PBGC uses to account for revolving fund activities) to PBGC headquarters, the Corporation will save $400,000 in operating expenses in the first year alone, and more in succeeding years.

PBGC continued developing and testing its Continuity Of Operations Plan, under which it would move all operations offsite in case of an emergency at PBGC headquarters. Completion of a fully functional plan is targeted for 2003.

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