SAFEGUARDING SOLVENCY

Record losses from completed and probable terminations of underfunded pension plans pushed the single-employer program into a year-end deficit for the first time since 1995 and to its largest deficit since 1986, reversing six consecutive years of positive net position in a single year. The multiemployer program recorded a financial gain for the year that restored a measure of financial strength to the program.

Financial Management

The net annual loss sustained by the single-employer program in 2002 was due primarily to losses from completed and probable terminations of underfunded plans, which accounted for more than 80 percent of the total annual loss. The Corporation’s statutory restriction to fixed-income instruments for a large portion of its investments worked in PBGC’s favor during 2002. Despite the volatility of the financial markets, the single-employer program more than offset its loss from equity investments with gains from fixed-income investments, providing an overall investment gain for the year. Premium revenues, which declined slightly, fell to their lowest level in 11 years while the program’s benefit payments exceeded $1.5 billion for the first time in PBGC history. For the year, the record losses from plan terminations in combination with the program’s other losses produced a total net loss for the year of $11.4 billion, reversing the program’s financial position from a net surplus of about $7.7 billion at September 30, 2001, to a net deficit of about $3.6 billion. Despite the loss and resulting deficit, the insurance program’s total assets of more than $25.4 billion assure that PBGC will be able to continue meeting its benefit and other obligations while it examines ways to restore a positive net position for the single-employer program.

The multiemployer program reported a net gain of $42 million as the program benefitted from reduced losses from financial assistance and increased investment income. With total assets of $944 million and liabilities totaling $786 million, primarily for nonrecoverable future financial assistance, the multiemployer program remained financially sound with an end-of-year surplus of $158 million. Investment income totaled $118 million while premium income from insured multiemployer plans increased slightly to about $25 million.

PBGC’s financial statements have received their tenth consecutive unqualified opinion from the Corporation’s auditors. The 2002 audit was again performed by PricewaterhouseCoopers LLP under the direction and oversight of PBGC’s then-Acting 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, 2002, the value of PBGC’s total investments in the single-employer and multiemployer programs, including cash, was approximately $26 billion. The Revolving Fund’s value was $17 billion and the Trust Fund’s value was $9 billion. Cash and fixed-income securities represented 72 percent of the total assets invested at the end of the year, as compared to 71 percent at the end of 2001, while the equity allocation remained at 28 percent of total assets invested. PBGC’s current allocation to equities is the maximum currently allowable to PBGC within its investment portfolio structure, 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.

Results for fiscal year 2002 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 2.1% return on total invested funds. PBGC’s fixed-income program returned 14.4% while its equity program declined 17.0%. 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 $2.2 billion from fixed-income investments and a loss of about $1.9 billion from equity investments.

Contract Management: Of the contracts issued during 2002, PBGC awarded 89 percent through full and open competition. This is a slightly lower percentage than in recent years due to the Corporation’s need to increase certain existing contracts in order to respond quickly to the unanticipated workload, particularly plan-processing obligations, that arose during the year. The remainder of PBGC’s contracts were sole-source contracts or set-asides for minority bids.

In a departure from past practice, during the year PBGC developed a solicitation for a performance-based contract. Prior to 2002, PBGC’s contracts essentially had been fee-for-service arrangements where contractors were paid for work without reference to measurable standards for quality. Under a performance-based contract, contractor payment will be based upon performance in relation to a measurable standard. The performance standard will be based on the services being provided. PBGC is reviewing all of its new contractual activities for applicability of performance-based contracting and will apply the new type of contract on a case-by-case basis. The Corporation intends to expand use of this form of contract in 2003 and future years.

The Corporation continued its emphasis on timely payments to vendors in order to reduce the late fees that PBGC has been paying. Through this effort, the amount of interest that PBGC paid due to late payment of invoices fell from about $29,000 in 2001 to less than $900 in 2002, a decrease of 97 percent.

As another means of improving service to PBGC vendors, PBGC created an e-mail address specifically for vendors (invoicemanager@pbgc.gov). The address provides vendors an easy way to submit questions and receive responses concerning invoices and payments.

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, 2002, as disclosed in Note 7 of the financial statements, was $35 billion (valued using data as of December 31, 2001), compared to $11 billion for fiscal year 2001.

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 Single-Employer Program 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 and the assumptions used in running the model, 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.)

PIMS starts with data on PBGC’s net position (a $3.6 billion deficit in the case of FY 2002) and data on the funded status of approximately 350 plans that is weighted to represent the universe of PBGC-covered plans. The model produces results under 5,000 different simulations.

Under the model, median claims over the next 10 years will be about $1.85 billion per year (expressed in today’s dollars); that is, half of the simulations show claims above $1.85 billion per year and half below. The mean level of claims (that is, the average claim) is higher, about $2.25 billion per year. The mean is higher because there is a chance under some simulations that claims could reach very high levels. For example, under the model there is a 10 percent chance that claims could exceed $4.3 billion per year.

PIMS then projects PBGC’s potential financial position by combining simulated claims with simulated premiums, expenses, and investment returns. The probability of a particular outcome is determined by dividing the number of simulations with that outcome by 5,000.

The median outcome is a $9.6 billion deficit in 2012 (in present value terms). This means that half of the simulations show either a smaller deficit than $9.6 billion, or a surplus, and half of the simulations show a larger deficit. The mean outcome is a $12.6 billion deficit in 2012 (in present value terms).

The median projected financial position is considerably lower than last year's median projection, which was based on a wide range of possible outcomes for each year of the projection. The actual experience of the last year approaches the most severe end of the range. For example, last year’s combination of poor financial returns in PBGC-covered plans with a decline in interest rates generated an increase in underfunding that was exceeded in less than five percent of last year’s simulations of the year 2002.

The poor returns and interest rate drop also worsened PBGC’s own financial position. In addition, record terminations of underfunded pension plans and financial weakness among many plan sponsors further eroded PBGC's financial position and significantly increased PBGC's exposure to future claims. These factors, together, produced a substantial change in the starting point of the projections, which led directly to a significant change in the median projection.

The model shows a wide range of outcomes that are possible for PBGC over the next 10 years. The other statistics give further details on the distribution of outcomes. The standard deviation is a measure of how widely the distribution is spread over its range and the percentiles indicate the likelihood of a position below particular values. For example, the model shows a 10 percent chance that the deficit could be as large as $43.8 billion and a 10 percent chance that PBGC could have a surplus of $15.6 billion or more. The probability of a surplus of any amount in 2012 is 30 percent.

Loss Prevention

Under the Early Warning Program, PBGC monitors certain companies with underfunded pension plans. Through this effort, PBGC identifies corporate transactions that could jeopardize pensions and works with companies sponsoring underfunded pension plans to arrange suitable protections for those pensions and the pension insurance program. One important source of information about underfunded plans is the report that must be filed annually with PBGC under Section 4010 of ERISA by companies that sponsor plans with significant amounts of underfunding. While PBGC does not confine its analyses simply to the information submitted under Section 4010, the Corporation continues to find this information to be extremely useful.

Loss prevention activities during 2002 continued to be dominated by bankruptcies as PBGC faced an escalating number of cases featuring more difficult issues and substantially increased amounts of pension underfunding. PBGC participated in more bankruptcies through membership on creditors’ committees in order to keep adequately informed on cases of importance to the pension insurance program and to make a difference where possible in the treatment of pension plans. The information it obtained through these committees enabled the Corporation to take timely action to protect the pension insurance program and the underfunded pensions of affected plan participants.

Despite its focus on bankruptcies, the Corporation also completed non-bankruptcy-related agreements valued at about $454 million. These agreements provided contributions, security, and other protections for the pensions of about 57,000 workers and retirees.

Litigation

Legal challenges to PBGC policies and positions continued in 2002. At the end of the year, PBGC had 86 active cases in state and federal courts and 527 bankruptcy cases.

Major cases in 2002 included:

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 were underfunded by about $19 million as of 1999. While undergoing reorganization in bankruptcy in 1999, 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. During 2002, Raytech withdrew its appeal of that decision and agreed to assume, maintain and fund the plans. The bankruptcy court approved the agreement shortly after year-end.

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 filed suit in 1996 alleging that PBGC breached its fiduciary duties, primarily by delaying issuance of participants’ pension benefit determination letters. Plaintiffs sought to replace PBGC with a new trustee. PBGC moved to dismiss. After issuing three conflicting decisions over a period of three years on PBGC’s motion, the district court certified the case for immediate appeal to the Second Circuit. The Second Circuit initially took the case but, after full briefing and oral argument, the court reversed itself and dismissed PBGC’s appeal for lack of appellate jurisdiction. The case returned to district court for further proceedings. The issues in the district court include the technical legal issue of whether PBGC operates as a “trustee” or a “statutory guarantor” when calculating guaranteed benefits, and whether PBGC has certain duties to provide information to participants. Pre-trial discovery is scheduled to conclude in November 2002, after which PBGC will seek summary judgment.

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. The ultimate decision in this case will not increase or decrease the benefits payable to the plan's 35,000 participants, virtually all of whom have now been sent their benefit determinations.

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. The plans cover about 36,500 people, including more than 15,000 active TWA workers, and were underfunded by about $700 million.

Even though 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 2002 the district court dismissed the complaint, finding that PBGC's termination of the Pilots Plan pursuant to the terms of the 1993 settlement agreement did not violate ERISA and was not arbitrary or capricious. The plaintiffs have appealed the district court decision to the U.S. Court of Appeals for the District of Columbia, and their appeal is pending.

On May 15, 2002, eight former TWA pilots filed another lawsuit challenging the termination. The plaintiffs in this second suit allege essentially the same set of facts as ALPA did in the first case and make the same legal claim – that the termination was contrary to ERISA. On July 19, the district court stayed proceedings in the second suit pending the decision of the Court of Appeals in the earlier-filed ALPA case.

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 union also told PBGC that there had been no “permanent shutdown” as of the proposed plan termination date, and PBGC relied on that representation in establishing the termination date. The employees now claim that they are entitled to the benefits. 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 ended on August 31 and dispositive motions are expected to be due in November 2002.

PBGC v. Republic Technologies International: RTI filed for bankruptcy in Ohio in April 2001. Subsequently, RTI negotiated a sale of its principal assets to a buyer who would not assume its four pension plans but would hire approximately 2,500 people covered by the two pension plans negotiated with the United Steelworkers of America (USWA). RTI and the USWA negotiated an agreement requiring RTI to declare a shutdown for purposes of triggering certain shutdown benefits under the pension plans upon the closing of the sale. RTI’s pension plans are underfunded by approximately $310 million, not including $170 million in the additional unfunded shutdown benefits. The sale and the shutdown agreement with the USWA were approved by the bankruptcy court and the sale closed in August 2002.

On June 14, 2002, PBGC published notices of intent to terminate RTI’s pension plans and filed a lawsuit in federal district court in Ohio seeking to terminate the plans, appoint PBGC as statutory trustee, and establish June 14, 2002, as the date of plan termination. PBGC acted to protect the insurance program from unreasonable losses, amounting in this case to about an additional 50 percent of an already substantial amount of underfunding.

The bankruptcy court found that the negotiated shutdown agreement between the company and the union did not bind PBGC. RTI and USWA are contesting the termination action and the June 14 date of plan termination. The termination action was still pending at year-end.

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