SINGLE-EMPLOYER PROGRAM EXPOSURE

The Employee Retirement Income Security Act requires that the PBGC annually provide an actuarial evaluation of its expected operations and financial status over the next five years. The PBGC historically has extended these forecasts to cover 10 years.
The PBGC=s Aexpected claims@ are dependent on two factors: the amount of underfunding in the pension plans that the 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 currently financially weak firms. The financial health of a plan sponsor is reflected in factors such as whether the firm has a below-investment-grade bond rating. The amount of underfunding for plans of these financially weak companies is based on the best available data, including the annual filings that certain companies with underfunded plans are required to make to the PBGC under Section 4010 of ERISA.

For purposes of its financial statements, the PBGC classifies the underfunding for vested benefits in the plans of financially weak companies as Areasonably possible@ exposure, as required under accounting principles generally accepted in the United States of America. The Areasonably possible@ exposure as of September 30, 2007, as disclosed in Note 7 of the financial statements, was $73 billion (valued using data as of December 31, 2005), compared to $108 billion for fiscal year 2005.

METHODOLOGY FOR CONSIDERING LONG-TERM SINGLE-EMPLOYER PROGRAM CLAIMS

No single underfunding number or range of numbers is sufficient to evaluate the PBGC’s exposure and expected claims over the next 10 years. Claims are sensitive to changes in interest rates and stock returns, overall economic conditions, contributions, changes in benefits, the performance of some particular industries, and bankruptcies. Large claims from a small number of terminations characterize the Corporation’s historical claims experience and are likely to affect the PBGC’s potential future claims experience as well.

The 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. PIMS is not a predictive model and it does not attempt to anticipate behavioral responses by a company to changed circumstances. (For additional information on PIMS and the assumptions used in running the model, see the PBGC’s Pension Insurance Data Book 1998, pages 10-17, which also can be viewed on the PBGC’s Web site at www.pbgc.gov/publications/databook/databk98.pdf.)

PIMS starts with data on the PBGC’s single-employer net position (an $18.1 billion deficit in the case of FY 2007) and data on the funded status of approximately 400 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 $1.5 billion per year (expressed in today’s dollars); that is, half of the simulations show claims above $1.5 billion per year and half below. The mean level of claims (that is, the average claim) is higher, about $1.9 billion per year. The mean is higher than the median 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 $3.7 billion per year for a present value of $37 billion over the 10-year period. PIMS then projects the 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 $15.4 billion deficit in 2016 (in present value terms). This means that half of the simulations show either a smaller deficit than $15.4 billion, or a surplus, and half of the simulations show a larger deficit. The mean outcome is a $17.6 billion deficit in 2016 (in present value terms).

The median projected financial position is a smaller deficit than shown in last year’s median projection, both of which were based on a wide range of possible outcomes for each year of the projection. A number of factors contribute to the change in the projected deficit. A primary factor is the reduction in the PBGC’s deficit from 2005 to 2007, which was largely attributable to the airline relief provisions in the Pension Protection Act of 2007 (PPA). These provisions led the PBGC to sharply reduce the amount of “probable” liabilities reflected on the PBGC’s balance sheet. Another factor that significantly reduces the projected deficit is an increase in projected variable-rate premium revenue due to PPA provisions that increase the amount of underfunding subject to the premium. Two other significant factors partially offset the effects of the starting deficit improvement and the variable premium revenue increase. The probable liabilities removed from the PBGC’s balance sheet were subsequently returned to the PIMS projection of future claims. Those liabilities, attributable to plans of sponsors that remain financially troubled, are associated with a significant increase in projected claims. Also, the PPA changes to the funding rules (for example, measuring funding targets after 2005 based on the corporate bond rates now prescribed by the PPA rather than Treasury bond yields) are responsible for a further increase in projected claims. However, the projections do not reflect the increase in projected claims attributable to the PPA's plan-specific mortality provisions.

The following graph illustrates the wide range of outcomes that are possible for the PBGC over the next 10 years. The other statistics listed on the graph 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 larger than $39.0 billion and a 10 percent chance that the PBGC could have a surplus of $2.4 billion or more. The probability of a surplus of any amount in 2016 is thirteen percent.

ADDITIONAL INFORMATION REQUIRED BY THE PENSION PROTECTION ACT OF 2007

The Pension Protection Act requires that the PBGC’s Annual Report include a summary of the PIMS microsimulation model, “including the specific simulation parameters, specific initial values, temporal parameters, and policy parameters used to calculate the financial statements for the corporation.”

It also requires that this Report include a comparison of (a) the average return on investments earned with respect to assets invested by the PBGC for the year to which the report relates and (b) an amount equal to 60 percent of the average return on investment for the year in the Standard & Poor’s 500 Index plus 40 percent of the average return on investment for such year in the Lehman Aggregate Bond Index (or in a similar fixed income index), and a statement regarding the deficit or surplus that the PBGC would have had for the year if it had earned the return described in (b) with respect to its invested assets.

A Summary of PIMS: The analysis of the PBGC’s projected financial position was performed using the PBGC’s Pension Insurance Modeling System. PIMS has a detailed database of nearly 440 actual plans, sponsored by 330 firms, which represent about 45 percent of liabilities and underfunding in the single-employer defined benefit system. The database includes the plan demographics, plan benefit structure, asset values, liabilities, and actuarial assumptions. It also includes key financial information about the employer sponsoring the plan.

The PIMS database contains pension plan information from Schedule B of the Form 5500 (Annual Return /Report of Employee Benefit Plan), generally from the 2004 plan year. In addition, more recent data available from ERISA Section 4010 filings is utilized for certain large underfunded plans.

PIMS simulates contributions, premiums, and underfunding for these plans using the minimum funding and premium rules as modified by the PPA, and then extrapolates the results to the universe of single-employer plans. It also uses the employer’s financial information as the starting point for assigning probabilities of bankruptcy, from which it projects losses to the insurance program.

The PIMS model is not predictive. That is, it is not intended to provide a single best estimate of future events. When used in a stochastic (random) mode, PIMS provides a range of possible future outcomes and quantifies the likelihood of these outcomes.

General Assumptions

Projections of claims against the insurance program are made stochastically. Claims against the pension insurance program are modeled by simulating the occurrence of bankruptcy for plan sponsors. The model reflects the historical relationship between the probability of bankruptcy and the firms’ financial health variables (equity to debt ratio, cash flow, firm equity, and employment). For each period, the model assigns a random change in each of these variables to each firm correlated with changes in the economy. The simulated financial health variables determine the probability of bankruptcy for that year.

The model assumes, with the exception noted below regarding variable-rate premiums, that all plan sponsors contribute the minimum amount each year. The model runs 500 economic scenarios (varying interest rates and equity returns), with each plan sponsor being “cycled” though each economic scenario 10 times (with varying financial health experiences, bankruptcy probabilities, etc.) PIMS then extrapolates the results of these simulations to the universe of insured single-employer plans.

All the following variables are stochastically projected:

 Interest rates, stock returns and related variables (e.g., inflation, wage growth, and multiplier increases in flat dollar plans are determined by interest rates in PIMS).

 Sponsor financial health variables (equity to debt ratio, cash flow, firm equity, and employment).
 Asset returns. At the beginning of each scenario, each plan’s asset allocation is randomly selected from a pool of allocations that reflects historic differences across plans in investment strategies. Each plan’s asset return also has a stochastic element that is uncorrelated with the simulated market rates and is uncorrelated across plans.

 Plan demographics. The number of active participants for a plan varies with its sponsor’s total employment level. Age and service also vary over time due to retirement and hiring assumptions. The numbers, ages, and benefits of retired and terminated vested participants vary depending on mortality, separation and retirement assumptions.

 Probability of bankruptcy. Sponsors are subjected to an annual stochastic chance of bankruptcy. A plan presents a loss to participants and/or the pension insurance program if its sponsor is simulated to experience bankruptcy and the plan is less than 80 percent funded for termination liability. Losses to the insurance program are calculated by averaging the losses in all simulations across all scenarios.

The most important variables in the stochastic simulations are stock returns and interest rates. Stock returns are independent from one period to the next. To determine a simulated sequence of stock returns, the model randomly draws returns from a distribution that reflects historical experience going back to 1926. Unlike stock returns, interest rates are correlated over time. With the model, the interest rate for a given period is expected to be equal to the interest rate for the prior period, plus or minus some random amount. The random draws affecting the bond yield and stock returns are correlated according to an historical estimate. Stock returns are more likely to be high when the bond yield is falling and vice versa.

Mortality

For purposes of projecting plan population — the 1994 Group Annuity Mortality table (94 GAM).
For determining the amount of underfunding at termination — 94 GAM set forward one year and projected to valuation year plus 10.
For determining funding targets (liabilities):
Prior Law (for years before 2008)

For current liability purposes, the current table (1983 GAM) is assumed to remain in effect until 2007. For 2007, RP2000 projected with scale AA to the year of valuation plus 10 is used to determine current liability.
For purposes of the current funding rules, the actuary’s selected table is assumed to remain unchanged throughout the projection period.

- PPA (for 2008 and later years)

The PPA provides that the Department of the Treasury will prescribe a table. For this purpose, we assumed the prescribed table will be the RP2000 table projected with scale AA to the year of valuation plus 10.

Contribution Level/Credit Balances

The credit balance at the end of the 2005 plan year was derived by reflecting available information on actual contributions made through 2005. From there, the credit balance was increased each year by the valuation interest rate and decreased by the amount assumed to be used to satisfy the minimum funding requirement. For purposes of modeling future claims in PIMS, it is assumed that employers will contribute the minimum required amount each year and that any credit balance remaining when the new rules take effect will be used to the maximum extent permitted until the balance is completely depleted.

Benefit Improvements

For flat-dollar plans, benefit multipliers are assumed to increase annually by the rate of inflation and productivity growth. For salary-related plans, the benefit formula is assumed to remain constant, but annual salary increases are reflected based on the rate of inflation, productivity growth, and a factor measuring merit and/or seniority.

Benefit Restrictions Under the PPA

Accrual restriction: Plans with funded percentages below 60 percent must cease benefit accruals. PIMS reflects this rule, and assumes that once a plan is frozen, it will remain frozen, even if the percentage increases above 60 percent at some future time.
The PPA requires that when determining funding percentages for triggering benefit restrictions, assets are reduced by credit balances. The PPA also provides that sponsors have the option of “de-classifying” credit balance assets at any time. By de-classifying a credit balance, a sponsor may be able to raise the funded percentage to the level needed to avoid a benefit restriction. For modeling purposes, it is assumed that sponsors will choose to “de-classify” credit balances to the extent necessary to avoid the benefit freeze restriction.
Benefit improvement restriction: As noted earlier, PIMS assumes that salary-related plans will not increase benefits and that hourly plans will increase benefits to reflect the rate of inflation plus productivity growth. But, under the PPA, benefit increases that do not exceed the average wage increase of affected employees are not subject to the benefit improvement restriction. Therefore, this provision was assumed to have no effect.

Variable-Rate Premiums

The PBGC’s experience has been that many companies make contributions in excess of the minimum in part to avoid or reduce their variable-rate premium payments. Virtually all of these companies have been at a low risk of bankruptcy and their plans have not accounted for a material portion of the PBGC’s claims. In contrast, the relatively small number of plans that result in claims are sponsored by companies that historically have not made contributions above the required minimum. Accordingly, variable-rate premium projections are modeled assuming aggregate contribution levels above the minimum levels, with an adjustment for additional future aggregate contributions that is based on the PBGC’s historic premium experience.

The PBGC’s Assets

Consistent with the PBGC’s investment policy, PIMS assumes that the PBGC allocates 20 percent of its assets to equity securities (the mid-point of the policy's target range) and that it maintains a bond portfolio that minimizes the volatility of the PBGC's assets and liabilities due to interest-rate risk.

Discounting Future Contributions/Claims
For calculations involving discounting future amounts, the discount rate used is the 30-year Treasury rate assumed to be in effect for the particular year and economic scenario.

Comparison of Returns: The PBGC faces numerous and complex risks in its roles as a financial guaranty insurer and as an annuity provider. The investment policy governing the Corporation's investment program addresses the economic, financial market, and interest rate risks faced by an insurer of underfunded pension plans and the somewhat similar financial market and interest rate risks of an annuity provider. Under this policy, the PBGC maintains a risk-controlled investment portfolio designed to limit exposure to changes in interest rates as well as to uncorrelated downturns in the financial markets. The policy establishes that the investment program’s primary objective is to limit volatility in the PBGC's financial condition due to a mismatch of the interest rate risks inherent in its assets and liabilities. Although it should yield lower returns over the long run than a policy that invests more in equity instruments, the policy is intended to yield a steady, more consistent return in relationship to the liabilities that it funds.
Under the provisions of the Pension Protection Act of 2007, the PBGC is required to estimate the effect of an asset allocation structure that is currently not employed by the PBGC. This suggested structure has higher interest rate and financial market risks: a 60 percent allocation to the Standard & Poor's 500 equity index and a 40 percent allocation to the Lehman Brothers Aggregate fixed income index. The PBGC has estimated that, for 2007, such an investment structure would have generated a return on total investment funds of 7.9% (compared to the 4.2% produced by the PBGC’s program). This, in turn, would have increased the assets of the Corporation by approximately $1.8 billion and reduced the deficit by a comparable amount.

Analyzing program returns over a one-year period has limited utility, however, given the long-term, cyclical nature of the capital markets. The PBGC has traditionally reported both one-year and five-year returns for its investment program. The comparable annualized returns for the five-year period ending September 30, 2007, would have been 6.4% for the hypothetical portfolio compared to 6.7% for the PBGC’s actual portfolio. Over the five-year period ending September 30, 2007, the hypothetical portfolio would have increased the PBGC's assets by a modest amount, only $300 million more than the $10.5 billion in returns actually generated by the PBGC’s risk-controlled investment program. The increase in assets for the hypothetical portfolio was higher than the actual increase in PBGC assets, despite lower five-year returns, because the bulk of the PBGC’s portfolio outperformance occurred early in the five-year period when its base of invested assets was much smaller.

2007 ANNUAL MANAGEMENT REPORT [AMR dated 11/15/06 to be included]

DIRECTOR'S TRANSMITTAL LETTER

FINANCIAL STATEMENT HIGHLIGHTS

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
MANAGEMENT REPRESENTATION
ANNUAL PERFORMANCE REPORT
CHIEF FINANCIAL OFFICER'S LETTER
FINANCIAL STATEMENTS
NOTES TO FINANCIAL STATEMENTS
ACTUARIAL VALUATION
REPORT OF THE INSPECTOR GENERAL
REPORTS OF INDEPENDENT AUDITOR
FINANCIAL SUMMARY

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