Potential PBGC problem: $13.5 billion GM liability

Pension & Investments:

A GM bankruptcy could become the PBGC's biggest nightmare because the automaker could dump as much as $13.5 billion in unfunded pension liabilities onto the PBGC — the largest ever from a single company — if GM were unable to fund its US defined benefit plans and terminated them. The claim would be almost twice as large as the current record of $7.5 billion from the 2005 termination of United Airlines pension plans.

NYT:

Decisions that the government will make soon on the future of GM and Chrysler could accelerate the decline of traditional pension plans. “If one of these companies solves its pension problem by shunting it off to the federal government, then for competitive reasons the others have to do the same thing,” said Zvi Bodie, a professor of finance at the Boston University School of Management and longtime observer of the government’s pension insurance system. “That is the death spiral.” For years, traditional pensions have been in a slow decline, with troubled sectors like aviation and steel shedding their plans in bankruptcy court as 401(k) plans have taken hold. But big sectors, particularly manufacturing and financial services, have clung to the old plans. The PBGC has roughly $67 billion in assets to cover the benefits of nearly 4,000 failed pension plans; GM has $84 billion just to cover promises to its own workers. For traditional pension plans, “maybe this is their last stand,” said Jeffrey Cohen, a partner with the law firm Ivins, Phillips & Barker in Washington who was chief counsel for the PBGC from 2005 to 2007. If the automakers’ plans fail, he added, “the biggest domino will have fallen for the PBGC.”

YRC aims to fund pensions with real estate

YRC Worldwide, the biggest trucking company in the US, is negotiating with its unions to allow it to suspend cash payments to its defined-benefit pension plan and to pledge real estate instead. It would be the first major US company to use its real estate to help meet its pension obligations.

I find this vaguely disturbing. Also, I'm surprised that no US source seems to be carrying this story.

Unprepared for retirement

Among workers without a defined benefit pension plan at work, 41 percent believe they have such a plan.

Mother Of All Bad ideas

In Florida, a plan recommended by the Citizens Property Insurance Corp. Mission Review Task Force would allow the state to borrow $2 billion from the state pension fund to back up the catastrophe fund in event of a hurricane.

What could possibly go wrong?

[Thanks to MPC for the link.]

FSA!

I became an FSA at 3:30 this afternoon. (The picture is from the conferment ceremony this evening.)

http://www.soa.org/files/pdf/edu-2009-03-fsa-names.pdf

Pension Relief For Companies With Strings

Corporations might get relief from stringent pension-law funding requirements — but with a big string attached that some experts see as a step toward a mandatory retirement system. Under a proposal now being considered by senior Democratic congressmen, companies with active plans would get a break from the 2006 Pension Protection Act's onerous new funding requirements, but only if they agree not to freeze their plans to new employees — perhaps for several years. Companies also would have to agree not to terminate their plans to get the funding relief. In addition, frozen plans would not qualify, even if those freezes apply only to new employees.

State Farm exercises nuclear option in Florida

Florida's largest private insurer is pulling the plug on homeowners' policies in the state, citing the losses suffered since the brutal 2004 hurricane season. The decision by State Farm Florida comes two weeks after state insurance regulators rejected the company's request to raise rates. The decision means State Farm Florida - a subsidiary of State Farm Mutual - will no longer renew policies for its roughly 1.2 million customers in the Sunshine State. "This is not an action we wanted to take, but one we must take given the realities of the Florida property insurance market," company President Jim Thompson said in a statement announcing the decision. The company said it has paid out $1.21 in claims for every dollar of premiums it has collected since 2000 and suffered billions in losses after the 2004 hurricane season, when four major storms hit the state. And it said its net worth had dropped by nearly 25% since 2006 even with no major disasters.

Thanks a lot, Gov. Crist! Any other bright ideas?

I want to be an actuary

Pension & Investments Article

Interest among US pension plan sponsors in Liability Driven Investing will reach a "tipping point'' within five years, with the development of more sophisticated strategies paving the way for near universal acceptance, a new report from Russell Investments predicts. That will happen despite short-term obstacles thrown up by the market trauma of 2008. For example, the severe underfunded status of many pension plans now will make it more difficult to aggressively implement an LDI program over the next year or so. Likewise, market mayhem will temporarily damp demand for essential hedging tools such as swaps, while setting back the development of pension buyout markets that had been picking up steam in countries such as the United Kingdom. In the end, the psychological impact of the market maelstrom that corporate pension sponsors are living through now will outweigh such short-term obstacles to LDI, predicted Robert Collie, director of investment strategy with Russell.

Mr. Collie said 2008 "is going to be one of those years which permanently changes the psyche of the people who lived through it,'' resulting in a generation of pension plan executives who will "see the world differently.'' At present, LDI is the "foundation'' for the investment strategies of perhaps 20% to 25% of US pension plans, and their experience over the past year is shaping the ongoing development of efforts to better match assets and liabilities. Part of the fallout from the past year's market fireworks will be a broadening of the scope of the risks LDI programs are designed to hedge against, moving beyond the preoccupation in recent years on interest-rate risk. For example, the mismatch that occurred between the valuations of the Treasuries anchoring many LDI programs and the high-grade corporate bond yield used to calculate the current value of future pension obligations has led to a much greater awareness of the need to take credit risk into account. Over the past year, investors seeking a safe haven have poured money into Treasuries, leading to higher prices and lower yields, while fleeing corporate bonds, which led to lower prices and higher yields. As a result, pension funds with LDI programs that added to their Treasury holdings have enjoyed an unexpected gain, as the value of their assets jumped while rising corporate rates slashed their liabilities. In effect, while LDI programs have failed to match assets and liabilities, they've done so in a way that has favored those pension plans - a lucky break. Still, the understanding that things could also have moved in an unfavorable direction has hammered home the point that "tactical considerations'' cannot be ignored, and a number of plans have taken steps to lock in the gains they've enjoyed.

Other risks that have come to the fore as a result of the past year include counterparty risk, which has lowered demand for swaps, and immunization schemes, such as pension buyouts. Underlying market demand will ensure that the current setbacks are temporary, even if the exact path for the development of key LDI components can't be sketched out with certainty today. It's clear that 20 years from now, there needs to be a long-term solution for companies that have frozen their pension plans and require a more cost-effective way to manage those assets than retaining an in-house staff, he said. Within three to five years, Russell officials expect depleted pension funding levels to have recovered, either by a rebound in equity markets or the significant contributions required under PPA. At that point, this battle-scarred generation of pension fund executives will begin implementing LDI programs in droves. Then, with 50% or more of pension plans adopting LDI programs, the herd mentality will kick in, and it will be a very short distance "from tipping point to game over."

Risk NON-Management

The credit crisis may be a year and a half old. But according to a new survey by audit firm KPMG, many bank executives are still struggling to find a seat at the table for their companies’ risk managers. In fact, despite hundreds of billions of dollars in write-downs of toxic assets, most bank executives continue to dismiss risk management. Indeed, three quarters of the risk managers polled said risk management is “stigmatized” at their institution. That group said risk management is seen as a mere “support function”—something akin to HR or IT. What's more, some 45% of the bank execs surveyed said their boards lacked expertise in managing risk. And barely half said they had senior managers with “deep practical risk management experience” working for their companies. “Risk management programs may have been in place at most banks, but the survey indicates there were shortcomings around the execution of those plans,” said Michael Conover, a principal in KPMG’s Financial Risk Management practice, in a statement. “Financial models don't prevent poor risk decisions, people do.”

Calvin & Hobbes

Passed FETE - My Last Fellowship Exam!

For posterity, here's the very long start-and-stop process that brought me to fellowship:

May 1996: Course 100
(which became Course 1 on 1/1/2000 and subsequently course P in the current system)

May 1996: Course 110
May 1999: Course 141
(these two combined to grant credit on Course 2 on 1/1/2000 and subsequently course FM in the current system)

May 2001: Course 3
(which converted to courses MFE and MLC in the current system)

November 2001: Course 4
(which converted to course C in the current system)

November 2004: Course 5
July 2006: Course 7
(these two converted to FAP in the current system)

May 2008: Course APMV

November 2008: Course FETE

Auditors urge rethink on pension calculations

Auditors are pressing companies to reconsider how they calculate their pension liabilities and urging them to use formulas that could give rise to much larger reported deficits than would be the case if they stayed with the current approach.

Critics say taxpayers may be paying for AIG's discounts

AIG is engaging in extreme price cuts to hang onto market share and may be using money from its federal bailout to pay for it, insurance insiders said. The CEO of Liberty Mutual said AIG is "doing some very stupid things" that are in danger of destabilizing the insurance market. An AIG spokesman denied that it is cutting prices.

Worker, Retiree and Employer Recovery Act of 2008

Was passesd by the House on Wednesday and the Senate yesterday. It is unclear whether Bush will sign it.

The Act

• Provides that shortfall amortization contributions will be based on a percentage of the funding target. The percentage will be 92% in 2008, 94% in 2009 and 96% in 2010, before reaching 100%. For example, under PPA a plan funded at 90% in 2008 had to establish an shortfall base equal to the entire 10% unfunded. Under the Act, this same plan would establish a shortfall base of only 2%.
• Permits asset smoothing.
• Provides that for the first plan year beginning on or after 10/1/2008 the test for the restriction on benefit accruals will be done using the greater of the current year or prior year AFTAP.
• Clarifies that plan expenses must be included as part of the target normal cost.
• Clarifies that target normal cost is reduced by the amount of mandatory employee contributions expected to be made during the year.
• Contains other provisions such as a waiver of age 70-1/2 distributions for 2009 for defined contribution plans, multiemployer funding relief, changes to maximum benefits for small employers and airline specific provisions. In addition, the Act includes some technical corrections.

NJ is insolvent due to pension plan

The state of New Jersey is insolvent. Bankrupt might be a better word. New Jersey is $60 billion in the hole on pension funding and the Governor is planning on skipping payments in a "pension payment holiday" until 2012 so as to not increase property taxes. To top it off, the ongoing plan assumptions are 8.25%. Sorry NJ, that simply is not going to happen.
[Reference: http://globaleconomicanalysis.blogspot.com/]

Earlier blog posts on the ongoing disaster with the NJ pension system:
June 15, 2007
April 12, 2007
April 6, 2007
March 16, 2007

Bad bad bad news for US pensions

On the expense side...

Assets of the 100 biggest US company pension plans, which account for 70% of defined benefit pension assets at corporations, fell by an estimated $120bn in October - the largest monthly loss in at least eight years. In 2008, PPA cash requirements were an estimated $32bn, which will likely rise to about $93bn in 2009.

On the funding status side...

If the spread between Treasuries and high-grade corporate bond yields hadn't more than doubled to 3.3 points over the past 12 months, the combined $60 billion surplus for S&P's 1,500 companies at the end of 2007 would now be a deficit of more than $400 billion. With the drop in liabilities due to a higher discount rate, however, the deficit as of Sept. 30 was only $35 billion.

Worker, Retiree and Employer Recovery Act of 2008 (WRERA)

Senate Finance Committee Chairman Max Baucus (D-Mont.) and Ranking Member Chuck Grassley (R-Iowa) were joined today by Senate Health, Education, Labor and Pensions Committee Chairman Edward Kennedy (D-Mass.) and Ranking Member Mike Enzi (R-Wyo.) in announcing legislation to help ease the financial strain on American families and businesses due to the lagging economy. The package includes important modifications to pension distribution requirements for seniors and businesses, as well as provisions included in the Pension Protection Technical Correction Act of 2008, originally passed by the Senate in December 2007 and the House in March and July of this year. The bipartisan package also extends for one year business tax relief that was included in the first economic stimulus package, and allows companies to write off a greater percentage of their investments in business assets to free up cash for payroll and other expenses.

Actuaries versus quants

A different angle than the stuff you usually see, from Paul Wimott.

Those working in the fields of actuarial science and quantitative finance have not always been totally appreciative of each others’ skills. Actuaries have been dealing with randomness and risk in finance for centuries. Quants are the relative newcomers, with all their fancy stochastic mathematics. Rather annoyingly for actuaries, quants came along late in the game and thanks to one piece of insight in the early 1970s completely changed the face of the valuation of risk.

The insight I refer to is the concept of dynamic hedging, first published by Black, Scholes and Merton in 1973. Before 1973, derivatives were being valued using the ‘actuarial method’, in a sense relying, as actuaries always have, on the Central Limit Theorem. Since 1973 all that has been made redundant. Quants have ruled the financial roost. However, this might just be the time for actuaries to fight back.

I am putting the finishing touches to this article a few days after the first anniversary of the ‘day that quant died’. In early August 2007, a number of high-profile and previously successful quantitative hedge funds suffered large losses. People said that their models “just stopped working”. The year since has seen a lot of soul searching by quants — how could this happen when they’ve got such incredible models?

In my view, the main reason why quantitative finance is in a mess is because of complexity and obscurity. Quants are making their models increasingly complicated, in the belief they are making improvements. This is not the case. More often than not each ‘improvement’ is a step backwards. If this were a proper hard science then there would be a reason for trying to perfect models. But finance is not a hard science, one in which you can conduct experiments for which the results are repeatable. Finance, thanks to it being underpinned by human beings and their wonderfully irrational behaviour, is forever changing. It is, therefore, much better to focus attention on making the models robust and transparent rather than ever more intricate.

As I mentioned in a recent blog, there is a maths sweet spot in quant finance. The models should not be too elementary so as to make it impossible to invent new structured products, nor should they be so abstract as to be easily misunderstood by all except their inventor (and sometimes even by them), with the obvious and financially dangerous consequences. Our goal is to make quant finance practical, understandable and, above all, safe.

When banks sell a contract they do so assuming it is going to make a profit. They use complex models, with sophisticated numerical solutions, to come up with the perfect value. Having gone to all that effort they then throw it into the same pot as all the others and risk-manage en masse. The funny thing is they never know whether each individual contract has “washed its own face”. Sure they know whether the pot has made money, their bonus is tied to it. But each contract? It makes good sense to risk-manage all contracts together but not to go into such obsessive detail in valuation when ultimately it’s the portfolio that makes money, especially if the basic models are so dodgy. The theory of quant finance and the practice diverge. Money is made by portfolios, not by individual contracts. In other words, quants make money from the Central Limit Theorem, just like actuaries, it’s just that quants are loath to admit it! Ironic.

It’s about time that actuaries got more involved in quantitative finance and brought some common sense back into this field. We need models people can understand and a greater respect for risk. Actuaries and quants have complementary skill sets. What high finance needs now are precisely the skills that actuaries have, a deep understanding of statistics, an historical perspective, and a willingness to work with data.

Thanks to CP for the link.

Insurance News

Hartford fell 10.24 (51.56%) to 9.62 after taking a $2.5 billion investment from German insurer Allianz.

In much more important news

The FDIC's powers could be expanded if Congress decides to shift insurance companies from state regulation to federal regulation, Sheila Bair said. The FDIC could start providing guarantees for insurance companies, much like it already guarantees the deposits of most US banks, if the insurance industry comes under federal regulation.