Established by the U.S. government in 1974, the Pension Benefit Guaranty Corporation currently guarantees pension benefits to about 44 million workers in slightly more than 35,000 defined-benefit pension plans. When plan sponsors are unable to meet pension obligations, PBGC steps in.

With so many potential claimants, PBGC is vulnerable to large losses that may have low probabilities. Future claims are sensitive to changes in interest rates and stock returns, overall economic conditions, underfunding in large plans, success or failure of sponsors in particular industries, and rates of bankruptcy of plan sponsors. Failure of a few large sponsors can generate large dollar amounts of claims. Future courses of these factors are uncertain.

To evaluate its risk exposures, PBGC uses a stochastic model— the Pension Insurance Modeling System (PIMS). Into the model PBGC feeds measures of historical behavior (including volatilities, autocorrelations and intercorrelations) of stock returns, interest rates, bankruptcy rates of defined benefit plan sponsors, and relationships between bankruptcy rates to financial ratios, employment counts, and pension data. PBGC also feeds in detailed data on the current state of a set of actual pension plans, which they weight to represent the PBGC-insured, single-employer universe, and data on the current financial health of plan sponsors.

Using the data and random sampling, the model simulates thousands of possible scenario paths up to a designated point in time. On each path, the model simulates claims, premiums, expenses, and investment returns. For the end of each year and for the end of each scenario path, the model calculates PBGC's financial position.

Each scenario position is the net value of PBGC's assets and liabilities. Assets are predominately investments at fair value. Liabilities are predominately the discounted present values of future benefits owed to pensioners by plans that PBGC has taken over.

The model plots the thousands of end-of-path scenario positions as a histogram. The histogram becomes a probability distribution of PBGC's financial position as of the designated point in time.

A run of the model based on year-end 2001 data shows the histogram for the corporation's financial position as of 2011 (expressed in 2001 dollars). This probability distribution roughly resembles a skewed bell-shaped curve. The tail on the deficit side is noticeably longer than the tail on the surplus side.

Academic experts on pension finance and risk have expanded upon some of the factors that figure into and complicate PBGC's risk profile. Zvi Bodie of Boston University observes that a drop in long-term interest rates would dramatically increase the present values of PBGC's future benefit obligations. A large drop in equity values would drop the value of the assets that back sponsors' plans. Such a drop could cause many fully funded plans to become under-funded. PBGC likely would terminate and become trustee for many of those plans. A drop in equity values also would decrease the value of PBGC's equity investments.

Bodie says that because, in the event of a drop in stock prices PBGC's liabilities will go up and the value of some of its assets will go down, PBGC in effect has sold a put on the stock market. (When you sell a put, you lose money if and when the market price of the underlying stock or index goes below the put's strike price. The farther the price of the underlying goes below the strike price, the more money you lose.) While some may think that the risk of having equity-linked risk diminishes with longer event horizons, option pricing theory readily shows that the risk attendant to selling puts increases with the put's exposure horizon.

If in dire scenarios PBGC attempts to raise premiums of fully funded plans to bail out under-funded plans, premiums eventually will hit a ceiling. Above a certain level, premiums become actuarially unfair. In a process of adverse selection, unfair premiums will prompt sponsors of fully-funded plans to terminate their defined-benefit plans and replace them with defined-contribution plans. To settle obligations to defined-benefit participants, sponsors will buy annuities for them. In such a scenario, PBGC could be left with only under-funded plans in their program.

To manage PBGC's risk exposures, Bodie puts several proposals up for discussion. The government could require plan sponsors to fund their plans with U.S. government bonds instead of equities. Bond values and maturities would match those of sponsors' pension liabilities. PBGC could charge premiums that vary with the volatility of assets sponsors use to back their plans. PBGC could use derivatives to give its equity assets the characteristics of fixed-income securities.

George G. Pennacchi of the University of Illinois has pointed out that government guarantors of pension funds could hedge against the risk of equity market price drops. To do so, they could sell equities short. Short sales would allow a guarantor to reap profits if and when equity markets fell. The profits would offset the loss in value of stocks they hold and help offset the likely increase in their unfounded liabilities. Alternatively, a guarantor could establish short equity positions in the futures markets or buy puts on equity indices.

If PBGC goes bust, does the U.S. taxpayer pick up the tab?

If PBGC goes into deficit, that does not mean it runs out of cash. It means the present value of its future liabilities exceeds the value of its assets. In other words, the insurance against underfunding would become underfunded.

The question arises: If a catastrophic scenario comes to pass and PBGC becomes unable to meet its obligations from its assets, will the U.S. Treasury and taxpayer become liable for those obligations?

Steven Boyce of PBGC says, "When PBGC has had large deficits in the past, we've gone to congress for authorization to increase premiums and/or to tighten funding rules. There is no legal provision for Treasury to relieve PBGC should those measures prove inadequate in the future."

Professor Bodie says, "The answer is yes. The US taxpayer will get stuck with the liability— as was the case with the now defunct FSLIC or would be the case with FDIC."

Professor Pennacchi says "As with the FSLIC, I suspect what would happen would be new legislation that would provide for taxpayer financing and for an increase in the schedule of PBGC rates."

The Pension Benefit Guaranty Corporation is a federal corporation created by the Employee Retirement Security Act of 1974 (ERISA). Pension plan sponsors pay insurance premiums to PBGC. If a single-employer plan becomes underfunded, and the sponsor becomes financially unable to maintain the plan (e.g., files for bankruptcy), PBGC becomes trustee of the plan. When workers in trusteed plans become eligible for benefits, PBGC makes the payments. If plan assets do not cover payments at guaranteed levels, PBGC makes up the shortfall. If a collectively bargained, multi-employer plan becomes unable to pay when due benefits at guaranteed levels, PBGC provides the plan enough money to make the payments. Such financial assistance may become nonrecoverable.

In 2001, the corporation took over the retirement plans of TWA, Grand Union, Bradlees Stores, and 98 other sponsors. At year end, PBGC was responsible for paying current and future benefits to about 624,000 plan participants.

In fiscal year 2001, PBGC collected $845 million in premium income and paid $1,044 million in benefits to 268,600 pensioners. The corporation lost $748 million on its investment portfolio. Combining the single-employer and multi-employer programs, PBGC's net position declined by $2.1 billion. At year end, assets exceeded liabilities by $7.8 billion.

PBGC's investable assets consist of premium revenues and assets from terminated plans and from their sponsors. By law, PBGC is required to invest premium revenues in fixed-income securities. Current policy is to invest those funds only in Treasury securities. The corporation invests plan and sponsor assets primarily in high-quality equities.

At the end of fiscal year 2001, PBGC had roughly $14 billion invested in U.S. government securities and $7 billion in equities and other instruments. 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.

ERISA requires that PBGC programs be self-financing and provides that the U.S. government is not liable for any obligation or liability incurred by PBGC. To finance its operations, PBGC may borrow up to $100 million from the U.S. Treasury but has not done so since its first year of operations.