Presentation to the Treasury Borrowing Advisory Committee U.S. - - PowerPoint PPT Presentation

UNITED STATES DEPARTMENT OF THE TREASURY

Presentation to the Treasury Borrowing Advisory Committee

U.S. Department of Treasury Office of Debt Management May 3, 2011

UNITED STATES DEPARTMENT OF THE TREASURY

Agenda

• Fiscal Developments

– Tax Update – MBS Portfolio – Non-Marketable Treasury Security Update – Deficit Forecasts – Debt Limit

• Auction Demand & Market Trends

– Coverage Ratios – Investor Class Data

• Portfolio Metrics

– Nominal Coupons and Bills – Treasury Supplementary Financing Program – TIPS – Average Maturity – Percentage of Debt Maturing in Upcoming Years

• Long-term Challenges

– Office of Management and Budget (OMB) Forecasts – Deficit Reduction Plans

2

UNITED STATES DEPARTMENT OF THE TREASURY

FISCAL DEVELOPMENTS

3

UNITED STATES DEPARTMENT OF THE TREASURY

Growth in Individual Tax Receipts Continued in Q2 FY 2011

4

• 40%
• 20%

0% 20% 40% 60% Mar-00 Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11

Withheld Taxes Nonwithheld Taxes Corporate Taxes

Q

Note: Adjusted for 9/11/01 Corporate Tax Receipts disruption Source: Monthly Treasury Statement

Quarterly Tax Receipts

Year-over-Year Percentage Change

A closer look at Q2 FY11 ending March-2011: Withheld Taxes: +3% Nonwithheld Taxes: +5% Corporate Taxes: -31% Note: Data plotted is year-over-year changes in quarterly receipts

UNITED STATES DEPARTMENT OF THE TREASURY

April Tax Receipts Show Strength

5

A Closer Look at April 2011 5-Year Average Receipt Composition FY2006-2010 Receipt Category

• Avg. % of Annual Receipts

Withheld 69% Corporate 14% Nonwithheld 17%

Receipt Category Composition Y/Y % Change Y/Y Change $Billions Withheld 42% 1% $2 Corporate 9%

• 6%
• $2

Nonwithheld 49% 29% $37

UNITED STATES DEPARTMENT OF THE TREASURY

Treasury Sales of MBS Will Reduce Borrowing Needs

6

• 20
• 10

10 20 30 40 50 10-May-2010 24-May-2010 7-Jun-2010 21-Jun-2010 5-Jul-2010 19-Jul-2010 2-Aug-2010 16-Aug-2010 30-Aug-2010 13-Sep-2010 27-Sep-2010 11-Oct-2010 25-Oct-2010 8-Nov-2010 22-Nov-2010 6-Dec-2010 20-Dec-2010 3-Jan-2011 17-Jan-2011 31-Jan-2011 14-Feb-2011 28-Feb-2011 14-Mar-2011 28-Mar-2011 11-Apr-2011

FNMA Current Coupon 30yr TSY OAS

2/11/11 GSE White Paper Released 3/21/11 US Treasury Announces MBS Portfolio Disposition

Tsy OAS Source: JP Morgan Agency-Guaranteed MBS Portfolio Proceeds from Sales by Treasury Principal and Interest Payments Total Taxpayer Recoveries Cumulative through February 2011 $100.8 billion $100.8 billion March 2011 $3.8 billion $3.2 billion $7.0 billion April 2011 $10.3 billion $2.8 billion $13.1 billion Cumulative through April 2011 $14.1 billion $106.8 billion $120.9 billion

UNITED STATES DEPARTMENT OF THE TREASURY

Treasury’s Current MBS Holdings

7

Note: Data through 4/29/2011 MBS Outstanding Float Source: JP Morgan

FNMA $1.36B FNMA $15.70B FNMA $18.84B FNMA $16.35B FNMA $7.91B FNMA $0.05B FRE $24.29B FRE $18.35B FRE $8.27B FRE $1.88B FRE $0.00B 0% 5% 10% 15% 4.0% 4.5% 5.0% 5.5% 6.0% 6.5% UST % of Total (FNMA) UST % of Total (FRE)

Coupon

Treasury Holdings of FNMA & FRE 30-Year

As a % of Outstanding Float (ex-CMO)

FRE $4.16B

UNITED STATES DEPARTMENT OF THE TREASURY

Non-Marketable Redemptions Continued in Q2 FY 2011

8

Source: Monthly Treasury Statement

• $30
• $20
• $10

$0 $10 $20 $30 Q1 FY2005 Q3 Q1 FY2006 Q3 Q1 FY2007 Q3 Q1 FY2008 Q3 Q1 FY2009 Q3 Q1 FY2010 Q3 Q1 FY2011 Savings Bond Foreign Series SLGS

Net Non-marketable Issuance

In Billions $

UNITED STATES DEPARTMENT OF THE TREASURY

Primary Dealer and Government Deficit Estimates

FY 2011-2013 Deficit and Borrowing Estimates

In Billions $ Primary Dealers* CBO OMB FY 2011 Deficit Estimate 1,431 1,480 1,645 FY 2012 Deficit Estimate 1,149 1,100 1,101 FY 2013 Deficit Estimate 920 704 768 FY 2011 Deficit Range 1,300-1,682 FY 2012 Deficit Range 1,025-1,300 FY 2013 Deficit Range 700-1,100 FY 2011 Marketable Borrowing Range 1,124-1,550 FY 2012 Marketable Borrowing Range 1,000-1,350 Estimates as of: Apr 2011 Jan 2011 Feb 2011 *Based on Primary Dealer feedback on April 29, 2011. Deficit estimates are averages.

9

UNITED STATES DEPARTMENT OF THE TREASURY

Treasury Expects to Reach the Debt Limit on May 16

10

4 6 8 10 12 14 16 1997 - Feb 1997 - Aug 1998 - Feb 1998 - Aug 1999 - Feb 1999 - Aug 2000 - Feb 2000 - Aug 2001 - Feb 2001 - Aug 2002 - Feb 2002 - Aug 2003 - Feb 2003 - Aug 2004 - Feb 2004 - Aug 2005 - Feb 2005 - Aug 2006 - Feb 2006 - Aug 2007 - Feb 2007 - Aug 2008 - Feb 2008 - Aug 2009 - Feb 2009 - Aug 2010 - Feb 2010 - Aug 2011 - Feb

Debt Subject to Limit Debt Limit

Total Public Debt Outstanding Subject to the Statutory Debt Limit

Current Debt Ceiling: $14.294 Trillion Current Debt: $14.230 Trillion Headroom: $64 Billion Note: Data through 4/28/2011

UNITED STATES DEPARTMENT OF THE TREASURY

Extraordinary Actions Used in the Past Do Not Provide as Much Flexibility

11

Fiscal Year 1996 # of Days of Debt Limit Impasse 136 Tools G-Fund, CSRDF, ESF, FFB, SLGS Fiscal Year 2002 # of Days of Debt Limit Impasse 85 Tools G-Fund, CSRDF, SLGS Fiscal Year 2003 # of Days of Debt Limit Impasse 93 Tools G-Fund, CSRDF, ESF, FFB, SLGS Fiscal Year 2005 # of Days of Debt Limit Impasse 37 Tools G-Fund, CSRDF, ESF, FFB, SLGS Fiscal Year 2006 # of Days of Debt Limit Impasse 29 Tools G-Fund, CSRDF, ESF, FFB, SLGS Fiscal Year 2011 # of Days of Debt Limit Impasse ??? Tools G-Fund, CSRDF, ESF, SLGS

There have been 6 occasions over the past 15 years where Treasury has been forced to use extraordinary actions to continue to fund government

• perations.

Some combination of the following actions have been used during these episodes:

• Suspension of issuance of new State and Local

Government Securities (SLGS)

• Suspension of investments in:
• the Government Securities Investment

Fund (G-Fund)

• the Exchange Stabilization Fund (ESF)
• the Civil Service Retirement and Disability

Fund (CSRDF)*

• Federal Financing Bank (FFB) swap transactions

These periods lasted between 29 and 136 days. In each of these cases, the extraordinary actions undertaken by Treasury were sufficient to continue funding the government. However, given financing needs, these tools will not sustain borrowing beyond early August.

*Also includes the redemption of existing investments

UNITED STATES DEPARTMENT OF THE TREASURY

AUCTION DEMAND & MARKET TRENDS

12

UNITED STATES DEPARTMENT OF THE TREASURY

Coverage Ratios Have Remained Strong in FY 2011

13

Source: Treasury Auction Data; Through 4/25/2011 1.0 1.5 2.0 2.5 3.0 3.5 $0 $500 $1,000 $1,500 $2,000 $2,500 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011YTD

Weighted Average Coverage Ratio on Nominal Notes and Bonds

In Billions $, Coverage Ratio

Gross Private Issuance Weighted Average Coverage Ratio

UNITED STATES DEPARTMENT OF THE TREASURY

Smaller Dealers Have Increased Nominal Coupon Auction Participation

14

Source: Treasury Investor Class Data; Data through 4/15/2011 *FY2006 through FY2010 SOMA 3% Primary Dealers 47% Other Dealers & Brokers 10% Investment Funds 17% Foreign & International 22%

FY2011 YTD: Average Investor Class Allotments

SOMA 9% Depository Institutions 1% Individuals 1% Primary Dealers 52% Other Dealers & Brokers 4% Investment Funds 14% Foreign & International 19%

Five-Year Average of Investor Class Allotments*

UNITED STATES DEPARTMENT OF THE TREASURY

Smaller Dealers Have Also Increased Bill Auction Participation

15

Source: Treasury Investor Class Data; Data through 4/15/2011 *FY2006 through FY2010 SOMA 12% Individuals 4% Primary Dealers 54% Other Dealers & Brokers 7% Investment Funds 13% Foreign & International 10% Other 1%

Five-Year Average of Investor Class Allotments*

SOMA 3% Individuals 2% Primary Dealers 55% Other Dealers & Brokers 12% Investment Funds 14% Foreign & International 13%

FY2011 YTD: Average Investor Class Allotments

UNITED STATES DEPARTMENT OF THE TREASURY

PORTFOLIO METRICS

16

UNITED STATES DEPARTMENT OF THE TREASURY

Nominal Coupons and Bills as a Percentage of the Portfolio

17

24% 15% 20% 25% 30% 35% 40% Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11

Bills

Percentage of Total Portfolio

Notes: Includes SFP and CMBs Average 2000 - 2007 Notes: Includes SFP and CMBs Last: 20% as of 3/31/2011 69% 50% 55% 60% 65% 70% 75% 80% Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11

NominalCoupons

Percentage of Total Portfolio

Average 2000 - 2007 Last: 74% as of 3/31/2011

UNITED STATES DEPARTMENT OF THE TREASURY

Balances in the SFP Have Fallen as the Debt Limit Approaches

18

$0 $100 $200 $300 $400 $500 $600 $700 $800 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11

Treasury Supplementary Financing Program Cash Balance

In Billions $

Max: $560B Min: $5B 12/30/09 $200B 3/31/11: $5B

UNITED STATES DEPARTMENT OF THE TREASURY

TIPS Issuance Will Continue to Increase

19

Note: Data through 4/21/2011 0% 3% 6% 9% 12% $0 $25 $50 $75 $100 1997 1999 2001 2003 2005 2007 2009 2011YTD

TIPS

CalendarYearIssuancein Billions $, PercentageofPortfolio

5-Year (L) 10-Year (L) 20-Year (L) 30-Year (L) TIPS as % of the Portfolio (R)

UNITED STATES DEPARTMENT OF THE TREASURY

Average Maturity of the Debt Continues to Lengthen

20

Note: Data through 3/31/2011 40 45 50 55 60 65 70 75 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Average Maturity of Marketable Debt

In Months

Average Maturity (Outstanding)

Current 60.4 as of 3/2011 Average 58.1 Min 42.4 in 4/1980 Max 70.9 in 5/2001 Statistics on Average Maturity since CY1980

UNITED STATES DEPARTMENT OF THE TREASURY

Percentage of Debt Maturing in the Near-Term Remains at Historic Lows

21

Note: Data through 3/31/2011 20% 30% 40% 50% 60% 70% Jan-90 Jul-90 Jan-91 Jul-91 Jan-92 Jul-92 Jan-93 Jul-93 Jan-94 Jul-94 Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11

Percentage of Debt Maturing in Next 12 to 36 Months

Maturing in 12 Months Maturing in 24 Months Maturing in 36 Months

UNITED STATES DEPARTMENT OF THE TREASURY

LONG-TERM CHALLENGES

22

UNITED STATES DEPARTMENT OF THE TREASURY

OMB FY 2012 Budget Projections

23

• 18%
• 16%
• 14%
• 12%
• 10%
• 8%
• 6%
• 4%
• 2%

0% 2% 4%

• $2,000
• $1,500
• $1,000
• $500

$0 $500 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

Budget Surplus/Deficit

In Billions $, Percentage of GDP

Surplus/Deficit $ (L) Surplus/Deficit % of GDP (R) OMB FY2012 Budget Projections

UNITED STATES DEPARTMENT OF THE TREASURY

OMB Long-Term Debt Metrics

24

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 $0 $100 $200 $300 $400 $500 $600 $700 $800 $900 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

Fiscal Year Interest Expense

In Billions $, Percentage of GDP

Interest Expense (L) Interest Expense as a % of GDP(R) Average Interest Expense as a % of GDP (R) OMBFY2012 Budget Projections

Note: Interest costs based on net interest on Treasury debt minus interest on trust funds and other income.

Average 1950-2010: 2% 20 40 60 80 100 120 $0 $5 $10 $15 $20 $25 $30 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

Fiscal Year Outstanding Debt

In Trillions $, Percentage of GDP

projections Public/Dollar projection intergovdollar Public as a % of GDP(R) Government Accounts as a % of GDP(R) Total Debt as a % of GDP(R) OMBFY2012 Budget Projections

UNITED STATES DEPARTMENT OF THE TREASURY

Deficit Reduction Plans

25

Deficit Reduction Relative to Current Policy Baseline, $ billion Administration Framework (2012-23) Simpson- Bowles (2012-21) Ryan Budget Resolution (2012-21)

Total Deficit Reduction

• 4,000
• 4,394
• 4,685

Spending

• 2,010
• 2,694
• 5,325

Security Discretionary

• 400
• 930
• 100

Non-Security Discretionary

• 770
• 600
• 1,740

Repeal ACA

• 1,410

Medicare/ Medicaid

• 480
• 460
• 1,100

Other Mandatory

• 360
• 224
• 975

Social Security + Superlative CPI

• 480

Tax Reform

• 1,000
• 1,000

1,420 Interest

• 990
• 700
• 780

UNITED STATES DEPARTMENT OF THE TREASURY

26

What adjustments to debt issuance, if any, should Treasury make in consideration of its financing needs in the short-, medium-, and long-term?

Presentation for:

The Treasury Borrowing Advisory Committee

May 3, 2011

The Charge

We would like the Committee to comment on the current state of public and private i f d i h U S H d bli d i i diff i h i h

g

pension funds in the U.S. How do public and private pensions differ in their approach to asset-liability management? Please discuss how these approaches affect their investment decisions in fixed income markets. Is there anything Treasury should consider when thinking about the overall composition of the Treasury debt portfolio consider when thinking about the overall composition of the Treasury debt portfolio and/or other Treasury products?

1

Part I: Characteristics of Public and Private Pension Funds

2

Historical Growth of U.S. Retirement Assets by Category y g y

• Retirement assets totaled approximately $17.5 trillion as of the end of 2010
• State and local government plans are almost exclusively defined benefit (DB) plans
• In the private sector, defined contribution (DC) plans are larger than defined benefit plans

18 20 $3.0 $1.4 $1.6 12 14 16 18 ($ trillions) $4.5 $2.2 4 6 8 10 Market Value ( $4.7 2 4 1 9 7 4 1 9 7 6 1 9 7 8 1 9 8 1 9 8 2 1 9 8 4 1 9 8 6 1 9 8 8 1 9 9 1 9 9 2 1 9 9 4 1 9 9 6 1 9 9 8 2 2 2 2 4 2 6 2 8 2 1 M 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 IRAs Defined Contribution Plans Private Defined Benefit Plans State and Local Government Pension Plans Federal Pension Plans Annuities

Source: Investment Company Institute (ICI)

3

Historical Growth of Defined Benefit Plans

• Total assets of state and local government DB plans first exceeded corporate DB plan assets in 1997
• Since then, state and local government DB plans have grown 66% (4% annually), while corporate

DB plans have grown by 25% (1.7% annually) I 2010 t t d l l DB l i d 57% f th t t l DB k t ($3 t illi f $5 2 t illi )

• In 2010, state and local DB plans comprised 57% of the total DB market ($3 trillion of $5.2 trillion)

3.5 2.0 2.5 3.0 ue ($ trillions) 0.5 1.0 1.5 Market Valu 0.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Corporate Defined Benefit State & Local Defined Benefit

4

Source: ICI

Comparison of Private and Public DB Plans p

• Private and public DB plans have different characteristics
• In general, public plans offer higher benefit payments but require larger contributions from both the

employer and employee

• Importantly, freezing a public DB plan is generally more difficult (due to collective bargaining

agreements, legal protections, etc.), thus reducing the degrees of freedom for public plan sponsors

Characteristic Private Plans State and Local Plans

Benefit Formula The most common plan structure sets retirement benefits based on the number

• f years of service, salary at/near retirement, and a constant accrual rate

Median Accrual Rate 1 1.5% 1.9%, if covered by Social Security 2.2%, if not covered by Social Security Cost of Living Adjustments Very rare Majority of plans have automatic COLAs Median Employee Contribution Rates 2 Very rare 5%, if covered by Social Security 8%, if not covered by Social Security Median Employer Contribution Rates 3 8% 8%, if covered by Social Security 10 7% if not covered by Social Security Rates 10.7%, if not covered by Social Security Can Employer Freeze Plan? Generally, yes Generally, not unilaterally

• 1. As of 2005
• 2. As of 2005. From 2002 – 2009, public employee contribution rates were stable.

5

p p y

• 3. As of 2005. In 2009, public fund figures were 9.4% and 12.7% respectively

Source: Center for Retirement Research at Boston College (CRR), Public Fund Survey

Complexity and Volatility are Causing Private Firms to Freeze DB Plans

• Regulatory, legislative, and accounting changes over the past several decades have made

private DB plans increasingly complex and have contributed to cash flow and earnings

p y y g

p p p volatility

• As a result, firms have increasingly frozen DB plans
• 59% of Fortune 1 000 companies sponsor a DB plan (vs 64% in 2004)
• 59% of Fortune 1,000 companies sponsor a DB plan (vs. 64% in 2004)
• 21% of Fortune 1,000 companies have frozen at least one of their DB plans (vs. 5% in 2004)

PBGC Standard Single Employer Terminations (% of insured plans) Status of DB Plans at Fortune 1,000 Companies

37% 41% 70% 80% 90% 100% 10% 12% 14% Pension Protection Tax Reform Act & Single Employer Pension Plan Amendment Act (1986) 59% 38% 5% 21% 20% 30% 40% 50% 60% 4% 6% 8% T E it d Fi l Pension Protection Act (2006) 38% 0% 10% 20% 2004 2005 2006 2007 2008 2009 2010 All DB Plans Active At Least One Frozen DB Plan No DB Plans 0% 2% 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Tax Equity and Fiscal Responsibility Act (1982) 6

Sources: National Institute on Retirement Security, PBGC, Towers Watson

DB Coverage is Declining, while DC Coverage is Rising g g, g g

• DB plan freezes and turnover of the labor force have contributed to a dramatic shift in

the coverage of DB plans p

• The percentage of workers covered by DB plans has declined by over 40 percentage points

since 1983

• Less than half of the participants in private DB plans (and 55% in public DB plans) are still

working for the sponsoring employer

Percent of Active Participants in Defined Benefit Plans Workers with Pension Coverage, by Pension Type

working for the sponsoring employer

50% 60% 70%

60% 65%

20% 30% 40%

50% 55%

0% 10% Defined Benefit Only 401(k) Only Both 1983 1995 2007

40% 45% 2001 2002 2003 2004 2005 2006 2007 2008

7

Sources: CRR, PBGC

126 Public DB Plans All Single-Employer PBGC-Insured Private DB Plans

Historical Growth of Public Defined Contribution Plans

• State & Local Defined Contribution plans represent a small portion of the DC market
• Only two states (MI and AK) have implemented mandatory defined contribution programs
• Most of the asset growth has been in voluntary contribution plans (similar to 401(k) plans)

Availability of Defined Contribution and Hybrid Plans Introduction of State DC and Hybrid Plans, by Year

8

Sources: ICI, CRR

Part II: Survey of Assets Held by Public and Private Funds y y

9

Asset Allocation Diverging Between Private and Public DB Plans - Historical

• Since the Pension Protection Act was enacted in 2006, corporations have increasingly focused on liability-

driven investment strategies

Asset Allocation Diverging Between Private and Public DB Plans Historical

• As a result, corporate DB plans have shifted from equities into fixed income and also increased the

duration of their fixed income assets to better match the duration of their liabilities (typically 12+ years)

• Over the past decade, the fixed income allocation of corporate DB plans has expanded from 26% to 39%,

while the allocation in public DB plans has declined from 29% to 27%

Asset Allocation for Corporate DB Plans Asset Allocation for Public DB Plans

while the allocation in public DB plans has declined from 29% to 27%

• Both have increased allocations to alternative strategies (such as real estate, private equity, and hedge

funds)

12% 8% 17% 70% 80% 90% 100% 10% 9% 19% 70% 80% 90% 100% 39% 61% 64% 43% 20% 30% 40% 50% 60% 70% 63% 61% 53% 20% 30% 40% 50% 60% 26% 26% 39% 0% 10% 20% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Cash Fixed Income Equity Alternatives & Other 26% 29% 27% 0% 10% 20% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Cash Fixed Income Equity Alternatives & Other 10

Source: Pensions & Investments (P&I)

Comparison of Funding and Accounting Rules p g g

• Differences in accounting and funding requirements impact asset allocation
• Under proposed accounting standards for private plans, the expected return on pension assets will no longer flow

through the income statement. This may cause private plans to increase their allocations to fixed income. Private DB Public DB Accounting Rules

Source Primarily FAS 87 and 158 Primarily GASB 25 and 27 Funded Status on Balance Sheet?

• Yes. Net asset for all overfunded plans + net

liability for all underfunded plans

• No. Incur a liability if annual contribution is below

the annual required contribution (ARC) 1 Pension Asset Valuation Generally at fair value Typically 3-5 year smoothing Liability Discount Rate Based on high-quality Based on expected rate of Liability Discount Rate Based on high quality corporate bond yields. Discount rate unaffected by asset allocation. Based on expected rate of

• return. Assumes sponsor will not default.

Income Statement Impact of Asset Allocation More aggressive portfolio Higher expected return Lower pension expense More aggressive portfolio Higher expected return Lower ARC Lower pension expense

Funding Rules

Source Primarily ERISA and PPA No uniform requirement Annual Required Contribution Normal Cost + Underfunding ti d

2

GASB recommends N l C t + U d f di ti d 30 amortized over seven years 2 Normal Cost + Underfunding amortized over ~30 years

• 1. Funded status (using actuarial value of assets and a discount rate equal to the expected return) is reported on a separate schedule.
• 2. Unlike the funded status reflected on balance sheet (which compares assets to the projected benefit obligation), funding requirements are calculated

with respect to the accumulated benefit obligation (which excludes future salary growth). Congress enacted pension funding relief in 2010 that allows sponsors to temporarily extend the amortization period.

Sources: Credit Suisse, JP Morgan

11

Asset Allocation Diverging Between Private and Public DB Plans - Prospective

• Surveys indicate that asset allocation trends between corporate and public DB plans are likely to

continue over the next few years

Asset Allocation Diverging Between Private and Public DB Plans Prospective

• 41% of corporate DB plan sponsors intend to increase their allocation to long corporate bonds over

the next one to two years (35% planning to increase allocation to long government bonds)

• Both corporate and public plans intend to reduce exposure to U.S. equities

Net Share of Sponsors Planning to Significantly Increase Exposure over Next 3 Years Asset Allocation for Corporate DB Plans over Next 1 – 2 Years

21% 20% 4% 3% 75% 70% 61% 56% 5% 9% 35% 42% High Yield Global Equity US Small Cap Equity US Large Cap Equity 32% 29% 27% 21% 67% 62% 59% 75% 1% 9% 14% 5% TIPS Emerging Markets Equity Non-US Equity High Yield 41% 41% 35% 57% 50% 63% 2% 9% 1% 0% 20% 40% 60% 80% 100% Long Corporate Bonds US Investment Grade Fixed Income Long Government Bonds 12

Sources: Empirical Research, Pyramis

0% 20% 40% 60% 80% 100% % planning to increase % planning no change % planning to decrease

Private DB More Concerned About Volatility, Public DB About Returns

• Surveys of plan sponsors indicate that corporate DB plan sponsors are primarily concerned with

volatility, while public DB plan sponsors are more concerned with improving their funded status

• When asked to define volatility, corporate DB plan sponsors were more concerned with funded status

volatility, while public DB plan sponsors were more concerned with asset volatility

• This difference in focus is likely the result of differences in regulatory and accounting standards, as

well as the lower funded status of public plans

Top Concerns of Corporate and Public DB Sponsors over the Next Decade

40% 45% 25% 30% 35% 40% 5% 10% 15% 20% 0%

Volatility Current funding status Risk management Low return environment Ability of our managers to generate excess returns (alpha) Impact of new regulatory and accounting changes Liquidity 13

Source: Pyramis

Corporate DB Plan Sponsors Public DB Plan Sponsors

DC Plan Asset Allocation

• Participants in corporate DC plans have been gradually de-risking
• Cash, stable value, and fixed income in aggregate have risen from 24% to 33% over the past 5 years
• Total equity allocation has declined 4 percentage points driven by a decrease in sponsoring

Total equity allocation has declined 4 percentage points, driven by a decrease in sponsoring company stock

• However, corporate DC plans still appear to have riskier asset allocations than public DC plans
• Changes in the risk profile of public DC plans, meanwhile, appear more muted
• Equity allocation has declined slightly, offset by an increase in alternative investments / other
• Fixed income assets have been re-allocated to stable value

Corporate DC vs Public DC Asset Allocation as of 2010 Change in Asset Allocation: 2010 vs 2006 (in percentage points) Corporate DC vs Public DC Asset Allocation as of 2010 Change in Asset Allocation: 2010 vs 2006 (in percentage points)

4% 6% 8% 50% 60%

• 4%
• 2%

0% 2% 10% 20% 30% 40%

• 8%
• 6%

Sponsoring Co Stock Equity Alternatives & Other Fixed Income Stable Value Cash 0% 10% Sponsoring Co Stock Equity Alternatives & Other Fixed income Stable value Cash

Corporate Defined Contribution Public Defined Contribution

14

Source: P&I Corporate Defined Contribution Public Defined Contribution

Part III: Public and Private Pension Fund Liabilities

15

What Drives the Growth of Pension Liabilities?

Each year workers accrue a future benefit based on a predetermined formula, typically linked to compensation and years

• f service

Benefit Accruals Wage / Salary Growth Changes in the future value of

Estimates of future benefit obligations include an assumption about the growth in wages over the working life of the beneficiaries

Inflation future value of benefits

Many public plans offer retirees a direct cost of living adjustment based on CPI

• inflation. Private plans rarely offer this

benefit

Increasing Longevity

Longer lives in retirement result in a greater liability as the benefits are paid until death, not to a fixed number of years

Changes in the

Private pension plans use a discount rate linked to the yield on high quality corporate bonds, which can fluctuate and lt i t i l h i th t

Discount Rate g present value of benefits

result in material changes in the present value of the liability. Public plans use a fixed discount rate that effectively insulates the liability from mark-to-market volatility

16

Measuring Pension Funding Gaps g g p

• Pension funding gaps fluctuate with pension assets and liabilities
• Main drivers of pension assets

Main drivers of pension assets

1. Investment Return (most volatile component) 2. Benefit Payments 3. Contributions (generally, but not necessarily, increase in response to reductions in funded status)

M d f l b l

• Main drivers of pension liabilities

1. Service cost + Interest cost 2. Benefit Payments 3. Changes in actuarial assumptions, especially the discount rate

• Due to differing accounting standards, funding gaps for public and private funds are not directly

comparable

• The choice of discount rate is particularly important in calculating the funded status of a plan

p y p g p

• Corporate DB plans are discounted using high-quality corporate bond yields
• Reflects credit risk of strong corporations
• In 2010, yields in the 5.5% - 6% range were generally used
• State & Local DB plans are discounted using an assumed long-term rate of return on plan assets
• Th

t ti l h g d t il ti d t t l l t

• These return assumptions rarely change, and are not necessarily tied to actual plan returns
• Currently, the average public plan discount rate is about 8%
• Discounting public plans using high-quality municipal bond yields may be a better choice
• In contrast, discounting each entity’s pension obligation using the sponsor’s bond yields may be a

poor choice because it would reduce the pension obligation as the sponsor’s creditworthiness

17

deteriorates

Funded Status of Public Pensions

• Public pension liabilities are valued using a discount rate that is linked to the expected return on

plan assets, which does not fluctuate based on movements in interest rates or credit spreads

• Assets are measured using either a mark-to-market valuation or a smoothed actuarial value,

resulting in different levels of estimated funded status

• St

g k t t i i g th f d d t t k t l b i A t i l t

• Strong market returns are improving the funded status on a market value basis. Actuarial returns

are continuing to decline as they still do not fully incorporate the financial crisis.

Estimated Funded Status of 125 State DB Plans over Time Estimated Funded Status of 125 State DB Plans as of 2010 Estimated Funded Status of 125 State DB Plans over Time Estimated Funded Status of 125 State DB Plans as of 2010

30 35 40

ns

95% 90% 100% 93% 100% 110% 10 15 20 25

Number of Plan

73% 81% 81% 86% 81% 95% 88% 90% 74% 89% 88% 86% 86% 87% 85% 79% 77% 70% 80% 90% 5 0% to 50% 50% to 60% 60% to 70% 70% to 80% 80% to 90% 90% to 100% 100% to 110% 110% to 120% 120% to 130% 69% 65% 60% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Current

Market Value Funding Ratio Actuarial Value Funding Ratio

18 Market Value of Assets Actuarial Value of Assets

Source: Wilshire, JP Morgan Market Value Funding Ratio Actuarial Value Funding Ratio

How Large is the State and Local Government Pension Gap? g p

• Public plans report their liability using a discount rate that is equal to the expected return on plan assets
• Based on “as reported” figures (adjusted for recent market movements), plans are ~78% funded. If a lower

discount rate were to be used, plan funding would be significantly worse (shown below). , p g g y ( )

• To calculate the increase in taxes necessary to fund accrued benefits, we assume that 22-year amortizing

pension obligation bonds are issued to fully fund the pension and then solve for the upfront tax increase that is necessary to pay off the debt. If yet-to-be-accrued benefits for current employees are taken into account, the figures are even larger (see subsequent slides).

Future Liability 42% % of PI % of taxes Unfunded gap % funded $4 3tn 1 6% Tax increase 16% Liability 55% 42% $2.6tn $4.3tn 0.6% 1.6% 6% 16% 78% Assets Present Liability $0.9tn 0.3% 3%

Note: For the tax increase analysis, the yield on the pension obligation bonds equals the discount rate. If future asset returns are lower than the discount rate, then taxes would need to be increased more than indicated above. “% of PI” indicates the tax increase as a % of personal income. “% of taxes” indicates the tax increase as a % of the existing state and local tax burden. Source: JP Morgan

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Projected Benefit Payments for Current State and Local Employees

• Already earned vested benefits (dark blue area) will peak at ~$380 billion per year in 2026
• If employees’ future service and salary increases are also included (all shaded areas), annual benefit payments will

peak at ~$660 billion in 2041 p $ 4

• This analysis does not take into account that new employees will be hired to replace retiring employees (and that

many of those new employees will retire during the illustrated timeframe)

700 500 600 efits ($bn) 200 300 400 al Pension Bene 100 200 Annua 2011 2021 2031 2041 2051 2061 2071 2081

Including all future service (projected value of benefits, PVB) Most commonly reported method (entry age normal, EAN) Including salary growth (projected benefit obligation, PBO)

20

Source: JP Morgan, based on work by Robert Novy-Marx and Joshua Rauh g y g (p j g , ) Termination value (accumulated benefit obligation, ABO)

Required State Adjustments To Fund Benefits for Current State Employees

• When including the full costs of future service and salary increases (PVB on the prior slide), the

total state and local gap increases to $3.9 trillion (of which the state portion is $2.5 trillion)

• Th fi

l dj t t i d t ti f th li biliti i ig ifi tl f t t t t t

Required State Adjustments To Fund Benefits for Current State Employees

States would have to dedicate 16% of their current revenue, on average, to fully fund their pension plans

• The fiscal adjustment required to satisfy these liabilities varies significantly from state to state

Which would mean increasing taxes by 0.8% of personal income (from 9.8% to 10.6%)

20 0.8% average 15 tes 4 states would have to dedicate more than 30%

• f their current revenue

to service the bonds that would be required to fund their pension systems 15 20 es 2 states would have to raise taxes for 22 ears totaling more 10 Number of Stat their pension systems 16% average 10 umber of State years totaling more than 1.5% of personal income per year 5 5 N

Note: Pensions discounted at a yield curve of taxable muni discount rates. Revenue is FY2011 total governmental funds excluding federal grants and aid. Source of revenue data: FY2009 and FY2010 CAFRs and NCSL survey of legislative analyst projections for FY2011. Unfunded pension liabilities also include full estimate of f i d l i d li i hi C f i i f d d i 22 f ll i i b d i d ( h

% of Revenues 0% 5% 10% 15% 20% 25% 30% 35% 40% 0% 0.5% 1.0% 1.5% 2.0% 2.5% % of Personal Income in the State

21

future service and salary increases and eliminate asset smoothing. Cost of servicing unfunded pensions assumes 22-year fully amortizing bonds are issued (at the same taxable muni rate) to pay for the entire unfunded liability. Source of personal income in each state: Tax Foundation. Source: JP Morgan

Alternatives to Raising Taxes g

• Aside from raising taxes, states have other levers at their disposal
• The chart below illustrates one possible solution that relies equally on cutting state spending,

increasing employee contributions, reducing COLAs, and increasing retirement ages

0.8% Cut state spending by 3 5% Reduce COLAs to zero Increase all

• 0.2%
• 0.2%
• 0.2%

by 3.5%

• f budget

Increase employee contributions by 8.5%

• f salaries

Increase all retirement ages by 5.7 years

• 0.2%

As with the chart on the right side of the previous page, all numbers show the adjustment as a percentage of l i i h

Raise taxes Dedicate more existing resources to pensions Reduce pension benefits

Employee contributions assume that each percentage point increase raises $250 per member per year. Present value of COLA reduction and retirement age increases based on “Policy Options for State Pensions Systems and Their Impact on Plan Liabilities” presented by Joshua Rauh and Robert Novy-Marx at Jackson Hole in August of 2010.

personal income in the state

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Source: JP Morgan

Limited Legal Precedents to Changing Benefits g g g

Decreasing cost of living adjustment for retirees Increasing early and full retirement ages

• Colorado’s 2010 legislation, amongst other

reforms, reduced the COLA to the lesser of 2%

• r inflation
• Minnesota’s 2010 legislation reduced COLAs
• Rhode Island’s 2009 legislation was carefully

crafted to generate as much savings as possible (e.g., impacting current workers too) while also respecting the vested rights of current workers: Minnesota s 2010 legislation reduced COLAs until the plan is 90% funded (COLAs from 2.5% to 2% for SERS, from 2.5% to 1.5% for state police, from 2.5% to 1% for PERS, from 2% to 0% for teachers)

• Increasing the retirement age from 60 to

62, but only for employees who are NOT yet eligible to retire Th l l 60 h

• South Dakota’s 2010 legislation ties COLAs

to a formula based on funded level (3.1% COLA if 100%+ funded, 2.1-2.8% if 90-100%, 2.1-2.4% if 80-90%, 2.1% if less than 80%)

• The closer an employee is to age 60, the

less it impacts him or her (proportionally with caps) No lawsuits have been filed to our knowledge 2.1 2.4% if 80 90%, 2.1% if less than 80%) Retirees in all three states have filed lawsuits alleging that the reduction in benefits represents a breach of contract No lawsuits have been filed to our knowledge

N t L l t ti b t t Note: Legal protections vary by state Source: National Conference of State Legislatures

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S&P 500 DB Funded Status is Improving and Likely Manageable

• After declining to ~77% in 2008, the funded status for S&P 500 companies has improved to ~85% as of

12/31/2010 (~$192 billion)

• A 50bp increase in the discount rate would improve the status to 90% (~$120bn), assuming an 11 year duration

A 50bp increase in the discount rate would improve the status to 90% ( $120bn), assuming an 11 year duration

• Employer contributions are sizeable: ~$66 billion in 2009, up from $39 billion in 2008
• In aggregate, $192 billion of pension underfunding ($125 billion after-tax) seems manageable

$ $

• In 2010, S&P 500 companies spent $299bn on share repurchase and $206bn on dividends
• Circumstances vary by sector and company

140% 9.0% 110% 120% 130% 7.5% 8.0% 8.5% 80% 90% 100% 6.0% 6.5% 7.0% 60% 70% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 5.0% 5.5%

24

Sources: Morgan Stanley, Wilshire, Standard & Poor’s, Citigroup S&P 500 Funded Status (%,LHS) Citigroup Pension Liability Index Yield (%, RHS)

Part IV: Considerations

25

Potential Fixed Income Inflows from Pension Asset Allocation Changes g

• Given expected asset allocation trends, flows into fixed income may increase in the coming years
• $2.2 trillion of assets in corporate DB plans, $3 trillion in state and local government DB plans
• A 10 percentage point increase in the fixed income allocation for corporate DB plans equates to $224bn
• For comparison, the Barclays Capital Long Corporate and Long Treasury indices have market caps of

$744 billion and $661 billion, respectively, as of 3/31/2011

• Currently, corporate DB plans have a fixed income allocation of 39%

Currently, corporate DB plans have a fixed income allocation of 39%

• However, changes in asset allocation are likely to be gradual. According to the Pyramis survey of corporate

DB plans cited earlier (pg. 12):

• 39% (net) of plans intend to increase their allocation to long corporate bonds over the next 1 -2 years
• 34% (net) of plans intend to increase their allocation to long govt. bonds over the next 1 -2 years
• If we assume that increasing the allocation to an asset class means changing the allocation by 5

percentage points, this would imply purchases of $44 billion of long corporate bonds and $38 billion

• f long government bonds *
• Given the lack of near-term catalysts, it appears unlikely that state and local government DB plans will

increase their fixed income allocation in the near future

* $2.24 trillion corporate DB assets * 39% increasing allocation to long corporate bonds * 5% increase in allocation = $44 billion For reference, $88 billion of long (>15 years) investment grade US corporate debt was issued in 2010 ($105bn in 2009)

26

, g ( y ) g p ( )

Sources: ICI, P&I, Barclays Capital, Pyramis

Implications for Treasury / New Product Ideas p y /

• The Treasury may be able to issue new types of securities to assist DB plans in hedging risks that are

currently difficult to hedge

• Ult

l T i

• Ultra-long Treasuries
• Pension liabilities are long duration and have meaningful convexity
• Wage inflation-linked Treasuries
• Retirement benefits are often linked to the retiree’s wage at retirement

g

• TIPS are linked to CPI and may not provide an adequate hedge against wage inflation
• The federal government already calculates wage inflation to index Social Security benefits
• OPEB liabilities are generally unfunded but could be funded with bonds in the future

H l h i fl i li k d i

• Health inflation-linked treasuries
• Public plans face an estimated unfunded OPEB liability of ~$1 trillion, while S&P 500 corporations

are underfunded by approximately $260 billion

• The growth rate of healthcare costs is an important factor in measuring OPEB liabilities
• While in theory the above products may generate new demand, it is important to also analyze the

practical implications of issuing a new type of security. For example, dealers have balance sheet constraints that limit their ability to warehouse new issues (particularly for new types of securities). This may lead to storage costs / higher yields for the Treasury. y g / g y y

• Average participation in 30-year bond auctions by various investor types (Aug ‘06 – present):
• Pension and retirement funds: 0.14% (essentially zero direct participation)
• Dealers: 54%
• Investment Funds: 25%

27

Sources: Pew Center on the States, Standard & Poor’s, US Treasury

UK and Netherlands Offer Alternative Models for Pension Regulation g

United Kingdom Netherlands

Assets $1.6 trillion $1.1 trillion Assets $1.6 trillion (10% public / 90% private) $1.1 trillion ( roughly evenly split public/private) Liability Discount Rate Gilts + margin (typically in 0.5-1.5% range) Euro swap curve Minimum Funding R i Less formula-driven than in the U.S. N h l d N h l h Three tests need to be met Requirements

• r Netherlands. Nevertheless, the

UK is viewed as one of the most stringent frameworks. Funding plan must be submitted to 1) Minimum Test: Assets must exceed 105% of

• liabilities. 3 year recovery period if below 105%

2) Solvency Buffer Test: Sufficient buffer to withstand g p the regulator. Deficits generally need to be rectified over the average duration of scheme (~15 years) ) y a 1-in-40 year market move. Typically implies assets exceed 120-130% of liabilities. 15 year recovery period if below this level 3) C ti it T t P f th t h t l i l 3) Continuity Test: Proof that coherent plan in place to run sustainable pension fund Accounting Regime IAS 19 IAS 19 (corporate schemes only. About 65% of market is industry-wide schemes) Average Funding Position 80-90% range 107% as of December 2010 g g g Asset Allocation 31% bonds & bills, 41% equities, 4% cash, 26% other 47% bonds & bills, 32% equities, 4% cash, 18% other Comments Clear trend toward LDI Duration mismatch versus liabilities is a major concern because it creates solvency level volatility and

28

because it creates solvency level volatility and increases required buffer

Sources: Presenting Member’s Firm, OECD

Considerations Regarding Public Pension Reform g g

• State and local government retirement plans should be structured to satisfy the needs of

retirees, employees, and taxpayers

• Clear disclosure is needed so that plan beneficiaries, plan sponsors, and investors in state and

local government debt can make informed decisions

• While some flexibility in accounting standards is necessary, sponsors should use standardized

/ h d l h bl d d d d f b l assumptions/methodologies to the greatest extent possible and standardize reporting dates for comparability

• Pension funds should take concrete actions before it is too late. Potential actions include:

1. Adjust benefits for current employees (COLAs, length of service, retirement age, etc) or increase employee contributions contributions

• Most direct approach. May face legal challenges if attempted unilaterally – once granted, may be deemed

“contractual obligations” 2. Contribute actuarially required contribution, funded by raising taxes and/or cutting expenditures

• Difficult given current state of economy. May be used as a bargaining chip when negotiating benefit cuts

3. Create a new tier of benefits or switch to a DC plan for new employees

• Fewer legal hurdles but does not address the potentially large benefits promised to current employees

4. Risk sharing - Implement a hybrid “cash balance” plan (low guaranteed return + DC component) or full DC plan

• Employees may demand higher current salaries or increased employer match if they view the new benefit

package as inferior to DB package as inferior to DB 5. Improve governance / oversight to ensure that plans are managed effectively by increasing training, setting higher standards for trustees, or hiring outside professionals 6. Issue pension obligation bonds and use proceeds to improve funded status

• If future returns are lower than the bond yield then the sponsor is worse off

29