Home > pensions > Gambling for Salvation: Why PBGC Should Just Say “No”

Gambling for Salvation: Why PBGC Should Just Say “No”

March 3, 2008

The Pension Benefit Guaranty Corporation (PBGC) has just announced its intention to double its investment in equities to 45 percent of its $67 billion portfolio.  This decision flies in the face of responsible financial management, which in this case calls for avoiding equities entirely, or even better, taking a short position in the stock market.

PBGC’s decision to gamble for solvency is such a bad idea, and is motivated by such perverse institutional incentives, that I’d like to commemorate it by making it the topic of this first blog entry.

First some background…The PBGC, which guarantees the private defined benefit pension plans of some 44 million American workers and retirees, reports a deficit of about $13 billion dollars.  That is down from its peak deficit of $23.3 billion in 2004, but observers fear that the deficit could reach new heights if the economic slowdown triggers a further wave of corporate bankruptcies.

Who will cover the shortfall?  The possible candidates are corporate plan sponsors, insured retirees, or taxpayers at large.  Corporate sponsors could be made to bear at least some of the cost by raising insurance premiums or by tightening funding requirements.  The current rules subsidize defined benefit plans—premium rates are fixed by Congress at levels well below fair value, especially for high-risk sponsors, and underfunded plans are allowed years to close their funding gap.  Whether or not placing more of the burden on plan sponsors is a good idea in theory, the very modest changes in the recently passed Pension Improvement Act indicate a lack of political will to do so.  Denying promised benefits to covered retirees would appear to be even less politically feasible.  That leaves a taxpayer bailout as the most likely resolution.

Why then more equities?  Although insolvent in present value terms, PBGC can postpone the ultimate day of reckoning as long as its investment portfolio has a sufficiently positive balance.  By tilting its portfolio to higher risk, higher expected return investments, PBGC hopes it can avoid that day indefinitely.  In fact, selecting the composition of its portfolio is the one and only major policy lever PBGC can control without Congressional approval.  In the plaintive words of PBGC director, Charles Millard, “The whole problem is that we are underfunded.  We are chronically underfunded.”

Of course, selling bonds to buy stocks does not really address the problem of chronic underfunding.  Imagine investor reaction if Goldman Sachs announced a similar strategy in response to its subprime losses.  A dollar of bonds is worth a dollar of equities, and taxpayers are in the hole by $13 billion dollars no matter how PBGC juggles its portfolio.

Now, finally, here is the point of all of this, which is to explain why this strategy is ill-advised on many levels.

First and most obviously, there is the risk of PBGC making a bad situation much worse.  The S&L crisis of the 1980s offers a striking parallel.  At that time Congress and regulators were faced with a similar choice:  allow insolvent thrifts to gamble on high risk investments or shut them down and pay off insured depositors.  The decision to do the former ultimately cost taxpayers an estimated $125 billion (which was still real money back then).

Although PBGC downplays the risk, it is not difficult to imagine what the downside scenario looks like in this case.  Imagine the not-so-unlikely situation of a faltering economy and falling stock market.  At the same time a few old industrial behemoths go belly up, leaving their pension liabilities to the PBGC.  This is a double hit to PBGC:  just as its own portfolio tanks it is forced to take on large and highly under-funded liabilities (highly under-funded because corporations also rely heavily on equities to fund their pension liabilities).

This highlights an interesting point (not original to me):  For the PBGC, investing in stocks is the opposite of hedging:  it is doubling down on risk!  PBGC would actually minimize the risk to taxpayers by investing in bonds and taking a slightly short position in the stock market, say by using S&P index futures.  That way when the market is down and its liabilities are up, the payoff on the futures contracts would offset the cost of the additional liabilities.

The general principle is that prudent fund managers minimize risk by matching assets and liabilities (they “immunize” their portfolios).  If liabilities look like bonds, then that is what they should invest in.  In fact, the liabilities already on PBGC’s books are very similar to bonds.  It is obligated to make fixed annual payments to a known group of beneficiaries over their remaining lifetimes.  Much to their credit, former PBGC directors Stephen Kandarian and Bradley Belt held to this principle, despite what must have been the strong pressure in the face of even larger deficits.

My final concern is the “slippery slope” issue.  If the best way to resolve PBGC’s underfunding problem is to let it gamble with taxpayer dollars by investing in the stock market, why not do the same thing for Social Security and for Medicare?  Why not issue Treasury securities, use the proceeds to buy stocks, and cut taxes?  If any of you are thinking, “yeah, why not?” I hope that you will write and explain that view.

Further readings:

More that I’ve written (with Wendy Kiska of CBO) on the cost of PBGC deficit and options for controlling it: The Risk of Exposure of the Pension Benefit Guaranty Corporation (PDF), Congressional Budget Office Paper, September 2005

Look at what the PBGC has to say for itself at: PBGC Announces New Investment Policy, PBGC news release, February 18, 2008.

Categories: pensions
  1. March 4, 2008 at 11:54 am

    Thanks, Zvi! I appreciate that you have been one of the earliest and most persistent voices for getting PBGC to manage their risk responsibly.

    Glad you pointed me to the Jubak’s Journal entry: “The year’s scariest investing news”—it’s right on point. The link is:


  2. Debbie Lucas
    March 5, 2008 at 3:47 pm

    Some additional links from John Ralfe:

    Skypala – US pensions safety net takes risky path
    Chancellor – Pensions still oblivious to bond wisdom
    Jackson – No compelling precedent for another switch into equities

  3. March 3, 2009 at 8:10 pm

    Hi Debbie and Bob,
    May the Lord bless you both. Here is a letter about the PBGC decision that John Ralfe and I had published in the FT last week:

    US pension body’s shift over equities adds insult to injury
    Published: February 26 2008 02:00 | Last updated: February 26 2008 02:00

    From Prof Zvi Bodie and Mr John Ralfe.

    Sir, The Pension Benefit Guaranty Corporation, an agency of the US federal government which protects the pensions of 44m Americans in defined benefit pension plans, has just announced a shift in its strategic asset allocation from 15-25 per cent equities to 55 per cent equities (report, February 19). This reverses the policy adopted in 2004, which saw a significant move from equities to duration-matched bonds. Does the move back to equities make sense for the PBGC?

    The PBGC already has huge exposure to equities through guaranteeing company pension plans. Poor equity performance, reflecting a weak economy, will increase the number of bust companies passing their pensions to the PBGC. With typical equity weightings in US pension plans, deficits and each PBGC loss will also be bigger.

    For the PBGC itself to hold more of its assets in equities adds insult to injury – like a company which insures hurricane damage investing its reserves in beachfront property. Annuities paid by the PBGC can only be matched by holding bonds – holding more equities looks like the PBGC trying to bet its way out of a loss. The UK equivalent of the PBGC, the Pension Protection Fund, has certainly got this simple message and holds only 20 per cent equities, explicitly limiting the equity “double whammy”.

    The PBGC press release asserts that the new strategy significantly increases the likelihood of full funding within 10 years and that the new policy “is designed to take advantage of a long-term investment horizon”. The PBGC clearly believes that equity risk, measured by the volatility of returns, decreases the longer the time horizon.

    Volatility analysis as a measure of equity risk ignores the severity of any shortfall. Although the probability that equities will earn less than the risk-free rate decreases with the time horizon, the extent of any possible shortfall increases. Equity risk should be measured as the cost of buying insurance via an equity put option, which increases over time. Adjusted for risk there is no equity “free lunch”.

    The PBGC guarantee of pensions has institutionalised “moral hazard” in the US since it was set up in 1974. US trustees have little incentive to reduce risk for members by matching assets and liabilities – they know that if the company goes bust, the PBGC will pick up the tab. The UK may be seeing this since the PPF opened.

    At September 2007 the PBGC had a $14bn deficit – assets of $68bn and liabilities of $82bn – following several large losses from bankrupt companies, as well as another $66bn of “reasonably possible” exposure for plans sponsored by junk-rated companies.

    As the US federal government backs the PBGC its structural deficit will, sooner or later, have to be made good by the government. We could see a re-run of the 1980s US saving and loans debacle.

    Zvi Bodie,
    Professor of Finance and Economics,
    Boston University School of Management,
    Boston, MA 02215, US

    John Ralfe,
    John Ralfe Consulting,
    Nottingham NG2 6EU, UK
    Copyright The Financial Times Limited 2008

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