Tuesday, February 26, 2008

US pension body's shift over equities adds insult to injury

(Zvi Bodie and John Ralfe in the FT) 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.

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