Wednesday, February 20, 2008
Pension Roulette
The Pension Benefit Guaranty Corporation (PBGC) claims that, to avoid a taxpayer bailout, it must shift its asset allocation more heavily toward equities, the Financial Times reported yesterday. The PBGC plans to up its equity allocation from 28% in 2007 to 45% of total assets, and allocate 10% to alternative investments, including hedge funds and real estate. The remainig 45% will be held in diversified fixed-income investments.
As quoted by the FT, Charles Millard, the director of the government-sponsored PBGC, succinctly stated, "The problem is wthat we are underfunded. We are chronically underfunded." Shifting their allocation toward equities "...significantly boosts the likelihood that the PBGC will achieve full funding," according to a PBGC spokesman quoted in the article. The PBGC is running a $14 billion deficit.
Mr. Millard puts odds on the strategy's success, claiming that, "This strategy gives the corporation a 57 per cent likelihood of full funding within 10 years, compared to 19 per cent under the previous policy."
That said, it increases the likelihood of further erosion in funding, particularly if the U.S. economy enters a recession -- just when the PBGC will be needed the most.
Many corporate and public pension funds are chronically underfunded, due in part to their over-reliance on equities over the past decade. The typical U.S. pension plan allocates about 60% of its assets to equities. Even though pension plan liabilities are closely linked to long-term bonds, there are powerful financial incentives for corporations to swing for the fences with equities. Although this strategy looked great during the late 1990s, it had disastrous consequences during the 2001 recession: falling interest rates drove the value of plans' liabilities higher, while the decline in equity prices pushed asset values lower. Many pension plans found themselves in dire straits, which put considerable strain on the PBGC.
As an insurer, the PBGC should be investing anti-cyclically. Generally speaking, the PBGC's services are utilized infrequently in bull markets, since most pension plans are heavily tilted toward equities. However, in a recessionary bear market, the asset-liability mismatch of most pension plans puts them at risk. It is in these markets that the PBGC is called upon most, and that the losses are most severe.
The PBGC's claims of excess returns to equities are also suspect. For example, compare the Vanguard Wellesley Income Fund (VWINX) -- allocated 1/3 to dividend-paying U.S. stocks and 2/3 to high-grade U.S. bonds -- to the Vanguard Balanced Index Fund (VBINX) -- which allocates 60% to U.S. equities and 40% to fixed-income -- and . The former is representative of the PBGC's current allocation, and the latter is representative of the new strategy. The table below summarizes the funds' total returns as reported by Vanguard:
Over the past 10 years, the Income Fund outperformed the Balanced Fund by a slight margin, belying the claim that a higher equity allocation offers superior returns. Moreover, during the years 2000-2002, the Income Fund had a total gain of 34%, while the Balanced Fund lost 14%. The relative performance of these two funds during the last recession and bear market suggests that the PBGCs strategy may be ill-timed, and may put the PBGC at great risk to further erosion of its funding.
As quoted by the FT, Charles Millard, the director of the government-sponsored PBGC, succinctly stated, "The problem is wthat we are underfunded. We are chronically underfunded." Shifting their allocation toward equities "...significantly boosts the likelihood that the PBGC will achieve full funding," according to a PBGC spokesman quoted in the article. The PBGC is running a $14 billion deficit.
Mr. Millard puts odds on the strategy's success, claiming that, "This strategy gives the corporation a 57 per cent likelihood of full funding within 10 years, compared to 19 per cent under the previous policy."
That said, it increases the likelihood of further erosion in funding, particularly if the U.S. economy enters a recession -- just when the PBGC will be needed the most.
Many corporate and public pension funds are chronically underfunded, due in part to their over-reliance on equities over the past decade. The typical U.S. pension plan allocates about 60% of its assets to equities. Even though pension plan liabilities are closely linked to long-term bonds, there are powerful financial incentives for corporations to swing for the fences with equities. Although this strategy looked great during the late 1990s, it had disastrous consequences during the 2001 recession: falling interest rates drove the value of plans' liabilities higher, while the decline in equity prices pushed asset values lower. Many pension plans found themselves in dire straits, which put considerable strain on the PBGC.
As an insurer, the PBGC should be investing anti-cyclically. Generally speaking, the PBGC's services are utilized infrequently in bull markets, since most pension plans are heavily tilted toward equities. However, in a recessionary bear market, the asset-liability mismatch of most pension plans puts them at risk. It is in these markets that the PBGC is called upon most, and that the losses are most severe.
The PBGC's claims of excess returns to equities are also suspect. For example, compare the Vanguard Wellesley Income Fund (VWINX) -- allocated 1/3 to dividend-paying U.S. stocks and 2/3 to high-grade U.S. bonds -- to the Vanguard Balanced Index Fund (VBINX) -- which allocates 60% to U.S. equities and 40% to fixed-income -- and . The former is representative of the PBGC's current allocation, and the latter is representative of the new strategy. The table below summarizes the funds' total returns as reported by Vanguard:
| VWINX | VBINX | |
| 1 year | 5.61% | 6.16% |
| 5 years | 7.48% | 10.08% |
| 10 years | 7.22% | 6.41% |
Over the past 10 years, the Income Fund outperformed the Balanced Fund by a slight margin, belying the claim that a higher equity allocation offers superior returns. Moreover, during the years 2000-2002, the Income Fund had a total gain of 34%, while the Balanced Fund lost 14%. The relative performance of these two funds during the last recession and bear market suggests that the PBGCs strategy may be ill-timed, and may put the PBGC at great risk to further erosion of its funding.
