Americans should by now understand the dangers that accompany the phrase “too big to fail.” It has been applied to Fannie Mae and Freddie Mac, to Wall Street firms and commercial banks, and to the Big Three automakers. Yet, while it is trite to say that those who do not learn from the past are doomed to repeat it, it is worrisome that some seem unable even to learn from the present. The new investment policy proposed by the Pension Benefit Guaranty Corporation (PBGC) is an example of such a failure to learn, and unless this policy is overruled by the Obama administration, the policy will impose more risk on taxpayers. 

The PBGC is a self-financing federal entity that assures workers and retirees that their pension benefits (up to $54,000 per year) will be safe, even if their employer declares bankruptcy. The PBGC is funded through premiums charged to employers who sponsor defined-benefit pension plans; it is not financed through general tax revenues.

The terminated pensions of 1.3 million workers and retirees are already held by the PBGC, up from only 500,000 at the beginning of the decade. Another 44 million American workers are presently being insured by the agency.

Unfortunately, the PBGC faces an uncertain future. The $62 billion in assets that the PBGC had at the end of fiscal year 2008 are not enough to cover $73 billion in liabilities already on its books. As pension plan failures rise and healthy employers drop defined-benefit plans, the PBGC’s financial lifeblood—premium income—will start drying up. Insolvency is the likely outcome, and unless one believes that Congress will allow millions of workers and retirees to lose their pensions, a taxpayer-financed bailout of the PBGC would follow.

While falling stock prices and low interest rates have hurt firms sponsoring defined-benefit pensions, the real blame lies with Congress. It is Congress, not the PBGC, which sets the agency’s operational rules. Congress has consistently charged premiums that are, on average, too low, and it has not permitted the PBGC to vary those premiums based on the credit risk of the plan sponsor or the risk of the plan sponsor’s pension investment strategy. Funding incentives are low, owing both to poor funding standards and a lack of transparency that makes it difficult for employees or investors to impose discipline on the plan. 

The PBGC’s new investment policy effectively tries to insure against declining stock prices by investing in stocks.

But there is one significant policy shift emanating from within PBGC itself that threatens to make a bad situation even worse. Last year, PBGC Director Charles Millard announced that the agency would shift its asset portfolio more heavily into equities, with an ultimate goal of reaching 45 percent stocks. Millard justified this switch as “taking advantage of the PBGC’s long-term investment horizon” and cited a review that “showed the new diversified portfolio would have yielded better results than the old investment policy 98 percent of the time over rolling 20-year periods.” Historically, PBGC has invested only 15 percent to 25 percent of its assets in stocks, with the majority in bonds whose maturities are matched to the program’s coming liabilities.

Millard defended his new policy, saying “If sixth-graders in America took finance, I could say to you that, ‘As every sixth-grader knows, diversification mitigates risk, and this policy is substantially more diversified, and that is why it has a lower standard deviation.’”

But a $60 billion investment portfolio should not be managed with a sixth-grader’s view of finance. More advanced finance says that true risk reduction depends on how asset values will vary with liabilities. The PBGC’s new investment policy effectively tries to insure against declining stock prices by investing in stocks. Under this plan, PBGC’s asset values are likely to fall precisely when they are needed the most—when firms are failing and have under-funded pension plans, both of which happen when stock markets turn down. As Boston University financial economist Zvi Bodie memorably wrote, “a company that insures against hurricane damage should not invest its reserves in beachfront properties.”

A diversified stock portfolio is a good investment strategy for individuals and organizations who are willing to bear downside risk in exchange for higher expected returns. But the PBGC is not an individual saving for retirement. It is an insurance agency that implicitly insures against market downturns.

The best way to reduce the PBGC’s risk with regard to terminated pensions already on the books is to invest in a portfolio of assets, such as bonds, that have a known payoff with durations similar to the liabilities being backed. For liabilities not yet on the books, risk can be reduced by taking a short position in equities, especially in industries such as airlines, steel, and automobiles, which appear most at risk. These steps would produce a broadly defined asset portfolio, inclusive of both PBGC’s explicit assets and demands on those assets placed by pension sponsors, with less risk than the agency’s new investment policy.

Last year, Congressional Budget Office Director Peter Orszag (the current Obama administration budget director) warned that under the new investment plan “PBGC is more likely to experience a decline in the value of its portfolio during an economic downturn—the point at which it is most likely to have to assume responsibility for a larger number of underfunded pension plans.” The PBGC needs many reforms; rolling the dice on stocks is not one of them.

Jeffrey R. Brown is a professor of finance at the University of Illinois. Andrew G. Biggs is a resident scholar at the American Enterprise Institute. His recent Retirement Policy Outlook asked “Will You Have Enough to Retire On?”

Image by Darren Wamboldt/The Bergman Group.