Commentary on "On asset-liability matching and federal deposit and pension insurance"

The PBGC assumes responsibility for a plan’s defined-benefit pension obligations when two conditions are simultaneously met: the sponsoring firm is financially distressed and the pension plan is sufficiently underfunded. As such, PBGC insurance is a compound put option held by definedbenefit plan sponsors, and PBGC liabilities can be valued using options pricing methods. Recently, Wendy Kiska and Marvin Phaup of the Congressional Budget Office (CBO) and I have developed an options-pricing model to quantify the PBGC’s prospective net costs and to serve as a tool to evaluate the effect of various policy alternatives. The results described here are drawn from that CBO (2005) analysis. To briefly describe the model, it employs a Monte Carlo simulation that takes into account the evolution of firm assets, firm liabilities, pension assets, and pension liabilities and their interaction with program rules. For simplicity, firm and pension assets are assumed to be stochastic, whereas firm and pension liabilities are taken to be deterministic. Both firm and pension assets are affected by correlated market risk, and taking into account this risk adds significantly to the estimated value of the put option. The model is calibrated using 2004 data covering the top 1,179 companies with defined-benefit pension plans. Although reported underfunding in 2004 totaled $450 billion, the forward-looking estimate of the PBGC’s net cost is only a fraction of this. Over a 10-year horizon, we project a net cost of T he recent failures of several very large corporations with severely underfunded pension plans (e.g., United Airlines, U.S. Airways, and Bethlehem Steel) have made the risk exposure of the Pension Benefit Guaranty Corporation (PBGC), the government agency that insures defined-benefit plans, front page news. Further, the prospect that other large corporations are likely to follow has motivated legislators to introduce several new proposals aimed at limiting the PBGC’s risk exposure. In his paper, Bodie (2006) reminds us of the straightforward but often ignored fact that much of the risk to the PBGC could be avoided if limits were imposed on the share of pension assets invested in stocks and other risky assets. Presumably, the lack of interest by Congress in imposing such restrictions is due to very strong resistance from the business community. The fundamental question, then, is why do managers believe that it is imperative to invest pension assets predominantly in stocks, despite the volatility in funding requirements that they have experienced following this strategy? In these comments I will focus on two broad questions raised by Bodie’s analysis: First, what are the main drivers of the PBGC’s risk exposure? Second, why do pension managers choose to invest pension assets the way they do and when should the optimal hedge portfolio contain some stocks?

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