MILLARD: Safer investing for pensions

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By Charles Millard

COMMENTARY:

Recent news about Fannie Mae and Freddie Mac highlights the issue of moral hazard. Moral hazard occurs when companies of individuals take actions carrying risks they don't bear. Instead, those risks are borne by someone not at the table - frequently, the taxpayer.

The Pension Benefit Guaranty Corp. recently changed its investment policy and asset allocation to avoid just such moral hazard. PBGC faces a long-term deficit of $14 billion. The prior investment policy essentially locked in that deficit and left it to Congress to figure out a solution. That solution would have been some form of bailout, higher premiums or reduced retirement benefits. The prior policy insisted on having Congress solve a problem rather than helping solve it ourselves through the use of mainstream investment and risk mitigation techniques.

PBGC has $55 billion in assets but faces $70 billion in liabilities. The previous policy, based on a strategy of asset-liability matching, carried very little diversity and called for 75 percent to 85 percent fixed income. It had a 19 percent chance of eliminating the deficit over the next 10 years.

The new policy, adopted this year by PBGC's Board, called for 45 percent diversified equities, 5 percent private equity, 5 percent alternatives, and 45 percent diversified fixed income. It is designed to give the PBGC a better chance of eliminating its deficit over time. Of course there are no guarantees, but the new policy has a 57 percent chance of reaching full funding in 10 years - triple that of the prior policy. It is a long-term policy, focused on prudently meeting our obligations over time.

Just as important, the new policy was specifically designed to reduce portfolio risk (standard deviation) as compared with the prior policy. This seems counterintuitive. How can a policy that moves toward "riskier" equity securities have less risk than one composed mostly of less "risky" fixed income securities?

The answer lies in the principal risk mitigation tool utilized by investors today: diversification. Or put differently: the issue that should concern us is not the riskiness of particular securities but the riskiness of the portfolio in times of stress. In fact, even in the worst case scenarios we were able to model, the overall new policy substantially outperforms the old.

All right, then if we are using diversification to mitigate risk, how can we also be generating higher returns? The truth is, diversification can do both. It can mitigate risk, or it can enhance return, or it can move along a spectrum between both. This policy could have reduced risk even further or could have targeted a return higher than the 7.5 percent we are shooting for. Instead the Board opted for a reasonable return for a policy this diverse, and we diminished our risk.

Why is this important? Because PBGC is trying to avoid the Fannie Mae and Freddie Mac trap. Those GSEs relied on an implicit government backing to take risks in the marketplace that no normal market actor would take. Their investments were completely undiversified, and the very discipline the market imposes on most actors was not properly imposed upon them.

The PBGC's investment policy is designed to do just the opposite. Unfortunately, we are not permitted to assess risk-based premiums, we certainly cannot reduce retirement benefits or guaranty levels, we have no ability to raise funds, nor does Congress wish to write a check. And the law that created PBGC explicitly states that the U.S. government does not stand behind our liabilities. Any market actor faced with that situation would reject a policy like the prior one that locked in the need for a bailout.

Of course, nobody would want PBGC to reject the old policy in favor of a strategy that was too risky. But by every measure that has been applied to the new policy by supporters or by critics, the standard deviation is below the average for large pension funds in America.

Decreasing the likelihood of moral hazard or bailout through the lower risk and higher returns provided by robust diversification certainly does not eliminate all risk, but it does make the insurance system healthier and should give Congress one less issue to worry about.

Charles E.F. Millard is director of the Pension Benefit Guaranty Corp.