A study co-written by a University of Illinois pension policy expert warns that the financial risks facing the government-sponsored corporation that insures all private-sector pension plans in the U.S. are much greater than commonly thought.Readers can download an executive summary and the entire paper on Brookings' site here. I note the following:
University of Illinois finance professor Jeffrey R. Brown says that the Pension Benefit Guaranty Corp. is facing a very large financial shortfall and ultimately may need to be bailed out by taxpayers.
"Our in-depth review of the PBGC's models indicates that they are likely to underestimate how bad things can get when the economy is weak," said Brown, the William G. Karnes Professor of Finance and the director of the Center for Business and Public Policy in the U. of I. College of Business. "The implication is that the financial risks facing the system are much greater than widely believed."
Brown co-wrote the paper with Douglas J. Elliott, Tracy Gordon and Ross Hammond, all of The Brookings Institution. The team of researchers conducted an independent review of the Pension Insurance Modeling System, the complex simulation model that is used for assessing the long-term health of the financially troubled PBGC insurance program.
"There is a lot of debate in the plan sponsor and policy community about whether PBGC's long-term financial projections are excessively optimistic or pessimistic," he said. "This is important because these projections frame the discussion about what steps, if any, Congress should take to strengthen the pension insurance program. Some interest groups believe that PBGC's models overstate the program's exposure, whereas many economists are concerned that the problem may be worse than it appears."
Brown, a former member of the bipartisan Social Security Advisory Board and a senior economist with the President's Council of Economic Advisers in 2001-2002, says that the federal pension insurance agency's model is "likely to substantially understate the degree of fiscal risk to PBGC's insurance programs."
"During a financial crisis or recession, you tend to have clusters of corporate bankruptcies," he said.
According to Brown, these clusters also tend to happen around the same time that the typical plan's funding status is worsening as a result of investment losses that accompany an economic downturn.
"The PBGC's model does not adequately account for these macroeconomic shocks that lead to correlated losses," he said.
Brown says the PBGC is supposed to be self-financing and not receive taxpayer funding – but notes that the same was once true of beleaguered mortgage giants Fannie Mae and Freddie Mac.
"Taxpayers are probably going to have to foot the bill in the same way we bailed out savings and loans in the 1980s and the mortgage agencies during the 2008 financial crisis," he said. "Nearly everyone believes that Congress is ultimately going to have to backstop the PBGC because it's insuring the pensions of tens of millions of people. No one believes they're going to just let it fail."
The paper is titled "A Review of the Pension Benefit Guaranty Corporation Pension Insurance Modeling System."
A key finding of our review is that the limited treatment of correlated risk factors arising from the macroeconomic environment is likely to substantially understate the degree of fiscal risk to PBGC’s insurance programs.This may be one reason that actual PBGC results have come out much below PIMS’ median projections. In the PIMS model, there are very few avenues through which broader macroeconomic factors can operate directly on the distribution of potential future losses.
In reality, however, macroeconomic factors directly affect many of the key drivers of PBGC’s finances: for example, during an economic downturn, it is reasonable to expect more plan sponsors to experience financial distress and more plans to be underfunded. Consequently, the distribution of possible loss exposure has much “fatter tails” (that is, the probability of extreme losses is much greater) than is currently captured by the PIMS model. This matters because PBGC and other insurers have an asymmetric exposure to fat tails, being hurt more by the negative extremes than they are aided by the positive extremes.
Although our analysis focuses narrowly on the PIMS model, rather than broader policy questions about the pension insurance program, it is worth stressing that these extreme negative events are most likely to occur in states of the world in which the broader U.S. economy is relatively weak, which means that it would be a particularly economically painful time for the nation to have to address an underfunded pension insurance program.
Recognizing the true economic costs of these correlated risks and how they affect the broader fiscal position of the U.S. government, therefore, has potentially important implications for program design, the average level of premiums, the question of whether to risk‐adjust premiums, and other important policy parameters which are well beyond the scope of this narrow technical review of the PIMS model.
Our review provides a number of specific observations about the model that could be used to guide future revisions to the model in this respect, particularly with regard to the modeling of the bankruptcy and financial market processes.A few thoughts on this paper and its broader implications. First, it hardly surprises me that the authors found a " limited treatment of correlated risk factors arising from the macroeconomic environment is likely to substantially understate the degree of fiscal risk to PBGC’s insurance programs." I don't think this problem is unique to PBGC but because it is a government insurer, it receives a lot more scrutiny than other organizations, and rightfully so.
Second, the authors are right to point out that risks to a corporate pension plan increase significantly during a recession, placing more pressure on PBGC's insurance programs as it deals with "clusters of corporate bankruptcies." Unlike U.S. public pension funds, corporate plans use market rates (typically AA or higher corporate bonds) to determine their future liabilities. So when a recession occurs, they experience investment losses and soaring liabilities.What made matters worse after the 2008 crisis is that public and private pension funds were piling into corporate bonds, driving rates to historic lows and pension liabilities to historic highs. No wonder corporations are now racing to de-risk pensions.
Third, while corporate America's pension time bomb has been defused for now, many corporate plans remain vulnerable to a substantial macroeconomic shock. It would make more sense to raise premiums during good economic times and decrease them during bad times to cushion the blow of a severe downturn. Of course, any suggestion of raising premiums will be met with fierce protests from corporations looking to cut pension costs.
Finally, from a broader policy perspective, I keep bringing up the point that pensions should be treated like a public good and corporations shouldn't be in the pension business at all. They should focus on their core business and pensions should be managed by well-governed public pension funds that operate at arms length from the government. This way, we can scrap defined-contribution plans and address the issue of pension portability, giving people the peace of mind that their pensions are properly managed no matter where they work, allowing them to retire in dignity and security.
Importantly, it's high time America and the rest of the world gets serious about pension policy. We can tinker at the edges but the reality is once the tsunami hits, millions of people will resort to flipping burgers to scrape by during their golden years (watch below). And they will be among the lucky ones. Most will resort to eating cat food to survive.