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November 24, 2004

SusPension of Disbelief

The Wall Street Journal is reporting that, "the Pension Benefit Guaranty Corporation, the quasi-government agency that insures private pension plans, announced a record deficit of $23.3 billion." They compare it to another S&L crisis in the making, and they're probably right. The S&L crisis was born of government insurance of an industry prevented by regulation from competing effectively.

Not only does this have immediate implications for the taxpayers, it could also help derail Social Security reform past its window of opportunity.

The proposal's immediate boost came in allowing companies to continue using an index of corporate bonds, instead of 30-year Treasuries, to discount pension liabilities. Since rates on corporate bonds are higher than Treasuries, liabilities appear to be lower and funding appears plumper.

A word on how this works. Treasury securities are assumed to be risk-free. That is, there is no doubt that the government will be able to pay its debts. Despite what you may have heard about the Federal deficit, this continues to be an excellent bet. Corporations, however, regularly go bankrupt. Even ones with excellent credit ratings have to reschedule their debts from time to time. Because of the added risk, companies have to pay a higher interest rate to attract investors.

"Discounting" is a means of determining how much today's money will be tomorrow. If I can use a higher interest rate to discount, I am assuming that I will be able to get a better return. Since a pension fund knows what its obligations will be, say, 10 years from now, using a higher interest rate means that I can claim that I'll be able to cover that same obligation then, with less money now.

Basically, the short-term fix proposed here is bookkeeping, to keep companies from drawing on the PBGC's resources if they don't need to.

The long-term fix would have required companies to match discount rates to the terms of liabilities, introduce more transparency in funding and stop underfunded companies from improving pension benefits.

This builds on the above explanation. If I know I have an obligation 10 years from now, I should use the current 10-year interest rate in discounting this particular obligation. Since short-term interest rates are typically lower than long-term interest rates, short-term obligations will need more money to be fully funded. Greater transparency subjects the pension fund managers to greater scrutiny; sort of the equivalent of having bloggers looking over Dan Rather's shoulder.

And if you're already underfunded, if you already can't fulfill your promises, you shouldn't be allowed to promise even more, just to keep your union from walking out on you. Supposedly, we learned this lesson with steel.

Naturally, Congress tried to revoke the long-term fix proposed by the President, while sweetening the short-term fix even further.

The problem in a nutshell, is that there's no incentive for companies to fully fund their plans. They pay a premium for belonging to this insurance system, but the premiums don't cover the long-term costs. Since the government has contracted this obligation, the taxpayers will get stuck with the bill for all these bad debts.

One popular solution is to raise the premiums paid by companies -- which haven't been increased since 1994 -- along with adjusting those premiums for risk. But a premium increase would make it more likely that healthy companies will drop out of the system, and risk-adjusted premiums give those financially fragile companies a strong incentive to terminate their plans.

There's actually a fairly simple solution - relieve fund managers of the burden of trying to beat the market. (While government pensions funds aren't covered by the plan, they're directly using public money, and have a horrid record recently.) Fund managers can restrict themselves to investing in bonds, where they can match the incoming cash flows to their obligations.

They can even, with periodic rebalancing, inoculate themselves against interest rate changes. Generally bond prices fall when interest rates rise, since new issues will pay a higher interest rate and be more attractive. But remember, you get to reinvest your payouts at that higher interest rate. Some fairly simple calculations will allow fund managers to match those investments against what they know they'll have to pay out.

This will disappoint a lot of fund managers, who want to earn their stripes before moving on to the big-leagues. Too bad. The state and city pension funds are one public trust. Poorly run corporate funds abuse another, while lying to their employees.

The good news is that even if nothing changes, the system won't go belly-up for about 16 years. The bad news is that if it isn't fixed, the papers will discover the problem just in time to discredit Social Security reform.

Posted by joshuasharf at November 24, 2004 06:23 PM | TrackBack
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