Uncle Sam Stocks Up

Risk-taking is the mother's milk of capitalism. But private sector risk-taking with public sector backing can be a recipe for trouble. Which is why news that the Pension Benefit Guaranty Corporation will diversify its portfolio to include more equities ought to concern taxpayers.

The PBGC is a quasi-government agency -- a "federal corporation" -- created in 1974 to guarantee pension benefits for U.S. workers and retirees. Operating as both an insurance business and pension fund, it is financed by corporate premiums and the assets it inherits when taking over failed pension plans. By the end of last year, the agency had amassed a $14 billion deficit, and the new policy is designed to erase that red ink with higher investment returns.

By statute, corporate premiums can only be invested in fixed-income securities, and in practice that has meant Treasuries. But there are no such constraints on how the agency can invest the assets it inherits from terminated pension plans. Back in 1974, Congress never anticipated that the lion's share of the agency's financing would one day come from the latter, yet today revenues from premiums comprise just 21% of PBGC's total assets.

Charles Millard, the agency's director, says PBGC has some $55 billion to invest under the new strategy. His plan, which deviates from a policy adopted in 2004 that favored duration-matched bonds, will allocate 45% to diversified equity investments. Another 10% will go toward "alternative investments" that will be split between real-estate and private equity. Last year, equity plays were only 28% of PBGC's portfolio.

Some equity exposure makes sense to hedge against longevity risks. The issue here is whether it's prudent to start making larger bets that could prove costly if the agency guesses wrong. Mr. Millard says the new policy is "less risky" than the old one because it "has a lower standard deviation," a "higher Sharpe ratio and better results in the 99th percentile worst-case scenario." Labor Secretary Elaine Chao, who chairs the PBGC board and signed off on the new plan, apparently agrees.

But as Zvi Bodie of Boston University has noted, while more exposure to equities might be less risky over time, the extent of any potential shortfall increases. Besides, PBGC policy should be to maximize returns subject to the nature of the liabilities the agency is taking on. And the fact remains that the PBGC guarantees pensions of the weakest companies -- those with little incentive to fully fund their plans because they can always be dumped on PBGC.

Mr. Millard says his agency doesn't have government backing under its statute, but PBGC does have an implicit claim on tax dollars. Mr. Millard's predecessors -- from Kathleen Utgoff to Steven Kandarian to Bradley Belt -- well understood the inherent moral hazard that could prompt a taxpayer bailout.

"Any insurance system runs the risk of encouraging bad behavior, but the level of moral hazard plaguing [PBGC] . . . is staggering," said Mr. Belt when he headed the agency in 2004. "Simply put, management and labor at financially troubled companies have a powerful temptation to make promises that they cannot or will not fund." A case in point is United Airlines, which was losing money in 2002 when it increased retirement pay for its ground crew, even though its pension was already 25% underfunded. Within a year United had declared bankruptcy and left PBGC with $6.6 billion in obligations.

There's also the problem of the government owning significant portions of the private sector. At one point a few years back, PBGC had 25% of United, 15% of Delta and 15% of Kaiser Aluminum. The last thing Americans should want is government owning huge chunks of corporate America, because with ownership eventually comes control.

Republican John Boehner, the current House Minority Leader, explained those consequences in a letter to his colleagues in 2005. "When worker pension plans are terminated as a result of outdated laws and the financial burden is placed on the federal Pension Benefit Guaranty Corporation, both workers and taxpayers stand to lose," said Mr. Boehner. PBGC's deficit then was $23 billion, and Mr. Boehner said "a taxpayer bailout of the agency remains a possibility." It still is.

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We realize Mr. Millard is in a tight spot and his options are limited. The most prudent way to fix what's wrong with PBGC, aside from getting rid of it, would be for the agency to promise less or collect more -- that is, reduce the amount of the pension guarantee or charge higher premiums that bear some relation to actual risk.

But enacting those changes requires Congressional action, and lawmakers -- no surprise -- have typically refused to properly fund the agency or to demand higher premiums from the companies that are insured. Until Congress grows a backbone and puts in place real reforms, it's better to limit, rather than increase, potential taxpayer exposure.

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