1 / 18

Deborah Lucas Northwestern University and NBER

Discussion of “ On Asset-Liability Matching and Federal Deposit and Pension Insurance” by Zvi Bodie. Deborah Lucas Northwestern University and NBER. Overview. Decomposing PBGC’s Risk Exposure What Does a Matched Portfolio Look Like?. PBGC’s Risk Exposure. Results drawn from:

simone
Download Presentation

Deborah Lucas Northwestern University and NBER

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript


  1. Discussion of“On Asset-Liability Matching and Federal Deposit and Pension Insurance”by Zvi Bodie Deborah Lucas Northwestern University and NBER

  2. Overview • Decomposing PBGC’s Risk Exposure • What Does a Matched Portfolio Look Like?

  3. PBGC’s Risk Exposure • Results drawn from: “The Risk Exposure of the Pension Benefit Guarantee Corporation” • CBO study by Kiska, Lucas and Phaup • available at www.cbo.gov

  4. PBGC’s Risk Exposure • Two conditions must be met simultaneously for PBGC to assume pension plans: • 1. Firm bankruptcy • 2. Under-funded pension plan • The probability of a joint occurrence is much lower than the probability that a pension plan is under-funded. • Fair premium for below-investment grade firms would have to be 18.5 times higher to match the current cost for investment-grade firms. • The fair price of PBGC premiums includes a significant charge for market risk, as both bankruptcy and under-funding are correlated with market downturns.

  5. PBGC’s Risk Exposure • PBGC insurance is a compound put option. • It can be valued using options pricing methods. • Monte Carlo model takes into account the evolution over time of: • Firm assets (stochastic) • Firm liabilities (deterministic) • Pension assets (70% stocks and 30% bonds) • Pension liabilities (deterministic) • and interactions with program rules

  6. CBO Estimates of PBGC’s Deficit

  7. Cost Components

  8. Summary of Findings • As Bodie suggests, more closely matching pension assets and liabilities significantly lowers PBGC’s projected costs. • But even with a matched portfolio, the model predicts that the PBGC will bear considerable costs. • Reason is that termination liabilities are systematically greater than current liabilities (i.e.,required funding levels). • We assume 20 percent mark-up of liabilities over assets at termination, following Pennachi and Lewis, and historical experience • e.g., U.S. Air > 90% funded in year prior to termination, <45% funded at termination

  9. Summary of Findings • Costs not arising directly from asset-liability mismatch can be attributed to regulatory forbearance, and to accounting conventions. • Forcing firms to fund to level of termination liabilities would result in systematic over-funding.

  10. The S&L analogy revisited • Similarities: • Mismatch in market sensitivity of assets and liabilities creates potentially huge costs for the insurer. • Regulatory forbearance exacerbates problem. • Differences: • Much less severe moral hazard due to compound option. Sound companies have very little chance of putting their plan to the PBGC. • Little evidence that distressed companies gamble more with pension plan assets. • Significantly lower projected costs.

  11. What perpetuates the mismatch? • Why don’t healthy companies use more bonds in funding their pensions, reducing volatility? • Why are policymakers reluctant to lower PBGC costs via restrictions on asset-liability mismatch? • Tentative answers: • Firms follow established norms. • The investment strategy that minimizes risk has not been fully articulated.

  12. Is the best hedge a bond portfolio? • Bodie’s example: • Pension liability of $1000 in 10 years • Put away present value = $1000/(1+r)10 in risk-free bonds • This is a perfect hedge

  13. The optimal hedge portfolio with wage indexation • Typical DB pension promises a fraction of terminal wages, a random variable. • e.g., annual pension = .4 x wage10 • Now the best hedge is the portfolio maximally correlated with wage10 • If wages and stock returns are correlated, the optimal portfolio will contain stocks was well as bonds. • How much stock? It depends…

  14. Finding the best hedge portfolio • When wages and stocks are correlated, the value of the pension liability can be modeled as a derivative. • The value of the pension liability, and the hedge portfolio, can be found using options pricing methods. • The optimal portfolio is dynamic, changing over time with the demographics of the labor force. • Bonds still play a big role: • Firms with predominantly retired workers should invest predominantly in bonds. • Firms with young workers should invest more in stocks. • When workers separate from the firm, their benefit becomes like a bond.

  15. An example • The following joint process for stocks, human capital and wages generates: • 1. an almost a zero correlation between wage growth and stock returns at a one-year horizon • 2. a correlation of .11 between wage growth and stock returns over 3 years, and .36 over five years • The aggregate value of stock evolves according to: • The aggregate value of human capital evolves according to: • Wages evolve according to:

  16. An example parameters

  17. An example -- results Bottom line: Optimal share in stocks increases with employment horizon.

  18. Final thoughts • Asset-liability mismatch is a major source of risk, but restricting investments to bonds may not be the right answer. • Any policy that seriously addresses the PBGC funding gap will likely accelerate the switch from DB to DC pensions. • Hence, the costs of PBGC insurance must be considered in the broader context of the goals of an employer-based retirement savings system.

More Related