Financial Derivatives and the PBGC

The Pension Benefit Guaranty Corporation (PBGC) insures pension plans, charging companies for this insurance and taking over plans when companies can no longer pay promised benefits. The PBGC isn't doing so hot. The Congressional Budget Office estimates that it faces a $100 billion deficit.

Why is the PBGC in this mess? Like any insurance, PBGC pension insurance creates a moral hazard problem. Workers whose pensions are insured will be less likely to monitor their companies to insure that the pension plans are appropriately funded. Companies in financial distress would love to dump their pension obligations on the PBGC.  So the very existence of the PBGC makes it more likely that pension plans will fail. In addition, the PBGC may be the victim of bad luck; if the number of pension plan failures has exceeded reasonable expectations, then the PBGC would have a deficit, even if the premiums it charges were originally set appropriately.    

But these are problems faced by any insurer-- why are many private insurance companies profitable while the PBGC faces an almost incomprehensible hole?

Private insurers often address the moral hazard problem through prices. Often, the probability of losses can be mitigated by certain behaviors. Insurance companies know this, and charge less to people who  behave in ways that are less likely to lead to losses. Thus, drivers without many driving infractions pay less for car insurance; non-smokers pay less than smokers. The PBGC tries to do this as well by charging more for companies that it deems more likely to default. The problem is that the appropriate price differential is hard to determine. Insurance companies have lots of data on the impact of smoking on death rates. Estimating pension default possibilities is more difficult and the PBGC has done a poor job.  (It probably doesn't help that the PBGC is a government agency rather than a for profit company.)

Insurance companies also do a better job of matching their assets to their liabilities. For example, many insurance companies issue catastrophe bonds against large risks. A hurricane "cat" bond pays little or nothing if a hurricane season is a bad one, but it pays high rates when the hurricane season is not so severe. The cat bonds allow insurance companies to spread expensive risks (such as the risk of hurricanes) with other investors. The PBGC's investments, by contrast, consist primarily of cash and fixed income securities. These assets have similar values whether times are good for the PBGC (ie. when there are few pension plan failures) or bad (many pension plan failures.) Therefore, when times are bad, the PBGC will have deep hole.

Happily recent developments in financial markets allow the PBGC to solve many of their problems. Credit default swaps allow a party to protect itself against default by a third party. If I am afraid that GM will fail, I can buy a credit default swap that protects me if GM defaults on it bonds. The PBGC should buy credit default swaps for all companies whose pension plans it insures. This would help the PBGC match assets and liabilities. When many companies default, the PBGC's liabilities will be high, but so will its assets, because the value of the PBGC's credit default portfolio will be high.

Credit default swaps will also help the PBGC price its insurance better. If a company's credit default swaps are expensive, then the company is at greater risk of defaulting. The PBGC should charge this company more for insurance than other companies because it costs the PBGC more to protect itself from the risk of a pension default by the at-risk company. The PBGC could calculate the appropriate premium increase by "passing through" the additional credit default swap cost to the company. This would decrease the moral hazard problem. A company will de deterred from risking pension default by the knowledge that its premium payments would rise as it approached default.

By buying credit default swaps, the PBGC can match its assets to its liabilities and charge more appropriate risk premiums. While this won't cure the problems with the PBGC, (it doesn't directly address a company's incentive to take risks with its pension investments), it will begin to put the PBGC on the road to solvency.  For another application of financial theory to the PBGC, click here.