Tuesday, February 19, 2008

Yikes! In Policy Shift, PBGC Turns to Stock Market

Hey, what could possibly go wrong?
Ya know how retail investment types always point to Ibbotson and say something to the effect "There's never been a ten year period...blah, blah blah"? Ask 'em about the Cowles extension and the longest period the index value showed a net decline (I seem to remember 42 years, I'll dig out the book). When they come back at you that you aren't including reinvested dividends, throw a right, left, right combination:

1) What was the average dividend yield in Cowles 1871-1937?
2) What was the payout ratio?
3) What was the equity risk premium?

I usually get the cow eyes.
Even simpler is to ask the question Zvi Bodie did, back in the '90's:
(he seems to have overcome his MIT doctorate)

"If the risk of negative returns decreases over time, why does the cost of long term puts increase?"
(now I know the arguments against Bodie's implication, here's a decent one, here's a counter to the counter, we've got links, baby.)

What I'm wondering is if an entity like the PBGC, with its implicit call on the U.S. Treasury, should be increasing its exposure to equities. Especially when you consider that most busted pensions got that way through a combination of underfunding and lousy investments.

From CFO.com:

The nation's pension insurer will shrink the portion of bonds in its portfolio to 45 percent from as much as 85 percent.

After five years of strictly matching its assets to its liabilities, the nation's defined-benefit pension insurer will stock its investment portfolio with a larger percentage of equities and a new host of "alternative investments," including real-estate and private-equity partnerships.

Under its new policy announced Tuesday, the Pension Benefit Guaranty Corporation "will allocate 45 percent of its assets to a diversified set of fixed-income investments, 45 percent to diversified equity investments and 10 percent to alternative investment classes," according to a press release. The PBGC has about $55 billion to invest under the new investment policy.

Here's Bodie again:

...By its action, "the PBGC is violating a fundamental principle of risk management," Bodie wrote. "Stated simply it is this: A company that insures against hurricane damage should not invest its reserves in beachfront properties." Since the insurer's pension liabilities are backed by corporate pension assets and corporate share, the PBGC is exposed to the risk of a market downturn even if it doesn't invest in a share of stock, according to the professor, who reasons that agency should invest in enough bonds and equity swaps so that its assets should be matched to its liabilities.

Pretty good with the analogies, huh?