Don’t Kill the Golden Goose! Saving Pension Plans

Defined-benefit (DB) pension plans are an endangered species; they are perceived as too risky and costly. But the emerging substitute, the defined contribution plan, has many shortcomings. The risk of DB plans can be controlled, first, by modeling the liability in terms of its market-factor exposures through surplus (asset minus liability) optimization. Then, sponsors may hold the minimum-risk position (a liability-defeasing portfolio) or they may move up on the efficient frontier—taking equity and other risks. The economic cost of a DB plan also needs to be managed, but it is a matter of managing the size of the pension promise; it is not an asset allocation problem.Defined-benefit (DB) plans are like a goose that lays golden eggs—monthly retirement income at a decent level, guaranteed for life. The gradual disappearance of these plans is a tragedy for employees and for society because they are the only practical way to provide an adequate retirement benefit. Defined-contribution (DC) plans are not a suitable replacement.DB plans offer forced savings, the sharing of longevity risk through annuitization, institutional-quality investment strategies, and institutional fee levels. Although DC plans could theoretically replicate all these features, in today’s legal and regulatory environment in the United States, there is no way this replication will actually happen. In fact, most DC-plan participants retire with plan balances so small they provide only a small supplement to Social Security income; they aren’t really pension plans at all.A back-of-the-envelope estimate shows that from sharing longevity risk alone, a given dollar amount of retirement benefit is 35 percent cheaper to provide through a DB plan than through a DC plan.DB plans are also valuable to employers because the economics of labor negotiation requires that this 35 percent (or greater) savings be shared between employer and employee. Thus, the total cost to the employer of obtaining a unit of labor is lower with a DB plan.DB plans are disappearing because employers perceive that the financial risk of being a DB-plan sponsor is unacceptably great. For illustration, employers point to the “perfect storm” of 2000–2002, during which equity prices fell by 50 percent from peak to trough while the present value of pension liabilities was rising dramatically because of the decline in long-term interest rates.However, these market events resulted in a perfect storm only because DB plans were poorly hedged. If assets had been selected with market risk exposures closer to those of the liability, there would have been little damage to pension plans over this period.To save DB plans, sponsors should use existing—although often poorly understood—technology to: (1) hedge the market-related risks in the liability that can be hedged and (2) use “surplus optimization” to rationally take additional risk in pursuit of higher returns.To hedge the risks that can be hedged, one must understand that the liability is someone else’s asset and can be modeled as one would any asset—namely, as the sum of the riskless rate, exposures to various market risks (in this case, inflation risk and real interest rate risk), and a residual or alpha portion. A portfolio of nominal U.S. T-bonds and Treasury Inflation-Protected Securities can be designed that will hedge the liability quite satisfactorily.Note that the market value of the liability is the value relevant to this analysis. This approach is required to build a hedge portfolio and eliminate most of the risk from DB-plan sponsorship. Market-value accounting is a good thing; it provides the transparency that allows risks to be managed by using available market tools.The hedge portfolio is, however, an extreme position. Its yield is too low to be acceptable to most sponsors. Surplus optimization, which is like asset-only optimization but with the liability included as an asset held short, should be used to assess the decision to hold equities and other risky assets. The sponsor can try to add value by taking “surplus beta risk”—that is, equity or equitylike risk not needed to hedge the risks in the liability—and by taking active (alpha) risk.A financially strong plan sponsor can afford to take more surplus beta risk than a weak one because the strong company can afford the higher plan contributions that will be required if the risk does not “work out” (that is, if the stock market performs poorly). In general, however, equity allocations in DB plans should be lower than they are in current practice.Most DB portfolios, then, should have a longer duration and less in equities than they do. Although the expected return from such a strategy is slightly lower than in today’s equity-heavy plans, theworst-case scenarios are much less bad. By holding assets that are closer to the liability in terms of their risk exposures, DB plans can be saved because the risk of sponsoring them will have been managed to acceptable levels.