Why Not Trade Pension Claims?

Trading pension claims would serve many purposes. Beneficiaries would be able to diversify the idiosyncratic credit risk of their plan sponsors. And systematic risk could be reallocated to comply with individual risk–return preferences. The result would be an alignment of companies’ and pension fund managers’ incentives to keep fund plans fully funded—in line with beneficiary interests—which would lower agency costs and costs of government bailouts of defined-benefit plans and would improve the general welfare. As an accurate valuation of pension liabilities, trading would provide a measurable yardstick for plan managers.Trading defined-benefit (DB) pension claims would serve many purposes. Beneficiaries would be able to diversify the idiosyncratic credit risk of their plan sponsors. And systematic risk could be reallocated to comply with individual risk–return preferences. The result would be a realignment of companies’ and pension fund managers’ incentives with the interests of beneficiaries—namely, to keep fund plans fully funded. Full funding would lower agency costs and the costs of government bailouts of DB plans and would improve the general welfare. As an accurate valuation of pension liabilities, trading would provide a measurable yardstick for plan managers.We propose a flexible, low-cost mechanism for transferring and transforming credit risks. It is based on a financial structure that we call a “collateralized pension claim obligation” (CPCO). The CPCOs (and possibly corporate entities) would trade pension claims to optimize diversification and balance their assets according to a number of characteristics (age, industry, geography, etc.). Just as loans or mortgages are pooled and tranched in traditional collateralized debt obligations, pension claims would be pooled and tranched in a CPCO.For example, suppose that, for any of several reasons, a beneficiary became reconciled to the idea that he would never collect the full face value of his pension claim and was uncomfortable with the specific risk of the plan sponsor. In this case, the pension beneficiary could trade in his claim to the CPCO.In this way, the CPCO would accumulate claims on many companies and would become naturally diversified. In exchange, the beneficiary would receive a claim on the CPCO. These claims would be organized in tranches. The senior tranche would be almost riskless because it would be protected by the other tranches. Mezzanine tranches of intermediate risk would offer lower, weaker guaranteed levels of income against a higher expected income, with the realized future income to be tied to the future value of the CPCO’s assets. The equity tranche of the CPCO would be provided by speculative funds.A participant would receive a claim on the CPCO tranche (or a mix of CPCO tranches) that she could select according to her affinity for risk and within the context of her overall wealth. Should the participant’s risk preference change, she could exchange her claim against that of another tranche that better reflected her new risk–return profile.Once a market for pension pools has been developed, designing a benchmark to be used for asset manager evaluation and compensation would be straightforward.