(October 12, 2012) – When plan sponsors backed by the Pension Benefit Guaranty Corporation (PBGC) start failing, the judgment of the people investing them often does too, a recent paper claims.
Katarzyna Romaniuk, a financial economist with the Universidad de Santiago de Chile and Université de Paris 1 Panthéon-Sorbonne, argues in her paper that defined benefit plan sponsors become overly aggressive with pension portfolios when those funds enter distressed territory, because the PBGC’s backing creates a moral hazard.
In normal, non-distressed times, Romaniuk argues, the same corporate pension portfolio fulfills both stockholders’ and members’ best interests. When things get rocky, however, taking on more risk is optimal for shareholders, because even if the gamble fails, the plan is backstopped by the PBGC. Thus, moral hazard.
“The equity-holders know that, in the case of bankruptcy, the limited-liability property allows them not to pay for the firm’s generated deficit,” Romaniuk writes. “When approaching financial distress, it is in their interest to gamble with the assets to try to (maybe) reverse the situation via a high-risk strategy. As actions on the firm’s conventional assets are very frequently constrained, such as by debt covenants, these conventional assets are a less convenient tool for these risky strategies than the pension assets.”
At this stage, she argues, the best interests of shareholders—and anyone making investment decisions is typically in this group—no longer match up with the best interests of plan participants or the PBGC.
“The interests of the sponsoring firms must be aligned (or at least become more compatible) with those of the PBGC via an adequate contract design to avoid the further accumulation by the PBGC of pension deficits as heavy as in recent years…The PBGC should thus play a more active role than it currently plays.” Romaniuk’s recommendation: “Grant the PBGC a control right on pension decisions as soon as the sponsoring firm approaches distress.”
Read Katarzyna Romaniuk’s entire paper, “Optimal Corporate Pension Policy for Defined Benefit Plans in the Presence of PBGC Insurance,” here.