(August 2, 2013) – The same question has arisen over and over in comment sections beneath news articles announcing America’s largest public bankruptcy: Will the Pension Benefit Guaranty Corporation (PBGC) cover Detroit’s pension promises?
The answer, of course, is no. The PBGC only insures corporate retirement systems, not public. But if not the PBGC, then who?
Bob Collie, Russell’s chief institutional research strategist for the Americas, would point out that Detroit’s pension system does have a sanctioned backstop: the City of Detroit.
“People have forgotten about the role of plan sponsor, which is the entity that’s supposed to step in during the bad times,” Collie told aiCIO.
In essence, the pension fund-plan sponsor model, whether for a public organization or corporation, was designed to function on Keynesian principles.
When markets are strong and a fund is reaping premia for investment risk, it grows in size and funded status. The sponsoring company, union, or government may be able to dial back its contribution rates.
However, as Collie noted, “there will be times that the market experience is worse than expected. A growth-oriented investment strategy creates a double hit: It fares worse in down markets and—based on a high assumed rate of return—the plan will likely have less money in it. The whole thing only works if the plan sponsor is willing to step in during the bad times.”
“In face of the inevitable uncertainty about investment returns, we need to be a lot clearer about just how important is the role of the plan sponsor or other entity left holding the bill in the event of a shortfall,” the Russell strategist wrote in a blog post. “If you assume an (aggressive) 7.5% and fail to achieve that, what happens? Who steps in to act as backstop? If you assume a (cautious) 3% and fail to achieve that, who is the backstop?”
Poor pension fund investment performance did not itself sink the city of Detroit. Still, the plan sponsor’s delinquency could sink the Detroit Retirement System.
“A lot of the decisions made about how funding policy interacts with investment strategy are based around normal times,” Collie said. “I think the biggest mistake any plan sponsors could make is try to wish the situation away—crossing their fingers, rolling the dice, and hoping they don’t have a bad result.”