On Asset Liability Matching & Federal Deposit and Pension Insurance Zvi Bodie Federal Reserve Bank of St. Louis 30th Annual Economic Policy Conference FEDERAL CREDIT AND INSURANCE PROGRAMS Oct , 2005

Outline The current pension insurance mess Lessons of the S&L crisis: importance of matching. Why did it happen to the PBGC? Equities are risky even in the long run, and especially for the PBGC. Investing in equities does not lower the ex ante cost of providing pension benefits. What should the government do?

Lessons of the S&L Crisis Forbearance can make the problem worse. Don’t adopt accounting rules that disguise the problem. Diversification across asset classes can increase total risk exposure. Hedging is more effective than diversifying in controlling specific risk exposures.

How to manage credit guarantees Mark collateral assets to market Allow for buffer (Capital requirements, full funding with a “hair-cut”) Right to seize collateral assets Restrictions on assets that can serve as collateral Charge market price for the guarantee

Why were the principles not properly applied to pensions? Fallacy about the risk of stocks in the long run misled investment advisers, pension actuaries, and regulators Bad pension accounting rules created a disincentive to match assets to liabilities

Implications for PBGC Investment in equities and “alternative assets” increases the cost to the government of providing pension guarantees.

What should the government do? Congress should act quickly to limit the scale of the shortfall: –Reorganize pension plans of sponsors in distress. –Make reorganized plans a model for the pension industry. Best of DB and DC. –Create incentives for better matching in healthy plans. Be an innovator in issuing new securities and let markets price them. –Examples: Long maturity bonds and TIPS