Black Hole Alert: The Last Sucker into the Stock Market Was the Pension Guaranty Corporation

You simply cannot make this stuff up.

The Pension Benefit Guaranty Board, which backstops defined benefit plans (yes, Virginia, they still exist) faced a rather sizable gap between its expected returns on its $64 billion in holdings and its expected liabilities.

So in a stroke of sheer genius, it increased its allocation to risky assets considerably at precisely the time those assets started tanking. It even managed to cut its allocation to Treasuries way back, reducing its participation in the big Treasury rally of last year.

Now anyone who was finance literate would look at the PGB’s new asset allocation and recognize it as conventional wisdom as dispensed by pension fund consultants. And if you had read Benoit Mandelbrot or Nassim Nicolas Taleb, you’d also know that those pension fund consultants base their prescriptions on theories that simply do not pan out empirically, and worse, greatly understate risk.

This was patently a silly move. First, it seemed to reflect a classic trader’s bad reflexes, of taking bigger bets to dig his way out of a loss, although the former head honcho vociferously denies that (hat tip readers John, Michael and Chris) :

Charles E.F. Millard, the former agency director who implemented the strategy until the Bush administration departed on Jan. 20, dismissed such concerns. Millard, a former managing director of Lehman Brothers, said flatly that “the new investment policy is not riskier than the old one.”

He said the previous strategy of relying mostly on bonds would never garner enough money to eliminate the agency’s deficit. “The prior policy virtually guaranteed that some day a multibillion-dollar bailout would be required from Congress,” Millard said.

He said he believed the new policy – which includes such potentially higher-growth investments as foreign stocks and private real estate – would lessen, but not eliminate, the possibility that a bailout is needed.

Yves here. This is double-speak, and pretty inept at that. We are supposed to believe that foreign stocks and private equity are less risky than Treasuries? Even if you have a dim view of government securities, trust me, if that market hits a down draft, equity related instruments will do worse.

So Millard wants us to believe that there are financial free lunches, that he can invest in “higher growth investments” without taking on more risk. I have a bridge I’d like to sell him.

Now some will say I am being unfair to jump on the fund’s utterly wretched timing. Wrong. It was obvious a train wreck was starting (and this isn’t 20/20 hindsight, any reader of the Financial Times would have seen the warning signs). Risky assets were clearly overvalued, as Martin Wolf pointed out in March 2007:

It is always a mistake to confuse a cycle with a trend. In the case of corporate earnings, it is worse than a mistake, it is a huge blunder. The intense cyclicality of corporate earnings is the most important reason why the unadjusted p/e ratio is a worthless indicator of value. The question one has to ask is whether they will be sustained or fall back again, as they have done in the past.

Over the past 125 years, real earnings of companies in the [S&P composite] index have grown at only 1.5 per cent a year – lower than in the economy as a whole, because the index is always underweight in new and dynamic companies. Over the past quarter century real earnings have grown at an annual rate of 3 per cent. The annual growth of 25 per cent seen since the most recent trough will not last. On past experience, it is far more likely to turn negative….

The dangers ahead look big. One is that markets will overreach themselves, so generating a destabilising correction. Another is a reduction in excess savings outside the US and a tightening of world interest rates. Another is a slowdown in US productivity growth. Yet another is a shift in global monetary conditions that threatens the soaring profitability of the US financial sector. But the biggest risk is that the end of the US property boom will persuade US households to tighten their belts at last, thereby ending the US role as the world’s big spender before the big savers are prepared to spend in turn.

We can be confident that profit growth will not continue at recent rates. But a sharp reversal, though possible, may not be imminent either. The economic risks are evident and the market does look expensive. But I would not dare to forecast a turning point. Forecasting is for far cleverer and braver people than I am.

So making a big shift to assets that look overpriced is not a winning investment formula. And the Boston Globe article gives other reasons why this investment approach wasn’t so wise:

Last year, as director of the Congressional Budget Office, [Peter] Orszag expressed alarm that the agency was “investing a greater share of its assets in risky securities,” which he said would make it “more likely to experience a decline in the value of its portfolio during an economic downturn the point at which it is most likely to have to assume responsibility for a larger number of underfunded pension plans.”

This investment blunder is going to create a new set of woes sooner rather than later, particularly if Team Obama does push GM or Chrysler into bankruptcy.

Currently, the agency owes more in pension obligations than it has in funds, with an $11 billion shortfall as of last Sept. 30. Moreover, the agency might soon be responsible for many more pension plans.

Most of the nation’s private pension plans suffered major losses in 2008 and, all together, are underfunded by as much as $500 billion, according to [Zvii] Bodie [former advisor to the fund] and other analysts. A wave of bankruptcies could mean that the agency would be left to cover more pensions than it could afford.

Note the underfunding is not the amount due in any one year, but the net present value of the total shortfall in future years.

The Pension Guaranty Board is not formally backed by the US government, but pressure to correct the agency’s blunders will be considerable. How can you bail out bankers and not hapless retirees?

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  1. john bougearel

    Millard will tell you he wasn't market-timing. He would never be caught so flat-footed as to allow himself to be accused of market-timing.

    To Millard's credit, he did partially recognize that the PBGB's business model was broken. His failure was believing he could tweak it with a meaningful shift in asset allocation to riskier asset classes.

    We could even concede Millard the possibility Millard considered several valuations models before making the asset allocation shift last year.

    Many consultants espoused equities over treasuries last year and this year based on the Fed's treasury yield model all throughout last year and this year (Jason Trennert in 09 e.g.) Others have consistent labeled the stock market cheap based on various p/e models.

    But, in this financial armageddon, there isn't a model that hasn't been laid to waste by it. When will money managers be taught that stocks are first and foremost very shaky collateral. Even a rumor, true or not, can reduce a stock price to mere rubble.

    Regardless of what path led Millard to make the painful mistakes he has made, the main takeaway here is the roughly $500 billion in underfunded private pension plans.

    Not only are the private pension plans underfunded, but the record wave of M&A and Buyouts in 2004-2007 were largely financed by companies using collateralized loan obligations (CLOs)become due to be refinanced. My understanding is theses CLOs are term obligations with long fuses, roughly 5 years. When these term loans come due, I also understand that these companies will not be able to secure the funding they will need to refi the CLOs. Unable to secure adequate financing, a wave of corp bankruptcies should roll through corp America between 2009-2012.

    And to your point, these bankrupt companies will leave the PBGB on the hook to insure those bankrupt firms private pension plans.

    But, as you note, they are underfunded to the tune of $64 billion. If they are the backstop for private pension plans, who will be the PBGB's backstop or guarantor?

    Perhaps Geithner will be able to cook up another scheme whereby the FDIC not only guarantees the credit creation that will occur with PPIP but also the PBGB. Don't know it will be any less legal constitutionally or otherwise than what Geithner is doing today with PPIP.

  2. jonhusband

    How can you bail out bankers and not hapless retirees

    Easy, if you’re the US government. Just say that the financial system that underpins the economy is too big to fail, and that it needs the money more than do the retirees.

    Who’s gonna make ’em say or do anything different ?

  3. doc holiday

    Re: “And if you had read Benoit Mandelbrot or Nassim Nicolas Taleb”

    Forget those hacks, read, John Locke and see the origins of:

    The Flaw Of Capitalism:

    The introduction of money marks the culmination of this process. Money makes possible the unlimited accumulation of property without causing waste through spoilage. He also includes gold or silver as money because they may be “hoarded up without injury to anyone,” since they do not spoil or decay in the hands of the possessor. The introduction of money eliminates the limits of accumulation. Locke stresses that inequality has come about by tacit agreement on the use of money, not by the social contract establishing civil society or the law of land regulating property. Locke is aware of a problem posed by >>> unlimited accumulation<<< but does not consider it his task. He just implies that government would function to moderate the conflict between the unlimited accumulation of property and a more nearly equal distribution of wealth and does not say which principles that government should apply to solve this problem.

    However, not all elements of his thought form a consistent whole. For example, labor theory of value of the Two Treatises of Government stands side by side with the demand-and-supply theory developed in a letter he wrote titled Some Considerations on the Consequences of the Lowering of Interest and the Raising of the Value of Money.

    >>>>>>Moreover, Locke anchors property in labor but in the end upholds the unlimited accumulation of wealth.<<<<<

    The End

  4. Juan


    locke’s labor theory of value was very undeveloped.

    a more developed labor theory of value is only inconsistent w/supply and demand if one takes value and price as identities, which is just what marginalist theories did as they shifted emphasis from production to consumption and the subjectivity of individual needs — which was also to re-base the system’s dominant ideology.

    in re. the post, a 2/19/08 cfo magazine article:

    In Policy Shift, PBGC Turns to Stock Market

  5. RPB

    “So Millard wants us to believe that there are financial free lunches, that he can invest in “higher growth investments” without taking on more risk. I have a bridge I’d like to sell him.”

    You refute Markowitz’s methodology, but not his conclusions?

  6. Yves Smith

    The most objectionable elements of MPT are:

    1. The assumption that correlations between asset classes are not highly variable over time

    2. The assumption of Gaussian distributions, which leads to overallocation to riskier types of assets

    When you are talking Treasuries vs. foreign stocks as an illustration of a higher growth investments, the assumption that the foreign stock is riskier is valid. You have currency as well as greater price volatility, and foreign equity markets can be highly volatile, due to the smaller size of the economies (they get whipsawed harder by overall global trends).

    Millard’s statement is tantamount to saying he can take on more risk without being exposed to more downside. While markets are not as efficient as theory has it, Millard’s statement of the inverse notion is pretty dubious.

  7. RPB

    Incredibly dubious, and I absolutely agree with your dissection of MPT. I just wanted to clarify your position so I could read your posts in the proper color.

    It was never wise to apply Gaussian probabilities to non-natural phenomena. But that should have been a foundation from which to build and innovate; not the end in itself. And let’s not give too much credit to Taleb, he was not the first to point this out. Its no secret that financial economics deserves the lemming award of the 20th century.

    Perhaps perverse incentives (and disincentives) in academia drive them to this sort of group think. Something to consider, especially in sciences and pseudo-sciences.

  8. Leo Kolivakis

    From the article:

    The Government Accountability Office is preparing a new review of the investment policy, but in the meantime it continues to place the agency on its list of federal programs at "high risk."

    >The PBGC is not properly staffed to deal with the complexities of alternative investments and given that they act as a backstop, they should be a lot more risk averse in their asset allocation.


  9. john bougearel


    As trustees and guarantors of private pensions and other people’s money, PBGB executives they have lost sight of its fiduciary responsibility to preserve capital.

    The evolution of portfolio management has inherently sought to take on more risk through diversification, which is exactly what Millard did.

    We have come along way from the days of the prudent man theory which was “designed to save the farm and the seed corn, to preserve the principal at all costs.” Hmmm, investment theory lost sight of this rule about the time that they lost sight of the farm – as the family farm disappeared, so did the prudent man theory. With the loss of tangible and real value, so too we now lament the loss of the prudent man theory.

    Onward through the decades, modern portfolio theory evolves and introduces the “prudent investment rule” which sought to balance acceptable risks and “expected” returns through diversification.

    Implicit in the rule of diversification, it leads to the fallacious belief that not only can you reduce risk and smooth out portfolio volatility but also generate “higher returns” otherwise, there wouldn’t be much incentive to abandon the “farm” or prudent man theory.

    It is worth pausing to note that under the prudent investment rule as embraced by pension funds all around the world “expected returns” have been forever and a day simply too high. This flaw in modern port theory as utilized in pension fund management is now being exposed by Leo and others.

    What I don’t know is whether this is a flaw inherent in modern portfolio theory itself. What matters however, is that pension funds have gotten “expected returns” consistently wrong for several decades of the baby boomer generation. Now that the boomers are heading off towards retirement, the gap between “expected” and “actual” returns are becoming glaringly obvious.

    From my limited understanding, most pension fund models “expected returns” are generally 8% or north of 8%. That is hardly a conservative number, especially net of fees! What has created this fatally flawed optimistic bias I wonder?

    Shit, we’re gonna have hell to pay for this mistake made by our fiduciary trustees.

  10. doc holiday


    I find it interesting that as coins were being weighed and played with by Newton, there was a sort of ambiguity within society as to how to define the relationship between pure greed and the sharing of resources. I was just trying to point out the original fallacy and flaw of capitalism at that early stage, which as you point out (with Locke) was undeveloped. I think that same undeveloped ambivalence remains a paradox, which continues to expose the fatal flaw of excess.

    I guess Lord Acton realized that when he said, “All power corrupts; absolute power corrupts absolutely.” I think he ripped off that off from someone else, but WTF?

    Also see:
    Psychiatry and Capitalism
    How was the unlimited accumulation of wealth to be justified? After all, there was a well-established moral tradition in Christianity that discouraged avarice, greed, and usury. The New Testament had long inveighed against needless acquisition: “Lay up not for yourselves treasures on earth,” “For what shall it profit a man, if he shall gain the whole world, and lose his own soul?” (Holy Bible, 1611/1952, pp. 1237, 1297).
    John Locke, articulating the soon-to-be prevalent view, argued that an individual who encloses land and cultivates it increases its yield so that the acquisition of land generates more wealth, which is presumably available to others in the forms of expenditures, jobs, charity, etc. With this argument Locke simultaneously helped to attenuate a serious moral problem intrinsic to capitalism and created an ideological view of accumulators as benefactors (Locke, 1690/1952, pp. 16-30).

  11. Mannwich

    “How can you bail out bankers and not hapless retirees?”

    Because that’s what lawless banana republics (with lazy thinking/acting citizens) do. We’ll see more, not less of it in the future, I’m sure. Why not? Who’s stopping it?

  12. Dan Duncan

    Doc Holiday,

    “Unlimited accumulation” is not a “serious moral problem intrinsic to capitalism”…any more than human nature is a “moral problem”. You’re writing about Original Sin. Whether or not one agrees with this concept (or even thinks such a thing exists)—it is at the heart of what Locke was attempting to express.

    Capitalism doesn’t cause a propensity for wanton accumulation. It’s the propensity toward wanton accumulation that causes capitalism.

    Of course in a world of limited resources extreme (not “unlimited” as you wrote) accumulation cannot be justified. But the inability to justify it has nothing to do with capitalism.

    As far as the moral confusion inherent in the notion of “accumulators as benefactors”…again, capitalism has nothing to do with this. Out of expedience, an accumulator, ie “The One with all the gold” has ALWAYS been hopefully and obsequiously viewed as a benefactor. If this naive view proved to be unfounded then the one with all the gold was simply reviled as a despot.

    I wholly agree that few things are as nauseating as one of these pre-bailout Master of the Universe types implying that his greed is good and moral…but assigning an anti-morality to capitalism is just as misguided.

  13. Thomas

    I would argue that GM’s underfunding alone already exceeds 100 bn $ (pension + healthcare benefits), if more conservative discount-rates are used. The ones they apply for the official calculation are way too high.

  14. Anonymous

    With all due respect, Yves, it looks to my financially uneducated eyes like Mr. Millard was simply following the Bush admin policy of dumping as much public money as possible into the stock market at the end of a bubble cycle to keep the prices up, leaving the suckers to pick up the tab. This was the plan with social security, as I’m sure you remember.

    I greatly enjoy reading your posts but sometimes your financial aspbergers gets in the way of what is essential a very simple situation to understand.

  15. Anonymous

    Bear with me for a moment as I seem to digress, but I have a solution to GM/Chrysler/Ford pension & healthcare commitments that would be doable in a sane society – which we are not, unfortunately.

    I was watching that documentary, whatever-the-name, about how GM destroyed mass transit and how all the automakers built the all-powerful highway lobby. Watching it makes you sick to your stomach, esp. if you have childhood memories of saintly, Church pillar women (aunts, etc.) that once and only once swore in front of the kids – when their trolleys were taken away and replaced by "that goddamed bus".

    So the first reaction is "good riddance to GM, I love my Toyota/Honda whatever". And that still lingers, but it's a corporation and it's death would mean nothing as even Waggoner and his ilk were also children when this was happening. Nobody who works there is really much to blame, and nor are most of the retired ones. The ones not dead are not going to be hurt much by any pension failure.

    So let's go back to that "good riddance, I prefer my Nissan" thought… Even, maybe especially in these down sales times, (insert your favorite car company's name here) clearly owes the very existence of a great chunk of US sales to Detroit's conversion of the US to a society where the automobile is a near-necessity.

    How much money would Toyota have made here over the years if we had rational transportation and land-use policies?

    So I think the US should simply take over adminstration of all "legacy" costs and pay for them with a surcharge on every passenger vehicle sold in the US, regardless of manufacturer. The claim is $1500 per GM car, GM has less that 1/3 of the market, so that's $500 a car sold.

    Could it be any simpler to justify and implement?

    And if it discourages car sales, so much the better frankly.

    — a different chris

  16. Juan

    Capitalism doesn’t cause a propensity for wanton accumulation. It’s the propensity toward wanton accumulation that causes capitalism.

    which must explain why pre-capitalist social formations did not enjoy crises of overproduction/overaccumulation
    but the contrary.

    in order to provide justification, one might love to believe that ‘human nature’ is some immutable set of qualities which was only able to realize its ‘true’ self after untold millennium and then only through and within a historically limited, now centuries ago new, set of social relations.

    justifiers can also be had through reliance on the ‘exogenous’ even though it is not, or, as is perfectly rational at one level, the attempt is to deny, displace, deflect criticism of the system itself,,so also deny a more complete grasp of what it is and why it moves as it does.

  17. Fred

    That old skool allocation with 45% long t-bonds would have done quite nicely during the past year…

    In any case, nothing the PBGC does is going to make the pie grow any bigger. PBGC should allocate its money the same way the corporations who pay fees to PBGC allocate their money. If PBGC runs a shortfall, up go the fees, and down go the earnings and stock prices at the corportions who pay into PBGC. No reason for the taxpayer to get involved until 100% of the stockholders and corporate bondholders at the corporations paying into PBGC have been wiped out.

  18. doc holiday

    The out-dated idea of unlimited accumulation of wealth has me spellbound today, because in all this TARP madness, The Subprime Flu and The Great Depression ll, there is a case to be made that most governments around the globe refused to regulate corporations and to stop antitrust abuse and accounting fraud.

    Although it would be easy to suggest that a global conspiracy was behind the push for a global tsunami of cheap and easy credit, perhaps this is the nature of capitalism, i.e, to capitalism can morph out of bounds and to a point where the system itself is corrupted.

    The current state of broken capitalism with its systemic failure and broken economic models is floundering because there remains in place a paradox between equal distribution which is fair and not a product of antitrust abuse, versus the current unregulated system which relies on government bailouts that are supportive of unlimited accumulation.

    Back to Locke: He just implies that government would function to moderate the conflict between the unlimited accumulation of property and a more nearly equal distribution of wealth…

    > Furthermore, when there is unlimited accumulation of wealth, to a bottle-neck'd point of abusive monopoly-like control linked to a shadow banking system fueled by derivative chaos, one could suggest that the circular flow of capitalism can be over-engineered to a point where systemic collapse is the only outcome, as we see today — or do I have that wrong, huh, huh …. ?

  19. Youri Carma

    This is Millard philosophy is the philosophy of a jobless vagrant, having his last straw, betting his last money in the Casino.

  20. Anonymous

    Capitalism, the unlocked lauder to the republics wealth. Governments watching of its use was removed to facilitate financial growth, in order to contend with a rodent plague (boomer’s retirement).

    Funny story from over here: Farmer a few years ago during rodent plague, had thousands of rodents hiding/breeding in a very large rack of hay 25m out side his front door. So after trying poison to no avail he decided to dig a small trench around said rack of hay.

    Upon completion of this trench he filled it with flammable liquid and at dusk (when the little critters come out to eat you out of house and home), lit the fuel, well in the rodents panic they ran through the flames, which was the intent of the farmer. But like many well laid plans some thing went wrong, instead of running around in circles till deaths arrival. They instead ran for the first available shelter they could find HIS HOUSE, which as an old house will do burnt to the ground before you could press send on your Mobile phone for help.

    Moral of the story, mess with the laws of the universe and feel the pain.


  21. Anonymous


    the process of capital accumulation becomes one of overaccumulation
    a. the mass of means of production becomes too great relative to labor created surplus value — each moving at different rates as competition for profit and market, as competition to end competition, has been/is also the attempt to reduce reliance upon living labor to a technical minimum while, same time, intensifying rate of exploitation. you might call it an inherent drive towards higher productivity but one which is self-destructive in that it tends to depress avg rate of profit.
    b. same also generates progressively greater relative disproportionality between production and consumption. differently, between capital’s need to realize surplus value and society’s ability to do so.

    until we fly to the arms of our savior

    counter-cyclic policies and credit creation

    that can, or at least used to be able to, ameliorate the latter, b, to degrees but at the unseen cost of perpetuating, even enhancing, the contradictions within a.

    so, what is industrial capital to do when faced with a falling rate of profit? perhaps try to offset by engaging in more speculative activities. presto, presto, better than the lhc, financial rate of profit, particularly when enhanced, can rise even as that which it must ultimately be based on slides.

    the two rates tend over longer than a few years to wavy, wavy, alternate,,,which was much less the case back in the good old days of 19th c when much of the mass of fictitious capital was cyclically destroyed. M-M’ or money from money could not so easily come to dominate M-C-M’.

    and wasn’t the point of neo-liberalism to re-create at least quasi-19th c conditions on a world scale.
    we did. and here we are.

  22. doc holiday

    One last final item and thanks to all who contributed to ideas related to Locke.

    When I read Locke (again): “He just implies that government would function to moderate the conflict between the unlimited accumulation of property and a more nearly equal distribution of wealth…”

    I think about the condition of a corrupt government being in bed with corrupt corporations and the joining and co-mingling of their forces and their abuses of power inside The Treasury Vault — this is where we are now with TARP and the unlimited accumulation of wealth by pirates. These noble pirates and crooks now demand in unison along with our elected reps that all their unlimited accumulation of wealth and future cash flows be uninterrupted and “legally” connected to the future tax revenues of the poor dumbass and retarded peasants that want change ……LOL and mooohawhahahahah; screw you all and please be more productive!

    Capitalism is just the word pirate spelled backwards and held before a steamed mirror at midnight!

  23. Lord Holiday

    But wait, one more thing on unlimited accumulation .

    What would Locke think about corporations and governments using supercomputers to engineer financial derivatives that have no basis in reality, yet they allow financial fantasy instruments to be designed so that they essentially become the mechanisms for increasing taxes. Americans are basically being taxed to pay off derivatives that no one really understands, and no one can price any of these Level lll unobservable assets, but taxpayers are being asked to donate $15 Trillion,or something around there, so go figure…

  24. Anonymous

    Millard seems to be defining risk as the probability that the fund will underperform its targets and require a bailout. He argues that this probability was effectively 100% with the old asset mix. Investing in riskier asset classes allowed him to lower that number to something below 100% (at the cost of a much larger bailout if things go badly, which he doesn’t mention). Hence less risk, for certain definitions of risk.

    So I read the quoted portion as an admission, rather than a denial, that he was making bigger bets.

  25. Anonymous

    Other than 5% (insignificant) in real estate it looks alright.
    Overall bearish on the dollar. By the way some emerging markets going great.

  26. Richard Kline

    Skippy: ” . . . [M]ess with the laws of the universe and feel the pain.” That should be Rule No. 1 According to God(s). Call it, The Subrpime Directive.

  27. Anonymous

    You simply cannot make this stuff up.

    Actually, you just do did – they have *approved* the asset switch bit not *implemented* it.

    Even if you have a dim view of government securities, trust me, if that market hits a down draft, equity related instruments will do worse.

    And if we have a sustained period of moderate growth and high inflation, will government bonds really out-perform stocks? I have a ten year Treasury yielding 2.7% I will happily sell you.

    And I agree with the comment above – if the PBGC “risk” is defined as “requires a government bail-out”, then given their current excess of liabilities over assets, higher volatility assets reduces their risk.

    If “risk” is adjusted to contemplate the magnitude of the bail-out and the likelihood that unfunded plans will fall into the PBGC lap during downturns (not really their experience, apparently, but past results don’t guarantee a future experience), then their conclusion that riskier assets reduce their risk is, hmm, counter-intuitive.

    They did have cool charts and graphs from a high-priced consultant, however. Rocaton Investment Advisers LLC, IIRC.

    The CBO chimed in.

    Tom Maguire

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