Why I Am Disappointed with the Pension Protection Act of 2006 by Zvi Bodie

Guest Article
Why I Am Disappointed with the Pension Protection Act of 2006
By Zvi Bodie
August 5, 2006
I am a finance professor who has been studying pension reform issues in the U.S. and other countries for more than 25 years. Because of the expertise I have acquired, it is not surprising that reporters have asked me for my reaction to the recent bill just enacted by Congress-- PPA 2006. Here is the answer that I have given them: I am very disappointed.
The bill does not address either of the two issues that I regard as crucial to fixing what is wrong with the U.S. private pension system today. The first of these relates to the traditional defined benefit pension system and the federal government agency that insures it: the PBGC. The second relates to the emerging new pension system that is built around 401k, 403b, IRAs and other self-directed investment accounts.
As I see it, the fundamental problem facing the PBGC and the traditional defined benefit pension system is that of a mismatch between the benefits promised to employees and the assets serving as collateral to insure that those promises are kept. I have analyzed the asset-liability mismatch problem in detail in "On Asset-Liability Matching and Federal Deposit and Pension Insurance." Here is the abstract:

Asset-liability mismatch was a principal cause of the Savings and Loan Crisis of the 1980s. The federal government's failure to recognize the mismatch risk early on and manage it properly led to huge losses by the Federal Savings and Loan Insurance Corporation, which had to be covered by taxpayers. In dealing with the problems now facing the defined-benefit pension system and the Pension Benefit Guaranty Corporation (PBGC), the government seems to be making some of the same mistakes it made then. Among the causes is the fallacious belief that because pension funds have a long time horizon the risk of investing in equities is negligible. In fact, the opposite is true. Moreover, for the PBGC, the mismatch risk is magnified by moral hazard and adverse selection. Distressed companies facing the prospect of bankruptcy have an incentive to underfund their pension plans and adopt risky investment strategies; healthy companies have an incentive to terminate their plans and exit the system. The paper explores some ways to limit the costs of a potential PBGC bailout.
(Federal Reserve Bank of St. Louis Review, July/August 2006, 88(4), pp. 323-29.)

The PPA 2006 does not even acknowledge that an asset-liability mismatch problem exists.
The fundamental problem facing the new 401k-IRA system of individual investment accounts is that it transfers the risk of not achieving an adequate retirement income to those least capable of bearing it: households. Currently more than half of the working population have either no pension protection or not enough. Rather than pass legislation that would encourage the private sector to design and produce contracts to guarantee an adequate retirement income, the PPA 2006 enables investment companies to expand the kinds of accounts that expose households to substantial market and longevity risks. I have analyzed this issue in detail in "An Analysis of Advice to Participants in Self-Directed Retirement Plans." Here is the abstract:

This study examines the investment advice currently provided to participants in self-directed retirement plans (401k, 403b, etc.) by financial service firms and investment advisory services. It finds much of the advice to be logically flawed and dangerously misleading. There exists a strong bias in favor of investing retirement savings in the stock market without insurance against a market decline. The paper concludes that in view of the limited ability of the general public to handle the complex task of investing for retirement, financial firms will have to design safer products with a small number of choices that are easily understood.
The complete text of my study appears as chapter 2 of a book, Mitchell and Smetters, eds., The Pension Challenge: Risk Transfers and Retirement Income Security, Oxford University Press, December 2003.

I would be happy to send copies of both of the pieces referred to above.