I saw this over at Calculated Risk and it just about made me choke….

The PBGC currently has approximately $55 billion to invest in the new investment policy. Under this new policy, the PBGC will allocate 45 percent of its assets to a diversified set of fixed-income investments, 45 percent to diversified equity investments and 10 percent to alternative investment classes. The agency’s previous policy set an equity investment target of 15–25 percent, although the actual level of equity investments was 28 percent at the end of FY 2007.

The PBGC had an accumulated deficit of $14 billion as of year-end FY 2007.

Because the PBGC’s obligations are paid over many years, the new investment policy is designed to take advantage of a long-term investment horizon. The strategy of increased diversification—including use of alternative investments—aims at generating returns, while providing superior protection against ultimate downside risks over time.

For those that don’t know, PBGC stands for Pension Benefit Guaranty Corporation. They are the ones who guarantee pension payments in the event that a pension fund goes broke.

In plain English, they are saying they are short $14 billion dollars so they are going to pursue a riskier investment plan in order to try to make up for their shortfall. They try to disguise this by saying that in any 20 year period their new investment strategy would have outperformed their old one so it is safer. (They state this later in their press release. Read the Calculated Risk post for more.)

But even granting this is true, it does not mean that it is safer. For example, let us say that a bond would pay 5% every year for 5 years. Let us say the stock market will go down for 5% for the first two years but go up by 20% for the next three. In this case the stock market would be a far better investment over the long term. But if your bills all came due in the first two years you would be far better going with bonds. If you can’t know for sure when you bills are going to come due, you would be far safer buying bonds than stocks.

PBGC is taking a really big risk in spite of trying to claim otherwise.

Think about it. Under what circumstances are pensions funds most likely to go bust? During times the stock market is going up or going down?

The answer is obvious. If stock markets ever go sharply down for a period of time, the PBGC is likely to have to rescue a lot more pension funds. So at the very time their assets are losing value, they will be taking on new obligations.

PBGC would argue that when they take over a pension fund, they take on an obligation that they have to pay for over a long period of time. Therefore, they have time to wait for the stock market to go up.

But I don’t buy this. If they have a lot of obligations dropped on them all at once (as I expect), they will have to pay out a lot more money than they are right now. To fund this they are going to have to sell assets. A major portion of their assets is now going to be stocks. So at the very moment that stocks are down they will have to be selling.

If you sell stocks while they are down (even if you only sell a portion of them) you can really wreck your long term return. This is why buy-and-hold is the recommended investment style. This is because stocks can really go down before they go up.

For example, let us say that you buy 100 shares at $10 a share and you hold them for 5 years. Let us say that after you buy the shares they drop to $5 a share and stay there for 2 years. But let us say that after that they start climbing again so that by the end of those 5 years those shares are worth $20 dollars a share. You have just made a 100% return in 5 years or a 20 percent return per year. Not bad.

But let us say that in those first two years you suddenly need $400. That is only 40% of the money that you invested. But because your stocks have halved in value you are forced to sell 80 of your shares. Even if you hold the rest of your 20 shares till year 5 you still will not make back the money that you lost by investing in shares. On the other hand, if you have bonds with a constant return, you are unlikely to have the same kinds of problems. Even if you have to sell they are unlikely to drop as sharply in value as stocks will (assuming high quality bonds).

That is just to give you an example of the types of problems that can crop up even if you are sure that your investments will perform better over the long term.

The Government will probably bail out the PBGC. But I still wish they would not do stupid stuff like this. The Government is going to have enough trouble as it is with having to pay extra because PBGC was stupid.