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Failure to take account of the mismatch between the assets in defined --benefit pension plans -- primarily equities -- and the liabilities -- deferred fixed annuities -- has long been a major unrecognized source of financial instability. The underfunding problems now facing state and local government pension plans and the Pension Benefit Guaranty Corporation are a direct consequence of this conceptual failure. Yet the source of the problems and the policies needed to correct them remain unrecognized by many, if not most, mainstream economists. This paper summarizes the principles for the efficient management of financial guarantees, demonstrates how option pricing theory is used to determine the amount of capital required to insure such guarantees when there is a mismatch between assets and liabilities. It concludes with some observations on how failure to properly manage government guarantees can lead to financial instability and crisis. The destabilizing feedback loop caused by government guarantees of too-big-to-fail financial institutions, moral hazard, forbearance, and ever bigger government bailouts is familiar to analysts of the U.S. banking system. It is less familiar, but no less pernicious, in the case of the pension system. In the case of pensions, however, the vicious cycle is less transparent because of the fallacious belief that the risk of equities goes away in the long run. Until there is a recognition that equities are not a match for the fixed liabilities of defined-benefit pension liabilities, it will remain a serious source of financial instability for the U.S. economy.

Mismatch Risk, Government Guarantees, and Financial Instability: The Case of the U.S. Pension System