Alpha Worth Paying For: Profit from Underfunded Pensions

One of the concerns during the recent unpleasantness, especially as the S&P approached 666* was the fact that those S&P 500 component companies that still had defined benefit pension plans tended to invest the equity portion of the plan in other S&P 500 companies. As the index declined the daisy chain turned into a vortex sucking all the cash flow the S&P could generate into the massively underfunded plans.
Just for grins and giggles the Pension Benefit Guarantee Corporation, the backstop for the pension plans was also investing in S&P 500 companies!**

From Turnkey Analyst:
Abstract:

The paper argues that the market significantly overvalues firms with severely underfunded pension plans. These companies earn lower stock returns than firms with healthier pension plans for at least 5 years after the first emergence of the underfunding. The low returns are not explained by risk, price momentum, earnings momentum, or accruals. Further, the evidence suggests that investors do not anticipate the impact of the pension liability on future earnings, and they are surprised when the negative implications of underfunding ultimately materialize. Finally, underfunded firms have poor operating performance, and they earn low returns, although they are value companies.

...MUCH MORE

Here's the paper: "Pension Plan Funding and Stock Market Efficiency"

 *The bear market intraday low was 666.79 on Mar. 6, 2009.

**From our February 19, 2008 (yes, before the crash) post "Yikes! In Policy Shift, PBGC Turns to Stock Market":

Hey, what could possibly go wrong?
Ya know how retail investment types always point to Ibbotson and say something to the effect "There's never been a ten year period...blah, blah blah"? Ask 'em about the Cowles extension and the longest period the index value showed a net decline (I seem to remember 42 years, I'll dig out the book). When they come back at you that you aren't including reinvested dividends, throw a right, left, right combination:

1) What was the average dividend yield in Cowles 1871-1937?
2) What was the payout ratio?
3) What was the equity risk premium?

I usually get the cow eyes.
Even simpler is to ask the question Zvi Bodie did, back in the '90's:
(he seems to have overcome his MIT doctorate)

"If the risk of negative returns decreases over time, why does the cost of long term puts increase?"
(now I know the arguments against Bodie's implication, here's a decent one, here's a counter to the counter, we've got links, baby.)

What I'm wondering is if an entity like the PBGC, with its implicit call on the U.S. Treasury, should be increasing its exposure to equities. Especially when you consider that most busted pensions got that way through a combination of underfunding and lousy investments....

Which was followed by (March 2, 2009 i.e. one week before the closing low) "Could 20 % of the S&P 500 Go Bankrupt?"

And on May 21, 2009, "Former Head of Pension Benefit Guaranty Corp. Pleads the Fifth (Oh, there's a $33 Billion shortfall too)".