Regulations Incent Public Pensions to Take Risky Investments

Researchers from Erasmus University Rotterdam, Maastricht University and Rotman ICPM, University of Toronto and the University of Notre Dame have found that U.S. public pension funds have incentives to increase risk-taking, arising from their unique regulation linking their liability discount rates to the expected return on assets, which enables them to report a better funding position by investing more in risky assets.                   

The regulation of U.S. public defined benefit (DB) pension funds allows considerably more discretion in setting the liability discount rate compared to the regulation of other DB pension plans (specifically of U.S. corporations and both public and private plans in Canada and Europe), the researchers note. U.S. public DB funds follow the Government Accounting Standards Board (GASB) guidelines for discounting liabilities, which allow them to base their liability discount rates on the (assumed and thus more discretionary) expected rate of return on their assets.

In contrast, the regulations pertaining to the discount rates of U.S. private as well as Canadian and European public and private pension plans require that these are based on high credit quality interest rates and thus cannot be managed by modifying the allocation to risky assets. For instance, Canadian public and private pension plans discount their liabilities using market yields of high-quality corporate debt instruments, while U.S. corporate plans use a discount rate that is a combination of upper-medium and high-grade long-term corporate bonds.

The GASB regulations for U.S. public DB funds have two important consequences, the first of which is that GASB guidelines allow U.S. public funds to severely understate their liabilities. The accrued pension benefits of U.S. public plans appear legally well-protected such that using the expected return on assets will generally imply a discount rate that is too high.

The second consequence of GASB regulations is that the link between the discount rate and the expected return on their assets affords U.S. public pension funds considerable discretion to manage their liability discount rate by changing their allocation across asset classes and choosing an expected return for individual asset classes. The main `regulatory incentives hypothesis’ we posit is that the regulatory link between the liability discount rate and the expected rate of return on assets gives U.S. public funds an incentive to increase their strategic allocation to risky assets. A larger allocation to risky assets allows these funds to employ higher expected returns and thus to justify a higher discount rate and, as a consequence, lower the reported value of the liabilities.

When testing the regulatory incentives hypothesis, the researchers argue that U.S. public pension funds that are more mature have stronger incentives to invest more in risky assets in order to maintain a higher liability discount rate, because reducing the discount rate creates larger immediate economic costs for more mature funds. Pension fund maturity is measured as the percentage of retired pension plan members. More mature pension funds have larger accrued liabilities for a given number of participants, since on average these participants have accrued liabilities for a longer period of time.

If a pension fund is underfunded—as essentially all U.S. public DB funds are in the researchers’ sample period—then it is required to pay 'catch-up' (deficit-reduction) contributions to amortize the total unfunded accrued liability. The size of these catch-up contributions depends on the dollar amount of the funding deficit, rather than on the funding ratio itself (as long as the pension fund is underfunded). Since mature pension funds have larger accrued liabilities, any reduction in the liability discount rate results in a larger increase in the dollar amount of their reported liabilities and thus in their funding deficit, which translates into higher required contribution payments. Higher required contribution payments create an immediate extra economic burden for taxpayers and/or employers (as well as potential additional burden for the participants) servicing a mature pension plan.

The researchers define the percentage allocated to risky assets as investments in public equity, alternative assets and risky fixed income (i.e., high yield bonds). In line with their hypothesis, they document that a 10% increase in the percentage of retired members of U.S. public funds is associated with a 5.34% increase in their allocation to risky assets, while for all other pension funds, a 10% increase in the percentage of retired members is associated with a 1.70% lower allocation to risky assets.

This increased risk-taking enables more mature U.S. public funds to use higher discount rates, as a 10% increase in their percentage of retired members is associated with a 69 basis point increase in their discount rate. In contrast, the asset allocation of the control group, consisting of U.S. corporate funds as well as Canadian and European funds, becomes more conservative as the funds mature.

The regulatory incentives hypothesis further suggests that U.S. public funds increase allocations to risky assets especially at times when expected asset returns decline. During the research sample period, the 10-year U.S. Treasury yield fell from 7% in 1994 to less than 2% in 2012. As the level of interest rates falls, the expected rates of return on both risky and non-risky assets fall, though U.S. public funds can refrain from lowering their liability discount rate by increasing their allocation to risky assets. The researchers found only U.S. public plans significantly increase their allocation to risky assets when interest rates are falling. Economically, the approximately 5 percentage point decline in the yield on ten-year Treasury securities is associated with a 15 percentage point increase in their allocation to risky assets.                    

Taking more risk may affect the pension fund investment performance as well. The regulatory incentives hypothesis implies that U.S. public funds change their asset allocation in order to manage the liability discount rate and the reported funding level rather than based on investment opportunities and asset-liability considerations. “However, if asset allocation decisions are in substantial part driven by regulatory incentives, U.S. public funds may be looking for additional investments in risky assets at times when they have relatively fewer attractive opportunities or limited capacity to select and monitor additional risky investments, in which case we could expect them to underperform,” the researchers note.

They evaluate the investment performance by adjusting the pension fund returns for both their investment costs and benchmark performance within various asset classes, thus taking asset allocation decisions as given. They find that U.S. public plans underperform the benchmarks by about 57 basis points a year, and their underperformance is substantially worse if the fund is more mature. A 10% increase in the maturity of U.S. public funds is associated with 23 to 40 basis point lower returns (depending on the specification). The underperformance of mature U.S. public plans is primarily due to lower returns in equities and alternative assets, i.e., those risky assets in which they particularly increased their allocation in order to maintain higher liability discount rates. None of the other groups of pension funds underperform on average.

In addition, the researchers found that U.S. public DB pension funds with a higher percentage of state-political and participant-elected trustees invest more in risky assets and use higher liability discount rates. For instance, pension plans whose boards consists only of state-political members invest 10 percentage points more in risky assets than a pension plan without state-political trustees. In addition, more mature pension plans with a higher percentage of participant-elected trustees also have greater allocations to risky assets, use higher discount rates, and obtain lower investment returns.