US public pensions make the riskiest investments of any pensions funds around the world—and research has shown that risk has not paid off in the form of excess returns, but quite the opposite.
“Asset allocation decisions are in substantial part driven by regulatory incentives.”American public funds underperform other pension plans—including Canadian and European pensions, as well as corporate US plans—by 57 basis points per year, according to Aleksandar Andonov (Erasmus School of Economics), Rob Bauer (Maastricht University), and Martijn Cremers (University of Notre Dame).
This underperformance was “particularly strong” among mature funds with large allocations to equity and alternative assets, the researchers found. None of the other categories—corporate, European, and Canadian—underperformed on average.
“The underperformance of US public funds in equity and alternative assets can be potentially explained by excessive risk-taking,” the researchers wrote.
This “excessive risk-taking,” they explained, was the result of the unique regulatory incentives faced by public pensions in America. Public pension regulations in the US link liability discount rates to expected return on assets. The higher a pension’s expected return, the higher the discount rate—and the higher the discount rate, the better that pension’s funding position.
Given that poor funding ratios can entail increases in contribution payments and pension benefit reductions, funds are pressured to maintain often unrealistically high return targets, which in turn require significant investments in risky assets.
“US 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,” the trio wrote.
The result is that funds underperform, missing their return targets and worsening their funding positions.
Meanwhile, since Canadian, European, and corporate plans all face regulatory environments that base liability discount rates on high credit quality interest rates—which cannot be managed by modifying allocations to risky assets—these funds maintain more appropriate strategic allocations.
“Asset allocation decisions are in substantial part driven by regulatory incentives,” the paper concluded.
Read the full paper, “Pension Fund Asset Allocation and Liability Discount Rates.”
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