(February 14, 2013) – Pension plans across the globe tend to react to low interest rates the same way, research has found: by lowering their liability discount rates.
Everywhere except in the United States’ public space, that is.
According to a paper by finance scholars from Maastricht and Yale universities, lax regulation of US public plans allows and encourages funds to keep assumed rates of return unreasonably high, and take on a surfeit of risk in their portfolios.
“We find that US public pension funds behave different from all other pension funds and not in line with economic theory,” authors Aleksandar Andonov, Rob Bauer, and Martijn Cremers assert. “In times of severe underfunding or political distress, the incentives are strong to not lower discount rates sufficiently in response to lower interest rates and a maturing client base, at the same time adopting (perhaps recklessly) risky asset allocation strategies and camouflaging the real costs of pension promises made to their beneficiaries and taxpayers.”
Andonov, Bauer, and Cremers studied an international 20-year dataset from CEM covering pension fund maturity, liability discount rates, asset allocation, and inflation indexation policies. Using regression analysis, the researchers sought linkages between regulation regimes and these various factors.
US public and corporate funds, on average, allocate 68.3% of their assets to “riskier investments” (defined as everything but cash and investment-grade fixed income), compared with 60.5% for Canadian funds, and 51.7% among European pensions. For every fund region and category except US publics, the study found that these allocations drop as funds become more mature (i.e. the ratio of retirees to working members rises).
Likewise, the researchers found that US funds also have the highest average liability discount rates, at 7.8% in the public space and 7.2% among corporates. Canadian plans come in lower at 6.8%, with European funds far below that at 3.8%, on average.
Regulations dictate that Canadian and European plans, along with US corporate funds, base their discount rates on interest rates, the study notes. “However,” the authors point out, “US public pension funds are allowed to base their discount rates on the expected rate of return of their asset portfolio, which provides them with incentives to take more risk over time in response to declining government bond yields. Taking more risk thus enables public pension funds in the US to maintain high discount rates and present more favorable funding ratios to the public, despite the fact that this does not in any way alter the nature of their liabilities.”
Still, many public pension funds in the US have lowered their assumed rates of return over the past year or so, including Illinois’ Teachers’ Retirement System (from 8.5% to 8%), New Jersey’s retirement system (8.25% to 7.95%), and Indiana (7% to 6.75%). The CIOs of all of those funds faced a difficult tradeoff—swallowing an increase in unfunded liabilities to make return assumptions more conservative—that is foreign to their corporate counterparts.
Andonov, Bauer, and Cremers conclude that no CIOs should have to face such a choice: “US policy pertaining to public pension funds needs drastic reform and to be brought in line with regulations pertaining to US corporate pension funds.”
Click here for the entire paper: “Pension Fund Asset Allocation and Liability Discount Rates: Camouflage and Reckless Risk Taking by U.S. Public Plans?”