Public Pensions Pile on Risk to Beat Underfunding

Public and private pension fund behave differently when faced with a funding shortfall.

(January 30, 2012)  —  Strict government accounting standards and fears of a larger shortfall push underfunded public sector pension plans in the United States to take on more investment risk than their private sector peers, new research has found.

Public sector pension fund investors and their fund managers react differently to an underfunded status than their private sector peers, Nancy Mohan and Ting Zhang at the University of Drayton found in research published this week.

The pair said that during their research they had found evidence that government accounting standards ‘strongly affect risk-taking behavior’, as most pension plans used higher return assumptions to discount their pension liabilities.

The paper said: “We find that government accounting standards strongly affect public fund investment risk, as higher return assumptions (used to discount pension liabilities) are associated with higher equity allocation and beta.”

In addition, as most of these public sector plans remain open for new members whereas many private plans are now closed, state retirement systems, for example, can push liabilities further into the horizon.

The paper said: “Unlike private pension plans, public funds undertake more risk if they are underfunded and have lower investment returns in the previous years, consistent with the risk transfer hypothesis.”

This hypothesis supposes that future tax payers will pick up the bill for pension payments being made at the current time. The paper said this occurred often when a public sector plan was underfunded.

Another factor that raised the risk profile of public sector pension plans was the ‘union effect’, according to the paper. This meant that instead of increased contributions by employers and staff being made to meet better benefit payments won by union bargaining, fund managers were encouraged to take on more risk in the hope of bringing in higher returns to fulfill the obligation.

Finally, the community of public sector pension funds was guilty of following the footsteps of those that had seen impressive investment returns.

“There also appears to be a herding effect in that a change in California Public Employees Retirement System (CalPERS ) portfolio beta or equity allocation is mimicked by other pension funds.”