How Should Public Pension Plans Invest?

Abstract

How public pension plan assets should be invested is an important but unsettled question. Some observers endorse the standard practice of investing heavily in higher yielding but riskier equities, reasoning that the higher average returns will reduce future required tax receipts and also help to reduce underfunding over time. Others advocate a more conservative approach that reduces the volatility of funding levels and the likelihood of severe shortfalls during economic downturns when government resources are already constrained.

The accounting rules for public pensions create a perverse incentive to invest in stocks: since projected liabilities are discounted at the expected return on assets rather than at a rate that reflects the generally lower risk of liabilities, investing the assets in the stock market leads to a higher allowed discount rate for the liabilities, which in turn lowers the accounting-based measure of liabilities and lowers required pension contributions. This choice of discount rate contradicts the valuation principle that the risk of the quantity under consideration determines the appropriate discount rate.

Determining optimal asset allocation requires us to specify who bears the risks and returns and how risks and returns are traded off, i.e., a budget constraint and an objective function. We solve a simple model that illustrates the asset allocation problem facing a public fiduciary who seeks to minimize the welfare cost of distortionary taxes, subject to a funding constraint. We demonstrate that there is a trade-off between the higher average return on equities which lowers average taxes and the greater risk of equities which increases expected tax distortions. We also incorporate the idea first exposited by Fischer Black (1989) that if there is a positive correlation between stock returns and pension liabilities over longer horizons, then holding some equities can serve as a partial hedge against liabilities, providing an additional reason for equity holdings. We consider the sensitivity of the conclusions about optimal asset allocation to the degree of initial underfunding, to the expected level of future taxes, and to the stochastic properties of pension liabilities. Although we do not model them formally, we discuss other considerations beyond minimizing tax distortions that can influence the optimal asset allocation in S&L pension plans, which together seem to point toward a policy of matching pension assets and liabilities.