Does Regulation Matter? Riskiness and Procyclicality in Pension Asset Allocation

Abstract

We investigate the influence of investment regulations on the riskiness and procyclicality of defined-benefit (DB) pension funds' asset allocations. We provide a global comparison of the regulatory framework for public, corporate and industry pension funds in the US, Canada and the Netherlands. Derived from panel data analysis of a unique set of close to 600 detailed funds’ asset allocations, our results highlight that regulatory factors are vitally important – more so than the funds’ individual and institutional characteristics, in shaping these asset allocations. In particular, risk-based capital requirements, balance sheet recognition of unfunded liabilities, lower liability discount rates, and shorter recovery periods lead pension funds to decrease their asset allocation to risky assets. Risk-based capital requirements reduce overall risky asset allocation by as much as 5%, mainly through alternatives. Our empirical results do not corroborate the theoretical predictions that risk-based capital requirements encourage procyclical investment.

Keywords: Solvency, pension funds, defined benefit, liability discount rate, valuation requirements, financial stability, regulation

JEL Classification: G11, G28, H55