Reach for Yield by U.S. Public Pension Funds
67 Pages Posted: 17 Jul 2019
Date Written: 2019-06-27
This paper studies whether U.S. public pension funds reach for yield by taking more investment risk in a low interest rate environment. To study funds' risk-taking behavior, we first present a simple theoretical model relating risk-taking to the level of risk-free rates, to their underfunding, and to the fiscal condition of their state sponsors. The theory identifies two distinct channels through which interest rates and other factors may affect risk-taking: by altering plans' funding ratios, and by changing risk premia. The theory also shows the effect of state finances on funds' risk-taking depends on incentives to shift risk to state debt holders. To study the determinants of risk-taking empirically, we create a new methodology for inferring funds' risk from limited public information on their annual returns and portfolio weights for the interval 2002-2016. In order to better measure the extent of underfunding, we revalue funds' liabilities using discount rate s that better reflect their risk. We find that funds on average took more risk when risk-free rates and funding ratios were lower, which is consistent with both the funding ratio and the risk-premia channels. Consistent with risk-shifting, we also find more risk-taking for funds affiliated with state or municipal sponsors with weaker public finances. We estimate that up to one-third of the funds' total risk was related to underfunding and low interest rates at the end of our sample period.
Keywords: U.S. public pension funds, reach for yield, Value at Risk, underfunding, duration-matched discount rates, state public debt
JEL Classification: E43, G11, G32, G23, H74
Suggested Citation: Suggested Citation