Reach for Yield by U.S. Public Pension Funds

67 Pages Posted: 17 Jul 2019

See all articles by Lina Lu

Lina Lu

Federal Reserve Banks - Federal Reserve Bank of Boston

Matt Pritsker

Federal Reserve Bank of Boston

Andrei Zlate

Board of Governors of the Federal Reserve System

Kenechukwu Anadu

Federal Reserve Banks - Federal Reserve Bank of Boston; Babson College

James Bohn

Federal Reserve Banks - Federal Reserve Bank of Boston

Multiple version iconThere are 2 versions of this paper

Date Written: 2019-06-27

Abstract

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

Lu, Lina and Pritsker, Matthew G. and Zlate, Andrei and Anadu, Kenechukwu and Bohn, James, Reach for Yield by U.S. Public Pension Funds (2019-06-27). FEDS Working Paper No. 2019-048. Available at SSRN: https://ssrn.com/abstract=3417744 or http://dx.doi.org/10.17016/FEDS.2019.049

Lina Lu

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

Matthew G. Pritsker (Contact Author)

Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States
617-973-3191 (Phone)

Andrei Zlate

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Kenechukwu Anadu

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

Babson College ( email )

231 Forest St.
Babson Park, MA 02457-0310
United States

James Bohn

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

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