Reach for Yield by U.S. Public Pension Funds

68 Pages Posted: 17 Jul 2019

See all articles by Lina Lu

Lina Lu

Federal Reserve Banks - Federal Reserve Bank of Boston

Matthew Pritsker

Federal Reserve Banks - 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: 2019-06-06

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 rates 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, G23, G32, H74

Suggested Citation

Lu, Lina and Pritsker, Matthew and Zlate, Andrei and Anadu, Kenechukwu and Bohn, James, Reach for Yield by U.S. Public Pension Funds (2019-06-06). FRB Boston Risk and Policy Analysis Unit Paper No. RPA 19-2. Available at SSRN: https://ssrn.com/abstract=3419118

Lina Lu (Contact Author)

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

600 Atlantic Avenue
Boston, MA 02210
United States

Matthew Pritsker

Federal Reserve Banks - Federal Reserve Bank of Boston

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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