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Federal Reserve Bank of Boston
Supervisory Research and Analysis Working Papers
Reach for Yield by U.S. Public Pension Funds
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.
Cite this item
Lina Lu & Matthew Pritsker & Andrei Zlate & Kenechukwu E. Anadu & James Bohn, Reach for Yield by U.S. Public Pension Funds, Federal Reserve Bank of Boston, Supervisory Research and Analysis Working Papers RPA 19-2, 06 Jun 2019.
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
- H74 - Public Economics - - State and Local Government; Intergovernmental Relations - - - State and Local Borrowing
Keywords: U.S. public pension funds; reach for yield; Value at Risk; underfunding; duration-matched discount rates; state public debt.
This item with handle RePEc:fip:fedbqu:rpa19-2
is also listed on EconPapers
For corrections, contact Andrei Zlate ()