Fed in Print

Board of Governors of the Federal Reserve System (US)

Finance and Economics Discussion Series

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 fundsâ€™ 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 plansâ€™ funding ratios, and by changing risk premia. The theory also shows the effect of state finances on fundsâ€™ 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 fundsâ€™ 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 fundsâ€™ 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 fundsâ€™ total risk was related to underfunding and low interest rates at the end of our sample period.

Lina Lu & Matthew Pritsker & Andrei Zlate & Kenechukwu E. Anadu & James Bohn, Reach for Yield by U.S. Public Pension Funds, Board of Governors of the Federal Reserve System (US), Finance and Economics Discussion Series 2019-048, 27 Jun 2019.

JEL Classification:

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
G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
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:fedgfe:2019-48 is also listed on EconPapers and IDEAS.

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