Data and Research

Regulations Incent Public Pensions to Take Risky Investments

Regulations allowing public DBs to base their liability discount rates on the assumed expected rate of return on their assets encourage investments in public equity, alternative assets and risky fixed income, research finds.

By PLANSPONSOR staff editors@plansponsor.com | July 20, 2016
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Researchers from Erasmus University Rotterdam, Maastricht University and Rotman ICPM, University of Toronto and the University of Notre Dame have found that U.S. public pension funds have incentives to increase risk-taking, arising from their unique regulation linking their liability discount rates to the expected return on assets, which enables them to report a better funding position by investing more in risky assets.                   

The regulation of U.S. public defined benefit (DB) pension funds allows considerably more discretion in setting the liability discount rate compared to the regulation of other DB pension plans (specifically of U.S. corporations and both public and private plans in Canada and Europe), the researchers note. U.S. public DB funds follow the Government Accounting Standards Board (GASB) guidelines for discounting liabilities, which allow them to base their liability discount rates on the (assumed and thus more discretionary) expected rate of return on their assets.

In contrast, the regulations pertaining to the discount rates of U.S. private as well as Canadian and European public and private pension plans require that these are based on high credit quality interest rates and thus cannot be managed by modifying the allocation to risky assets. For instance, Canadian public and private pension plans discount their liabilities using market yields of high-quality corporate debt instruments, while U.S. corporate plans use a discount rate that is a combination of upper-medium and high-grade long-term corporate bonds.

The GASB regulations for U.S. public DB funds have two important consequences, the first of which is that GASB guidelines allow U.S. public funds to severely understate their liabilities. The accrued pension benefits of U.S. public plans appear legally well-protected such that using the expected return on assets will generally imply a discount rate that is too high.

The second consequence of GASB regulations is that the link between the discount rate and the expected return on their assets affords U.S. public pension funds considerable discretion to manage their liability discount rate by changing their allocation across asset classes and choosing an expected return for individual asset classes. The main `regulatory incentives hypothesis' we posit is that the regulatory link between the liability discount rate and the expected rate of return on assets gives U.S. public funds an incentive to increase their strategic allocation to risky assets. A larger allocation to risky assets allows these funds to employ higher expected returns and thus to justify a higher discount rate and, as a consequence, lower the reported value of the liabilities.

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