Distinct regulation of United States public pension funds that links the liability discount rate to expected return on assets, rather than to the riskiness of their promised benefits, sets them apart – in a bad way. US public funds have underperformed other pension fund cohorts because of higher allocations to risky assets. Arguably, regulation is at the core of that decision.
A new paper by Aleksandar Andonov and Rob Bauer from Maastricht University and Martijn Cremers of the University of Notre Dame shows that US public funds have an annual underperformance of more than 60 basis points from 1990 to 2010 compared to their peers.
The underperformance, the authors argue, seems to be driven by the conflict of interest between current and future stakeholders, and could result in significant costs to future workers and taxpayers.
Pension fund asset allocation and liability discount rates: camouflage and reckless risk taking by US public plans? compares the asset allocations, liability discount rates and performance across six groups: public and private pension funds in the US, Canada and Europe using the CEM database.
Distinct from any of the other five groups measured in the study, the US public fund regulation links the liability discount rate to the expected return on assets rather than to the riskiness of their promised pension benefits. This means they behave differently from all other pension funds.
Even within the US, regulation is very different: public funds are regulated by the Government Accounting Standard Board, while corporate funds are regulated under the Pension Act 2006.
Stacking up the stats
Significantly in the past 20 years, the group of US public pension funds measured have uniquely increased allocations to riskier investments to maintain high discount rates – and oddly this is especially the case as more members retired.
On average, the percentage of retired members among private plans increased from 31 per cent in 1993 to 52 per cent in 2010, and from 28 per cent in 1993 to 39 per cent in 2010 among public pension funds.
Economic theory suggests that asset allocation and liability discount-rate choices should be more conservative as the fund matures. But with US public funds, the proportion of retirees relative to non-retirees is positively related to the allocation to risky assets.
The study found that a 10-per-cent increase in the number of retired members of US public pension funds is associated with a 2.05-per-cent increase in the allocation to risky assets, while a 10-per-cent increase in the number of retired members is associated with a 1.16-per-cent lower allocation to risky assets among all other pension funds.
This results in the funds “camouflaging the degree of underfunding” the paper argues.
“If the liability discount rate equals the expected rate of return, it makes liabilities very hard to measure. It is subjective and hard to argue about,” one of the authors, Martijn Cremers says. “Liabilities shouldn’t be hard to define or be so subjective.”
Cremers, who is professor of finance at Notre Dame, says US pension funds need to be objective as possible about their liabilities, which would allow an equally objective assessment of the outcome and current promises.
It is then possible to do asset liability modelling and think about asset allocation with the right perspective.
According to the authors, US private pension funds, and both public and private Canadian and European pension funds are subject to significantly stricter regulatory guidelines. Their regulations generally require that liability discount rates be chosen as a function of current interest rates.
“We argue that the distinct regulatory framework for US public funds gives them strong incentives to shift a larger allocation to risky investments as this increases the assumed expected rate of return on their asset portfolio and thus (through their regulation) results in higher liability discount rates,” the paper outlines. “This in turn helps these pension funds camouflage their degree of underfunding and potentially delay making difficult decisions on contribution levels and pension benefits. Over the last two decades, increased allocations to assets with higher (assumed) expected returns have allowed US public pension funds to maintain high-liability discount rates, even as interest rates significantly declined.”
Cremers argues it is finance 101 to link the liability discount rate to investment grade yields.
Other academics have also argued this (for example, Robert Novy-Marx and Joshua Rauh of the National Bureau of Economic Research), but uniquely it is the regulation of US public pension funds that continues to ignore this finance missive.
Financial theory suggests that future streams of pension benefit payments should be discounted at a rate that reflects their inherent riskiness, particularly their covariance with priced risks.
Academics have been proposing the use of liability discount rates based on yields on government and municipal bonds and swap rates.
“In our empirical analysis, we find that pension funds generally lower liability discount rates as interest rates decline, which is consistent with both their regulations and economic theory.
However, US public pension funds are again different, as we find no association between liability discount rates and interest rates. This is consistent with their incentives and their distinct regulation that explicitly links liability discount rates to their expected rate of return on assets rather than to the level of interest rates. This result holds even while controlling for the proportion of assets invested in risky asset classes, which means that US public pension funds have made the economically surprising choice of not lowering their nominal expected return estimates on risky assets as interest rates decline.”
In the early 1990s yields were 7 to 8 per cent, so Cremers says it made sense for the return expectation to be 7 to 8 per cent. But as yields have declined, the return expectations have not declined.
A prudent assessment of reality
“The prudent thing is fairly unambiguous. With US public funds, regulation gives strong incentive to kick the can down the road,” Cremers says.
“US public funds are not making asset allocation on where opportunities are or true asset liability matching, but on camouflage, on short-term responses,” Cremers says.
Perhaps the most important aspect of the study, however, is the emphasis on the fact that US public pension funds are not being transparent about the true state of the underfunding position.
“Whatever the policy, it needs to be based on a prudent assessment of reality,” Cremers says. “The first step is to identify the current pension status, which is worse than people say. And regulation that gives incentive to public pension funds to invest in risky assets is imprudent.”
While funds admit that they are underfunded, academics and study by the Pew Report, show the situation is much worse than reported.
Cremers says the average funding level of US public pension funds is 80 per cent, but in reality it is much worse, with Pew estimating it is 57 per cent.
“If a more realistic liability discount rate is used, then it is a more dire picture of funding status. But then we can talk about how to respond, and at least there is a conversation about where we are,” Cremers says.
“As a financial economist, I can say that you make better decisions if you are realistic about where you are.”