Reach for Yield by U.S. Public Pension Funds

Kenechukwu Anadu (), James Bohn, Lina Lu, Matthew Pritsker and Andrei Zlate

No RPA 19-2, Supervisory Research and Analysis Working Papers from Federal Reserve Bank of Boston

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. (search for similar items in EconPapers)
JEL-codes: E43 G11 G23 G32 H74 (search for similar items in EconPapers)
Pages: 68 pages
Date: 2019-06-06
New Economics Papers: this item is included in nep-mac
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Citations: View citations in EconPapers (2)

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Working Paper: Reach for Yield by U.S. Public Pension Funds (2019)
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