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Reach for Yield by U.S. Public Pension Funds

Author

Listed:
  • Kenechukwu E. Anadu
  • James Bohn
  • Lina Lu
  • Matthew Pritsker
  • Andrei Zlate

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.

Suggested Citation

  • Kenechukwu E. Anadu & James Bohn & Lina Lu & Matthew Pritsker & Andrei Zlate, 2019. "Reach for Yield by U.S. Public Pension Funds," Supervisory Research and Analysis Working Papers RPA 19-2, Federal Reserve Bank of Boston.
  • Handle: RePEc:fip:fedbqu:rpa19-2
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    References listed on IDEAS

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    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Negative Nominal Interest Rates: A Primer
      by Steve Cecchetti and Kim Schoenholtz in Money, Banking and Financial Markets on 2019-12-02 13:10:33

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    Cited by:

    1. John Y. Campbell & Roman Sigalov, 2020. "Portfolio Choice with Sustainable Spending: A Model of Reaching for Yield," NBER Working Papers 27025, National Bureau of Economic Research, Inc.

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    More about this item

    Keywords

    U.S. public pension funds; reach for yield; Value at Risk; underfunding; duration-matched discount rates; state public debt.;
    All these keywords.

    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
    • 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

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