Reach for Yield by U.S. Public Pension Funds

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 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 funds?? total risk was related to underfunding and low interest rates at the end of our sample period.