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Reach for Yield by U.S. Public Pension Funds

Author

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

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 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.

Suggested Citation

  • Lina Lu & Matthew Pritsker & Andrei Zlate & Kenechukwu E. Anadu & James Bohn, 2019. "Reach for Yield by U.S. Public Pension Funds," Finance and Economics Discussion Series 2019-048, Board of Governors of the Federal Reserve System (US).
  • Handle: RePEc:fip:fedgfe:2019-48
    DOI: 10.17016/FEDS.2019.049
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    File URL: https://www.federalreserve.gov/econres/feds/files/2019048pap.pdf
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    References listed on IDEAS

    as
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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;

    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
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • H74 - Public Economics - - State and Local Government; Intergovernmental Relations - - - State and Local Borrowing

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