Swedroe: Looser Regulation Harms Pension Returns

July 05, 2016

Defined benefit (DB) pension funds promise retirement benefits dependent upon an employee’s earnings history, tenure of service and age. When a DB pension fund is underfunded (when asset values are lower than the value of their liabilities, or the promised pension benefits), conflicts of interest can arise.

This conflict can occur because a reported funding shortfall in pension fund accounting depends on the liability discount rate used to value the stream of promised benefits. The higher the discount rate, the lower the reported present value of the liabilities and the stronger the pension plan’s funding position as reported in the accounting statements.

Unfortunately, the regulation of U.S. public DB pension funds allows considerably more discretion in setting the liability discount rate compared with the regulation of U.S. private pension plans, and public as well as private plans in Canada and Europe. U.S. public DB funds follow the Government Accounting Standards Board guidelines for discounting liabilities, which allow them to base liability discount rates on the assumed (and more discretionary) expected rate of return on their assets. U.S., Canadian and European public and private plans require that the liability discount rates be based on high-credit-quality interest rates.

For example, until 2004, U.S. corporate pension plans were required to discount their liabilities using the 30-year Treasury rate, both for funding purposes and when estimating deficit reduction contributions. Since 2006, corporations have been allowed to discount liabilities using a rate that blends long-term corporate bonds, which includes upper-medium and high-grade securities. Thus, they cannot be managed by modifying the allocation to risky assets.

Different Rules For Public DB Plans
In the U.S., however, public DB pension plans are given considerable discretion in estimating returns to risky assets, such as equities. Choosing a higher rate lowers the value of the liabilities, creating incentives to choose higher rates than perhaps some unbiased practitioner would. And because liability discount rates are linked to the expected return on assets, DB plans can raise the discount rate by investing more in riskier assets.

That, in turn, creates incentives to understate the liabilities of underfunded plans and leads them to increase the allocation to risky assets. The reason is that a higher liability discount rate results in a smaller dollar amount of reported liabilities, and, thus, in their funding deficit, which translates into lower required contribution payments. On the other hand, lower discount rates lead to higher required contribution payments, which then create extra economic burdens for taxpayers and/or employers.

Aleksandar Andonov, Rob Bauer and Martijn Cremers, authors of the March 2016 paper “Pension Fund Asset Allocation and Liability Discount Rates,” contribute to the literature by examining how the difference in regulation is associated with pension fund strategic asset allocation and investment performance.

They studied whether differences in the board representation of various stakeholder groups could be associated with funds’ decisions on the allocation to risky assets. Their dataset comprised more than 850 DB pension funds, with more than $4.5 trillion in assets, for the period 1990 through 2012, and covers the U.S., Canada and Europe.

Effects Of Differences In Regulation
Defining risky assets as funds’ investments in public equity, alternative assets (such as real estate, commodities, natural resources, infrastructure, private equity and hedge funds) and risky fixed income (such as high-yield bonds, emerging market bonds and mortgage-backed securities), the authors found:

 

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