Swedroe: Looser Regulation Harms Pension Returns

The reasons are pretty clear, but the clock is ticking on a solution.

Reviewed by: Larry Swedroe
Edited by: Larry Swedroe

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:


  • The strategic allocation to risky assets of public pension funds increased from 56.1% in 1993 to 72.4% in 2012, mainly due to increased risk-taking among U.S. public pension funds. In contrast, private plans decreased their allocation to risky assets from 63.0% in 1993 to 60.2% in 2012. And compared with Canadian and European funds, U.S. pension funds on average allocate a greater percentage of their assets to risky investments.
  • U.S. pension funds, on average, use higher discount rates than Canadian and European pension funds.
  • Among U.S. funds, despite the sharp decline in the yield on 10-year U.S. Treasury notes from 7.1% in 1994 to 1.8% in 2012, public plans had maintained steady discount rates of around 7.5-8.0% during the entire period. Pension funds were able to maintain the higher rate by increasing their allocation to risky assets and taking advantage of the flexibility allowed by accounting regulations.
  • Reflecting the fall in the risk-free rate, the liability discount rates of U.S. private pension funds decreased from 8.2% in 1993 to 4.4% in 2012.
  • More mature U.S. public funds (which are more likely to have underfunded liabilities), as well as funds with more political- and participant-elected board members, take greater risk and use higher discount rates.
  • While prudent risk management suggests pension funds should take less investment risk when their promised benefits need to be met sooner (i.e., they have more retirees) and become less uncertain due to increased retirements, a 10% increase in the percentage of retired U.S. public fund members is associated with a 5.34% increase in their allocation to risky assets.
  • For all other pension plans, a 10% increase in the percentage of retired members is associated with a 1.70% lower allocation to risky assets. This is appropriate, as more mature funds should use lower discount rates that better reflect the shorter duration of their cash outflows and the corresponding, generally upward-sloping, yield curve.
  • U.S. public plans significantly increase their allocation to risky assets when interest rates are falling. A roughly 5-percentage-point decline in the yield on 10-year Treasury securities was associated with a 15-percentage-point increase in their allocation to risky assets. The reason for this behavior is that, as the level of interest rates falls, the expected rates of return on both risky and nonrisky assets drop, raising the valuation of liabilities. To offset this impact, the allocation to risky assets increased.
  • Pension funds manage approximately 80% of their assets actively and only 20% passively.
  • The increased risk-taking of U.S. public pension plans is negatively related to the plans’ performance.
  • U.S. public plans underperform benchmarks by about 0.57% a year, and their underperformance is substantially worse if the fund is more mature.
  • The underperformance of mature U.S. public plans is primarily the result of lower returns in equities and alternative assets—those risky assets in which they, in particular, increased their allocation to maintain higher liability discount rates.
  • A 10% increase in the strategic allocation to risky assets among U.S. public plans is associated with an increase in underperformance of 10.4% annually.
  • U.S. public pension funds have a 0.25% lower annual return in equity and a 2.36% lower return in alternative assets.
  • Other groups of pension plans the authors examined did not exhibit underperformance.
  • U.S. public DB pension funds with a higher percentage of state-political and participant-elected trustees invest more in risky assets and use higher-liability discount rates. This is consistent with the intuition that such trustees have stronger incentives to maintain high-liability discount rates. Pension plans with a board that consists only of state-political members invest in risky assets at a rate 10 percentage points higher than pension plans without state-political trustees.
  • More mature pension plans with a higher percentage of participant-elected trustees also have greater allocations to risky assets, employ higher discount rates and obtain lower investment returns. This, too, is consistent with intuition that, at least in the short term, plan participants are not obliged to pay higher contributions if increased risk-taking results in low returns and underfunded liabilities, but they could benefit from increased benefits if risk-taking yields good returns.


US Public Pensions Are Risk-Takers
The authors concluded that, gradually, U.S. public pension funds have become the biggest risk-takers among pension funds internationally. To camouflage underfunded status and avoid painful measures like raising taxes or cutting benefits, U.S. public pension funds take advantage of the flexibility allowed by accounting rules to maintain higher-liability discount rates and invest more in risky assets.

Unfortunately, U.S. public plans also underperform compared with other pension plans by about 0.57% per year. This underperformance is particularly strong for mature U.S. public pension funds with large allocations to equity and alternative assets.

Moreover, the authors’ findings are consistent with those of a March 2016 study authored by Aleksandar Andonov, Yael Hochberg and Joshua Rauh, “Pension Fund Board Composition and Investment Performance: Evidence from Private Equity.”

For example, they found:

  • The performance of public pension funds’ private equity investments is strongly related to the relative representation of different categories of members on their boards.
  • Each additional 10 percentage points of board membership that goes to government officials reduces performance by 0.9 net IRR (internal rate of return) percentage points if the official is appointed by another government official and by 0.5 net IRR percentage points if the official sits on the board by virtue of his or her office (ex officio).
  • An additional 10 percentage points of board membership going to elected members of the pension plan itself reduces performance by 0.2 to 0.4 net IRR percentage points.
  • State-appointed, state-ex officio and participant-elected trustees underperform within both real estate and private equity. The underperformance in private equity cannot be explained solely by higher allocation to fund-of-funds, and it is strongly concentrated in VC funds.
  • Even within the real estate category, pension funds governed by boards heavily populated with state-appointed, state-ex officio and participant-elected trustees select worse funds. An increase of 10 percentage points in a fund’s proportion of state-appointed board members is associated with a decrease of 0.80 percentage points in annual net IRR on real estate investments.

Wake-Up Call

Given the huge amount of assets at stake, the issues raised by the research present serious concerns for beneficiaries as well as taxpayers. Stronger regulations eliminating the flexibility to manipulate discount rates are urgently needed.

In addition, stronger governance of plans in terms of the composition of boards’ membership—perhaps to require members who have the skills necessary to make better investment decisions—is needed. If not, there is likely to be an intergenerational transfer of funds because the benefits of most public pension plans are protected by constitutional nonimpairment clauses and common law.

Given the estimates showing the vast underfunding of many public pension plans, time is of the essence.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he was vice chairman of Prudential Home Mortgage.