Swedroe: What Hampers Pension Plans

April 18, 2018

It is no secret that many public and private pension plans are significantly underfunded. A combination of changing demographics, lackluster investment performance and low interest rates have all played a part. The long-term solvency, regulation and investment performance of these plans are all being questioned. This is particularly so for taxpayer-funded U.S. public pension plans.

Regulatory guidelines for U.S. public pension funds allow for considerably more discretion in setting liability discount rates compared with guidelines for other pension funds. They follow the Government Account Standards Board (GASB) guidelines for computing discount rates, which allow them to base liability discount rates on the expected return of assets held by the plan.

This contrasts to other types of pension plans, like U.S. private plans and Canadian and European private and public plans, which require the use of some type of high-credit-quality interest rate as a discount rate.

Given the many important implications of this dichotomy for public pension recipients, my colleague, Tim Jost, an institutional services advisor with my firm, Buckingham Strategic Wealth, supplied the following analysis of recent research into regulatory incentives, asset allocation and the performance of pension plans.

Recent Research

In the February 2017 paper, “Pension Fund Asset Allocation and Liability Discount Rates,” Aleksandar Andonov, Rob Bauer and Martijn Cremers examined whether the asset allocations and performance of U.S. public pension funds (those offered to federal, state and local government employees) were related to the unique regulatory framework that defines how liability discount rates are determined.

The authors also explored the role that regulatory incentives play in different asset allocations among types of plans, and how these incentives impact performance. Their data set included more than 850 U.S., Canadian and European pensions, and covered the period 1990 through 2012.

Andonov, Bauer and Cremers investigate a “regulatory incentives hypothesis,” implying there is an incentive for U.S. public pension plan stakeholders to increase allocations to risky assets. They found that when comparing public and private pension funds in the U.S., Canada and Europe, U.S. public pension funds act on their regulatory incentives and tend to take more risk—their asset allocations reflected the highest levels of risk among funds analyzed in the paper.

By increasing allocations to risky assets, U.S. public plans are able to increase expected returns and discount rates, having two primary positive effects: 1) the present value of liabilities goes down; and 2) the plan funding level goes up.

These twin effects allow states and municipalities to make fewer contributions to their public pension plans in the near term. Thus, it can be said that GASB guidelines encourage the funding of future liabilities with investment gains as opposed to contributions.

Stakeholders in U.S. public pension funds, as well as taxpayers, need to ask an important question: In the absence of unique GASB guidelines, should these funds be taking the amount of risk that they are?

Plan Maturity & Risk Taking

The collective allocation to risky assets for public pension funds across the U.S., Canada and Europe increased from 56.1% in 1993 to 72.4% in 2012, mainly due to U.S. public pension funds. Private pension plans actually decreased their allocation to risky assets from 63% in 1993 to 60.2% in 2012.

Taking more investment risk, as U.S. public pension funds have done, isn’t necessarily a bad thing—as long as it is within appropriate levels of risk tolerance and is being adequately compensated.


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