Why public-sector pension plans take more risk

IMAGINE two kinds of investment funds, both of which have the same aim: to provide pensions for their employees. You might think that they would invest in a similar way. But when it comes to American pension funds, you would be wrong. It turns out that public funds have a rather different, and more aggressive, approach to risk than private pension funds (and indeed than their counterparts in other countries).

As a recent paper* by Aleksandar Andonov, Rob Bauer and Martijn Cremers shows, that different approach is driven by a regulatory incentive—the rules that determine how pension funds calculate how much they need to put aside to meet the cost of paying retirement benefits. Usually, the bulk of a pension fund’s liabilities occur well into the future, as workers retire. So that future cost has to be discounted at some rate to work out how much needs to be put aside today.

Private-sector pension funds in America and elsewhere (and Canadian public funds) regard a pension promise as a kind of debt. So they use corporate-bond yields to discount future liabilities. As bond yields have fallen, so the cost of paying pensions has risen…Continue reading

This post was originally published in the Economist.

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Why public-sector pension plans take more risk

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