When interest rates are low, how does this influence U.S. public pension plans’ propensity to take risk?

In a working paper looking at the period between 2002 and 2016, the Federal Reserve Bank of Boston found, on average, pension funds take more risk when both risk-free rates and funding ratios are lower. Specifically, the paper’s authors estimated one-third of the funds’ risk was tied to interest rates and their funded statuses.

The paper used a theoretical model to look at how interest rates and other factors can affect risk-taking, by altering funding levels and changing risk premia.

It also found more risk-taking when the pension plan sponsor was a municipal or state government with weak public finances.

Matthew Pritsker, senior financial economist at the bank and one of the paper’s co-authors, cautions this isn’t going to be the case for all funds, noting the theory predicts what happens on average.

The researchers were interested in the topic because they wanted to understand how the low-interest rate environment affected risk-taking by different types of financial institutions and investors, says Pritsker. “And then we look at public pension funds in particular because there was data on it, so it was easily accessible.”

As interest rates continue to lower, what will this mean for funds? Will they take more risk?

“I think the answer is our research suggests this might be the case for some funds, but it depends on many things, like how well hedged funds are to interest rate changes, whether they actually want to take more risk if their funding level changes because they don’t necessarily have to do that,” he says. “They may choose to do that and that’s what we found in our earlier research. And finally, it depends how risk premia are going to look going forward in the future.

“And we know what we’ve seen empirically in the past, but economic conditions are different now.”