What drives U.S. state-sponsored pension plans to take bigger risks?

What effect do low interest rates really have on how pension funds invest and what are the long-term consequences?

When plan sponsors are underfunded, they have a few set options, according to a new paper by the Federal Reserve Bank of Boston. For a state-sponsored plan, the choice of whether to take on assets with higher expected returns, but also higher risk, or to somehow find the money to increase plan sponsor contributions, is an inherently political question.

If an underfunded state plan is also facing a lower interest rate environment, it can be more inclined to take on riskier investments, the paper found. While a lower-funded ratio would be enough to influence that behaviour, lower interest rates correlate with more pronounced risk-taking. Further, plans whose state sponsor had shakier finances, as represented by higher levels of public debt or a muted credit rating, took more risk as well, especially during low interest rate periods.

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In addition, the research found increased risk-taking was often contingent on whether the state sponsor could default on its non-pension outstanding debts.

“Our modelling of state finances suggests that if states can default on their non-pension debt, states with high debt-to-income ratios may choose to take higher risk in their pension funds because they can shift the risk of poor fund performance away from taxpayers and toward state debt holders,” the paper said. “On the other hand, our model also implies that states may choose to take less risk if state debt is high but they cannot default on it, or if the penalties for defaulting are large.”

Since states that can default are more likely to take on increased risk in their pension investments, the upshot could prove to be an overall worsening of the state’s total finances, the paper said.

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It noted that ramping up risk in pension portfolios may also be an attempt to disguise how serious a plan’s liabilities are becoming, since U.S. accounting rules allow public pension funds to discount their liabilities based on the expected return on their assets. The issue remains whether or not the pensions are projecting those returns reasonably.

Based on its proprietary modelling, the researchers tested these questions, using state plans’ 2016 portfolios. It concluded that, if one in 20 year adverse return event took place that year, the potential transferable loss would have been an average of about three per cent of a state’s income, or about 39 per cent of its debt. It noted between 12 and 32 per cent of those losses were attributable to the funds’ risk-taking behaviour.

“The effects of low interest rates on risk-taking are especially pronounced for funds more underfunded or affiliated with states with weaker public finances,” the paper said.

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