How Accounting Rules Create Perverse Risk-Taking Incentives for US Public Pension Funds

Following GASB guidelines, US public pension funds can set their discount rates based on their expected returns. The practice is at odds with the prudent liability-based approach used by the US corporate pension funds and pension funds in other countries. In a survey, 98% professional economists agree that US public plans understate their liabilities by using high discount rates under government accounting standards. The expected-return approach does not only undervalue pension liabilities, but also encourage public plans to increase risk taking in their investments to sustain a high discount rate. A recent paper by Aleksandar Andonov, Rob Bauer, and Martijn Cremers analyzes these incentives in detail.

To test the “regulatory incentive hypothesis” to examine whether the accounting rules governing the discount rates for US public plans affect their risk taking behavior, the paper compares the US public plans with a control group consisting of US corporate, Canadian and European pension plans. Unlike public plans in the US, those latter plans are subject to regulatory guidelines that require them to discount their liabilities at market yields of high-quality debt instruments. US plans, on the other hand, have substantial discretion in setting their discount rates through modifying the risk profile of their investment portfolios.

The paper finds consistent differences in risk-taking behavior between US public pension funds and pension funds in the control group. Pension funds in the control group invest more conservatively and use lower discount rates as they mature, which is in line with the fact that more mature funds have shorter-duration and more certain obligations. More mature US public funds, however, invest more in risky assets to maintain higher discount rates to avoid large increases in immediate contributions.

Consistent with the regulatory incentive hypothesis, US public pension funds also significantly increase their allocation to risky assets at times when interest rates decline. This shift in asset allocation cannot be explained by the availability of attractive investment opportunities or those funds’ ability to manage additional risky assets, given the fact that US public funds underperform compared to the control group. The underperformance is more pronounced for more mature US funds.

Because investing more in risky assets to preserve a high discount rate harms the long-term financial health of a pension fund but eases its short-term costs, the paper also finds that these regulatorily induced behaviors are more prevalent in pension funds that have more state-political and participant-elected board members, who tend to have more short-term incentives than general public board members.