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Why Public Pensions Are Taking More Risk

Public pension funds, particularly those with higher underfunded statuses, are taking on more risk as rates stay low.

In a low-interest-rate environment, public pension funds facing widening gaps between their assets and liabilities are making riskier investments, new research shows.  

The United States Federal Reserve has kept interest rates low in the wake of the Great Recession of 2008 to 2009. The federal funds rate is now hovering around 2.5 percent, with the Federal Reserve signaling that it will keep rates there for the time being.  

Members of the Federal Reserve Bank of Boston set out to determine how persistently low rates affect the tolerance of public pension plans, particularly those that are underfunded, meaning the value of their assets is worth less than their obligations. In a research paper entitled “Reach for Yield by U.S. Public Pension Funds,” published earlier this month, four members of the Boston Fed, along with a member of the Board of Governors of the Fed, concluded that this combination of factors pushes pensions to take more risk. 

The researchers used the Public Plans Database from the Center for Retirement Research at Boston College, pulling plan-level annual data from 2001 through 2016 for 170 public pension funds. According to the paper, 114 of those funds were administered by states, while 56 were administered locally. The sample covered 95 percent of public pension plan membership nationwide, the paper said. 

The researchers estimated that one-third of public pension funds’ total risk was related to underfunded status or low interest rates, research published on July 8 showed. The researchers found that risk-taking behavior related to underfunded status alone was responsible for about 12 percent of total risk taken on by the funds. 

The researchers noticed that those low-interest rates and underfunded statuses, when combined, increased risky investing strategies.  

“The effect of a lower funding ratio on risk-taking behavior was more pronounced when interest rates were relatively low,” such as the period between 2012 and 2016, according to the research.  

The public pension funds that were affiliated with states or municipalities that had weaker financial situations (higher levels of public debt or worse credit ratings) also took on more risk, the researchers showed.  

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If a state is allowed to default on its debt, public pension funds will often take on more risk, according to the research. The extra risk taken on by those public pension funds is essentially shifted onto taxpayers, who — if the state defaults on its debt — would pay the price, the research shows.  

In other words, pension funds taking the most investment risk tend to be those on the most precarious financial footing. 

“Risk-taking behavior is most pronounced among funds with sponsors with the least ability to bear additional risk,” the paper showed.    

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