Pension Fund Asset Allocation and Liability Discount Rates

  • Aleksandar Andonov, Rob Bauer and Martijn Cremers, International Centre for Pension Management
Closeup photo of coins and pens sitting on a sheet of paper.

The unique regulation of U.S. public pension funds links their liability discount rate to the expected return on assets, which gives them incentives to invest more in risky assets in order to report a better funding status. Comparing public and private pension funds in the U.S., Canada, and Europe, we find that U.S. public pension funds act on their regulatory incentives. U.S. public pension funds with a higher level of under-funding per participant, as well as funds with more politicians and elected plan participants serving on the board, take more risk and use higher discount rates. The increased risk-taking by U.S. public funds is negatively related to their performance.


Brian O’Donnell, Executive-in-Residence, Global Risk Institute

This month we build upon our ongoing collaboration with the International Centre for Pension Management (ICPM), an association of 41 pension management firms from around the world. The ICPM conducts leading edge research for the pension fund industry, along with hosting webinars, discussion forums and a Board Education Program to promote education for Board members across the industry. The Global Risk Institute is a member of the ICPM, and contributes research resources particularly for projects focusing on risk management in the pension industry.

Below is our first publication in collaboration with ICPM, and is an excellent research paper on asset allocation and discount rates. All readers who have an interest in both pension industry risks and potential systemic risks will find this article of interest. The authors, Aleksandar Andonov, Rob Bauer and Martijn Cremers explore the state of public defined programs across the United States, where the methodology for selecting a discount rate for the program’s liability (payout to members over time) is having significant implications for asset allocation and risk management. The issue emanates from the pension accounting rules outlined in the Government Accounting Standards Board, which calls for pension fund liabilities be discounted at the rate being earned by the pension funds’ assets; in most other jurisdictions the discount rate is divorced from the asset side of the balance sheet and based, for example, on a spread over a long term government bond.

Mr. Andonov, Mr. Bauer and Mr. Cremers explore the implications of this accounting methodology on the asset allocation and performance of the pension funds. What they find is that such funds are incented to hold a riskier asset portfolio, despite their members’ demographic profile and risk appetite. Such funds are shown to include much higher levels of equities and alternative assets (including private equities). Board composition of public funds, often including political appointees, seem to have a political motivation to increase risk asset holding, which leads to a higher discount rate on their liabilities, which lowers their calculated (and publicly disclosed) funding gap, all of which then delays requirements to find a way to fund the shortfall (either through politically difficult tax increases or program spending cuts). The pension funds are therefore more exposed to equity / general economy risk, which will likely come home to roost some day.