Andonov: Pension fund asset allocation and liability discount rates

Question 1

DB pension funds promise retirement benefits that depend on ..

Answer 1

the employee’s earnings history, tenure of service and age

Question 2

DB retirement systems typically pool the assets of ..

Answer 2

multiple generations and allow for intergenerational as well as intragenerational risk-sharing

-> can create conflict between the different stakeholders or across generations

Question 3

underfunded

Answer 3

the value of assets is lower than the value of liabilities representing the promised pension benefits

Question 4

the funding shortfall in pension fund accounting statements depends heavily on the ..

Answer 4

liability discount rate -> the higher the discount rate that is used, the lower the reported present value of liabilities and the stronger the pension plan’s funding position

Question 5

US public pension funds follow the Government Accounting Standards Board (GASB) guidelines for discounting liabilities which allows them to base their liability discount rates on the ..

Answer 5

expected rate of return on their assets

Question 6

US private pension funds, and Canadian and European public and private pension funds, require that their liability discount rates are based on ..

Answer 6

high credit quality interest rates -> their discount rates cannot be managed by modifying the allocation to risky assets

Question 7

consequences of the GASB regulations for US public pension funds:

Answer 7

1) GASB guidelines allow public pension funds to severely understate their liabilities
2) the link between the discount rate and the expected return on assets affords US public pension funds considerable discretion to manage their liability discount rate by changing their allocation across asset classes and by choosing an expected return for individual asset classes

Question 8

regulatory incentives hypothesis:

Answer 8

the regulatory link between the liability discount rate and the expected rate of return on assets gives US public pension funds an incentive to increase their allocation to risky assets

Question 9

a 10% increase in the percentage of retired members of US public pension funds is associated with a 5.93% ..

Answer 9

increase in their allocation to risky assets

Question 10

for all other pension funds, a 10% increase in the percentage of retired members is associated with a 1.67% ..

Answer 10

decrease in their allocation to risky assets

Question 11

increased risk-taking enables more mature pension funds to use ..

Answer 11

higher discount rates

–> a 10% increase in the percentage of retired members is associated with a 75-bps increase in their discount rate

Question 12

US public funds significantly increase their allocation to risky assets when interest rates ..

Answer 12

delice.

–> a 5% decline in the yield on ten-year treasury notes is associated with a 15% increase in their allocation to risky assets

Question 13

US public funds with a higher level of underfunding per participant invest more in ..

Answer 13

risky assets and use higher liability discount rates

Question 14

US public pension funds with a higher percentage of state-political and participant-elected trustees allocate more to ..

Answer 14

risky assets and use higher discount rates

Question 15

what explains the allocation and discount rate choices of funds?

Answer 15

Differences in regulation, not country effects

Question 16

what is not the key determinant of the differences in strategic asset allocation and liability discount rates?

Answer 16

fund type (private vs public)

Question 17

liability side

Answer 17

number of active and retired participants, inflation protection policies, liability discount rates

Question 18

asset side

Answer 18

strategic asset allocation

Question 19

percentage allocated to risky assets

Answer 19

sum of strategic asset allocation weights to equity, alternative asset classes, and risky fixed income investments

Question 20

non-risky assets

Answer 20

cash and investment grade fixed income investments

Question 21

public US pension funds maintain steady discount rates around ..

Answer 21

7.5-8%

Question 22

funding status data

Answer 22

actuarial value of assets, liabilities, and funding ratio from Comprehensive Annual Financial Reports (CAFR)

Question 23

Board members

Answer 23

1) state trustees: represent state, county or city as an employer
2) plan participant trustees: represent currently employed and retired plan members
3) general public trustees: represent citizens (taxpayers)

can be 1) elected by plan members 2) appointed by governmental executive 3) serve as ex officio members by virtue of their function

Question 24

average underfunding per plan member

Answer 24

mature US public pension funds have a greater deficit per participant

Question 25

pension fund that are more mature, whose liabilities have shorter duration and are more likely to be paid, should use lower discount rates than younger funds because ..

Answer 25

the yield-curve is generally upward sloping

Question 26

the allocation to risky assets is positively related to ..

Answer 26

liability discount rates

Question 27

fund maturity is strongly positively related to ..

Answer 27

liability discount rates

Question 28

in general, discount rates are positively related with ..

Answer 28

yields

–> a 100 bps decrease in the government bond yield is associated with a decrease in the liability discount rate of 39 bps (private US, Europe, Canada)

Question 29

mature pension funds use ( … ) rates to discount their liabilities, and their discount rates are not related to the dynamics in government bond yields

Answer 29

higher

Question 30

US public pension funds ( … ) other pension funds by 36 to 61 bps annually

Answer 30

underperform

Question 31

investments of US public pension funds ( … ) perform differently from the investments of other pension funds when their percentage allocation is not inflated by regulatory incentives

Answer 31

do not

Question 32

the percentage of retired participants is positively related to the ..

Answer 32

level of underfunding

–> fund maturity proxies for worse funding situations and higher required contribution payments

Question 33

mature US public funds have stronger incentives to use a ( … ) liability discount rate because it enables them to transfer a larger economic cost of underfunding to the future

Answer 33

higher

Question 34

fund maturity is related to the pension fund board composition

Answer 34

the percentage of retired members is positively related to the percentage of state-political trustees and participant-elected trustees

Question 35

the lower performance of US public funds is mainly due to ..

Answer 35

the lower performance of funds governed by participant-elected and state-political board members

Question 36

( … ) risk taking does not in general lead to ( … ) performance, but in combination with poor governance it tends to deliver lower returns

Answer 36

high

lower

Question 37

pension funds with more trustees from the general public invest more in ..

Answer 37

risky assets and use higher discount rates, but there is no indication that their performance is different