Paper: For Public Plans, Are Accounting Rules Distorting Asset Allocation?

(February 17, 2012) – A recently posted academic paper suggests that equities represent too large a percentage of American public plan portfolios—a result, the authors posit, of accounting rules.

Public plans hold large amounts of equities, Deborah J. Lucas of Northwestern University’s Kellogg School of Management and Stephen P. Zeldes of Columbia Business School admit, but add that “this exposure led to a loss of an estimated $1 trillion dollars following the decline of the stock market from October 2007 to October 2008 (Munnell, Kelly Haverstick, and Jean-Pierre Aubry 2008).” However, they note, “some observers endorse the standard practice of investing heavily in higher yielding but riskier equities, reasoning that the higher average returns will reduce future required tax receipts and also help to reduce underfunding over time.”

The average state or local public plan holds around 60% of their portfolio in equities, the authors note, with 75% having between 50% and 75% in the asset class as of 2006. The authors view this at least partially as a result of perverse accounting rules. “The accounting rules for public pensions create a perverse incentive to invest in stocks: since projected liabilities are discounted at the expected return on assets rather than at a rate that reflects the generally lower risk of liabilities, investing the assets in the stock market leads to a higher allowed discount rate for the liabilities, which in turn lowers the accounting-based measure of liabilities and lowers required pension contributions,” they write.

One problem with this allocation structure is this, the authors note: When equities fall, taxpayers are on the line for benefits. “We demonstrate that there is a trade-off between the higher average return on equities which lowers average taxes and the greater risk of equities which increases expected tax distortions,” they write.

The authors do not claim that there is no reason for holding higher-risk equities in public plan portfolios, however. “Our analysis of the asset allocation problem facing (state & local) pension plans suggests two distinct reasons, each related to tax smoothing, for holding a portion of pension assets in higher returning equities,” they write. The first: “In the presence of distortionary taxes, the equity premium produces higher average returns that reduce the need to raise revenues in the future through distortionary taxes,” even though these equity holdings may increase the volatility of taxes due to periodic decreases in equities. However, the authors suggest a caveat: “While these considerations do suggest a positive share of stocks in the portfolio, they do not rationalize the clustering of observed equity shares around 60%. They also do not justify the GASB rule that allows projected liabilities to be discounted at the expected return on plan assets.” 

In conclusion, the authors point to accounting shortfalls—and an urge to avoid them—as a driver of asset allocation decisions at public pension plans. “One leading possibility (for current asset allocation decisions) is that the accounting rules that allow state and local plans to discount liabilities at the expected return on assets create an incentive to invest in high risk–high return assets in order to lower accounting shortfalls,” the authors write.

Click here to download the paper in its entirety.