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An Economic Reformulation of Public Pension Funding Policy

Current public pension funding policy has arguably failed on both theoretical and empirical grounds. The traditional actuarial approach elides the risk-return tradeoff at the heart of finance economics and has resulted in steadily rising contribution rates, instead of a sustainable steady state. We propose an economic reformulation of funding policy based on steady-state analysis of the fundamental equations of motion for pension asset and liability growth, incorporating both an expected return on risky assets and a low-risk discount rate for liabilities. Our steady-state result simultaneously conveys the benefit of risky investment and the cost of the associated risk. We integrate our analysis into a simple social welfare function to re-examine the basis for pre-funding and elucidate the net benefits of using risky assets to defray contributions. We also formally derive a family of transition policies for convergence to the expected steady state. We illustrate how the parameters of our proposed policy can be adjusted to manage the tradeoff between long-run contribution rate risk and short-term responsiveness. We believe our analysis provides the basis for reformulating contribution policy in a way that better supports sustainability and coherently conveys the tradeoffs consistent with finance economics.

pension finance
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EdWorkingPaper suggested citation:

Costrell, Robert M., and Josh B. McGee. (). An Economic Reformulation of Public Pension Funding Policy. (EdWorkingPaper: 22-674). Retrieved from Annenberg Institute at Brown University:

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