Toward 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 integrating: (1) steady-state determination of the expected contribution rate, based on an expected return on risky assets and a target funded ratio based on a low-risk discount rate for liabilities; (2) adjustment parameters to achieve convergence toward steady state; and (3) determination of target funded ratio based on policymakers’ revealed preference toward risk, by their choice of asset allocation under a simplified objective function.  This provides a new understanding of the basis for pre-funding, in which the perceived net benefits of risky investment may far outweigh the traditional Samuelsonian rationale.  Specifically, we find that convexity of the long-run risk-return relationship should lead more risk-tolerant policymakers to pursue higher target funded ratios.  We believe our analysis provides the basis for reformulating contribution policy in a way that better supports sustainability and more coherently conveys the tradeoffs consistent with finance economics, and as evaluated by policymakers.