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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.

Keywords
pension finance
Education level
Topics
Document Object Identifier (DOI)
10.26300/wrsb-as16

EdWorkingPaper suggested citation:

Costrell, Robert M., and Josh B. McGee. (). Toward An Economic Reformulation of Public Pension Funding Policy. (EdWorkingPaper: 22-674). Retrieved from Annenberg Institute at Brown University: https://doi.org/10.26300/wrsb-as16

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