How Should Public Pension Plans Invest?

How public pension plan assets should be invested is an important but unsettled question. Alicia H. Munnell and Mauricio Soto (2007) find that the share of state and local (S&L) plan assets held in equities has grown over time, largely in parallel with private sector practices, from an average of about 40 percent in the late 1980s to about 70 percent in 2007. 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). Nevertheless, 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. Others advocate a more conservative approach that reduces the volatility of funding levels and the likelihood of severe shortfalls during economic downturns when government resources are already constrained (e.g., Lawrence N. Bader and Jeremy Gold 2007). 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