Less Money, More Problems: An Analysis of US Public Pension Plans’ Funded Ratio, Asset Allocation, and Investment Returns from 2001 – 2022

Abstract

Though less common than their defined benefit counterparts, public pension plans still represent an important source of retirement income for more than 14.9 million active and 12 million retired public sector employees. Yet by some measurements - decreasing funded ratio and stagnating investment returns relative to expectations - one could argue that public pension plans have been mismanaged over the last 21 years. The goal of this thesis is to study the relationship between public pension plans’ funded ratio, asset allocation, and investment returns. Previous literature has often focused on one of two buckets: either the relationship between funded ratio and asset allocation, or the relationship between asset allocation and investment returns, never studying the three seemingly interdependent variables simultaneously. This thesis studies the relationship between the three interrelated variables using data from 2001 to 2022, thus providing a comprehensive and up to date understanding on America’s public pension plans. I first focus on the causal relationship between funded ratio and asset allocation before studying investment returns. Using instrumental variables regression to account for issues of endogeneity and reverse causality, I find that funded ratio is generally inversely related to allocation to alternative assets, with two minor exceptions. I then find evidence of a negative relationship between allocation to alternatives and long-term returns. Lastly, I find that long term returns are positively related to funded ratio. My findings reveal that the three variables exist in a cyclical feedback loop where both internal and external factors combine to affect the health and vitality of public pension funds.