Does Regulation Matter? Riskiness and Procyclicality in Pension Asset Allocation

Abstract

We investigate the extent to which regulations governing investment, valuation and funding affect the riskiness of defined benefit pension funds' asset allocations. We compare the regulatory frameworks of public, corporate and industry pension funds in the United States, Canada and the Netherlands over 1992-2011. Derived from panel data analysis of a unique set of asset allocation details for close to 600 funds, our results highlight that regulatory factors are more economically significant than funds' characteristics in shaping their asset allocation. In particular, risk-based capital requirements and mark-to-market valuation are associated with a 7% lower risky asset exposure, regardless of market conditions. Most of the decline in investment risk-taking concerns equities. The exposure of a fund subject to a 100% funding requirement does not differ significantly from that of an unconstrained fund during normal times, but the constrained fund invests 2% less in risky assets during a financial crisis. In line with theoretical predictions, we find that risk-based capital requirements and minimum funding limits have different consequences for pension funds’ risk-taking during periods of financial market stress.