Financial Economics Principles Applied to Public Pension Plans

Abstract

Working from basic principles of economics, financial economics, and public finance, we develop implications for the financial management of public pension plans, and develop a complete and integrated set of investment, funding, reporting and benefit design solutions that seek to maximize efficiency and preserve intergenerational equity, strictly defined. We address the measurement and reporting of pension liabilities and costs, including the cost of risk, and conclude that full funding based on liabilities measured using default-free discount rates, and investing to hedge those liabilities, is efficient and fair across generations. Hedging is more effective when plan design incorporates market principles and avoids off-market equivalences and options. Risk-sharing plans that incorporate individual preferences are found to be superior to risk-sharing plan designs currently popular in Europe and Canada that treat all cohort members in unison.