Prudent Public Sector Investing and Modern Portfolio Theory: An Examination of Public Sector Defined Benefit Pension Plans

Abstract

This research examines the extent to which public pension programs allocate assets in a manner that is consistent with an optimal portfolio, as defined by Modern Portfolio Theory (MPT). The examination is pursued by way of a statistical analysis, using a portfolio optimization model and data on some of the nation's largest public DB plans. The analysis illustrates that the majority of the plans in the sample are incurring far more risk in their portfolios than is optimal given their target rates of return and that this risk level is a result of nonprudent allocation across asset classes. The findings suggest that there might be opportunities to improve the long-term performance of defined benefit plans by adjusting asset allocation targets and legal lists in a manner that is more consistent with MPT.