The Return Expectations of Public Pension Funds

Abstract

The return expectations of public pension funds are positively related to cross-sectional differences in past performance. This positive relation operates through the expected risk premium, rather than the expected risk-free rate or inflation rate. Pension funds act on their beliefs and adjust their portfolio composition accordingly. Persistent investment skills, risk taking, efforts to reduce costly rebalancing, and fiscal incentives from unfunded liabilities cannot fully explain the reliance of expectations on past performance. The results are consistent with extrapolative expectations, since the dependence on past returns is greater when executives have personally experienced longer performance histories with the fund. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.