We study effort and risk-taking behaviour in an economy with a continuum of principal–agent pairs where each agent exerts costly hidden effort. Principals write contracts based on both absolute and relative performance evaluations (APE and RPE, respectively) to make individually optimal risk–return trade-offs but do not take into account their impact on endogenously determined aggregate variables. This results in contractual externalities when these aggregate variables are used as benchmarks in contracts. Contractual externalities have welfare changing effects when principals put too much weight on APE or RPE due to information frictions. Relative to the second best, if the expected productivity is high, risk-averse principals over-incentivize their own agents, triggering a rat race in effort exertion, resulting in over-investment in effort and excessive exposure to industry risks. The opposite occurs when the expected productivity is low, inducing pro-cyclical investment and risk-taking behaviours.

Using a sample of state pension funds’ equity holdings, we find evidence of not only local bias, but also bias towards politically-connected stocks. Political bias is detrimental to fund performance. State pension funds have longer holding durations of politically-connected local firms and display disposition behavior in these positions. Political bias is positively related to the percentage of politically-affiliated trustees on the board and Congressional connections. The more politically-affiliated trustees on the board, the more the fund shifts toward risky asset allocations. Overall, our results imply that political bias is likely costly to taxpayers and pension beneficiaries.