Pension Reform

Discount Rates and the Fair-Market Valuation Pension Critique

At its core, the debate over how to properly fund public pension plans starts with how to accurately value liabilities so that governments can meet their obligations in the future. SBS recently released a report criticizing the Governmental Accountability Standards Board’s upcoming changes to public pension financial reporting guidelines. It mentioned in passing the fact that GASB guidelines remains horribly off the mark in continuing, at all, to encourage plans to discount their liabilities according to the expected investment return on assets.

Andrew Biggs and Kent Smetters with the American Enterprise Institute released a paper explaining in far greater detail the greatest challenge to GASB’s interpretation of pension funding: the fair-market valuation critique.

As both its supporters and detractors commonly characterize it, this critique calls for plans to discount their liabilities at a rate lower than the 8 percent average that many currently use. That is, when plans undergo the process of calculating the present value of projected future liabilities by subtracting interest each year, 8 percent is the wrong rate to use. Assumptions this high, the thinking goes, carry the risk of not being met leading to underfunded retirement promises.

While this explanation in a way captures the outcome of the argument, it falls short in expressing the actual reasoning. Biggs and Smetters offer two important misconceptions of the fair-value critique:

For instance, many believe that when economists argue that public pensions should not discount their liabilities at the 8 percent interest rate that pensions assume for their investments, they are claiming that actual investment returns will be lower than 8 percent. Similarly, some believe that because economists advocate using lower discount rates to value pension liabilities, they are arguing that public pensions should hold only low-risk investments in their portfolios. Neither belief is correct.

The aspect of the fair-market critique calling for plans to use lower discount rates has little to do with expected returns on assets. Instead, it calls for plans to discount liabilities based on the risk carried by the liabilities themselves. Whatever happens to the plan’s assets will have no direct impact on the liabilities. If assets experience massive gains or losses, the amount of money owed to retirees remains unchanged.

Further, public pension benefits are highly protected by law. Once vested, it becomes extremely difficult legally to modify, let alone deny, benefits to a retiree. The risk that they will not be paid is extremely low, so they should be discounted accordingly.

Thus, the fair-value critique calls for discounting liabilities at a risk-free, or nearly risk-free rate, because of the characteristics of public pension liabilities themselves. Getting an accurate grasp of liabilities in this manner is a necessary first step for fully funding any pension plans benefits.

In Depth: Pension Reform

Modern, 401(k)-style plans are now commonplace in the private sector. For state workers, however, traditional pensions are still the norm. As former Utah State Senator Dan Liljenquist wrote in Keeping the Promise: State Solutions for Government Pension Reform, this is not a partisan issue, but a math problem. State Budget…

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