Pension Reform

What’s in a Discount Rate?

Readers of Unaccountable and Unaffordable may have noticed that the measurement of unfunded liabilities differs from the liabilities listed in state annual comprehensive financial reports (ACFRS) and state actuarial documents.  That is not a mistake. The liabilities ALEC shows are the result of challenging the status quo accounting assumptions that are put into state financial documents. 

In each edition of Unaccountable and Unaffordable, the authors use the ALEC risk-free discount rate instead of the discount rates provided by state pension plans. We do this for two reasons: to show a liability measurement that reflects the fact that the state cannot back out of pension promises and to create a common scale to compare pension liabilities across the country.

Under old government accounting guidelines, pension plans were allowed to use a discount rate based on the assumed rate of return on pension assets, so it’s understandable that the two get conflated.  Under current government accounting guidelines, plans are advised to value the funded portion of pension liabilities with a higher-risk discount rate and value the unfunded portion of liabilities based on the low-risk return on tax-exempt municipal bonds.

As discussed in the report, the discount rate is often conflated with the investment rate of return, but the two are different. Discount rates are used to measure the level of risk for pension liabilities and help determine the present value of the amount of pension benefits owed to retirees in the future.  The investment rate of return, on the other hand, shows the level of risk in a pension plan’s assets. 

The levels of risk differ for plan assets and plan liabilities. The difference in risk stems from changes in pension plan investments. In the 1940s, public pension plans almost exclusively invested in municipal bonds. Over time, pension plans also invested in U.S. Treasury notes, corporate bonds and by 1983, most public pension assets were invested in corporate stocks. As the yields on municipal bonds and treasury notes steadily declined, pension plan managers began to chase returns in stocks and other riskier assets. 

Meanwhile, as the level of risk increased in pension assets, the level of risk did not change for pension liabilities. As discussed in Unaccountable and Unaffordable, states protect pension promises through various judicial, statutory and constitutional protections. With these protections, states cannot back out of pension promises. It is the opinion of many economists, the authors of Unaccountable and Unaffordable included, that the discount rate used to measure pension liabilities reflect the strength of these promises using a risk-free discount rate based on the yield curves of U.S. Treasury Bonds.

The ALEC risk-free discount rate relies on the average of the yield curve of the 10-year and 20-year U.S. Treasury Bond yields. While it varies year to year, the risk-free discount rate in the sixth edition of Unaccountable and Unaffordable is 1.13%. The authors also use a 4.5% discount rate to control for changes in the risk-free discount rate year from year.

Source: Ohio Public Employees’ Retirement System; authors’ calculations

 

 

 

Shown in the chart, the Ohio Public Employees’ traditional defined benefit plan (one of six public plans from Ohio observed in Unaccountable and Unaffordable) uses an assume discount rate of 7.2% which calculates about $19.56 billion in unfunded liabilities. If the discount rate is lowered to the ALEC fixed rate of 4.5%, unfunded liabilities total $71.46 billion and if it is lowered to the risk-free rate of 1.13% unfunded liabilities total over $175 billion. When a tenth of a percentage point difference means a difference of hundreds of millions of dollars in pension liabilities, the OPERS discount rate is 6.07 percentage points higher than the ALEC risk-free rate.

All public pension funds, including the funds in Ohio, should adopt a risk-free discount rate like the one used in Unaccountable and Unaffordable. Doing so will help provide an accurate picture of how much those guaranteed pension promises truly cost.


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…

+ Pension Reform In Depth