Commentary: A note on the discount rate

One of the most heated debates about the already white-hot issue of public pension plan accounting is exactly what discount rate to use in measuring assets and liabilities and, therefore, the amount of unfunded liability. Plausible arguments can be made for both approaches currently used.

Pension administrators argue forcefully that the most appropriate discount rate is the expected future return on assets. The methodology for calculating that rate — currently about 7.5% and declining slightly in many states — is prescribed by the Governmental Accounting Standards Board under a complicated and somewhat controversial formula. Backers of the expected future return on assets model contend that long-term (30-year) historical returns have been even higher (about 8.5%) and, furthermore, state plans can command state revenues if they get into trouble. It's worth noting the 10-year return as of June 30, 2018, for the three largest public plans (the California Public Employees' Retirement System, the California State Teachers' Retirement System and the New York State Common Retirement Fund) averaged only 5%, compared to the projected average of 7.5%.

By contrast, the approach recommended by most financial economists is use of a "risk-free" rate — a more conservative model since future asset returns are quite variable while pension liabilities are quite fixed. As Don Kohn, then vice chairman of the Federal Reserve Board, put it in 2008: "The only appropriate way to calculate the present value of a very low risk liability is to use a very low risk discount rate."

In current practice, the risk-free rate is generally a 10-year Treasury bond (about 1.6%). Corporate pension plans are required to use a discount rate equivalent to an AA-rated bond (about 2.6% currently). The Federal Reserve uses in its calculations a AAA bond rate. By employing a risk-free rate, it is argued, taxpayers will be protected against having to bail out bankrupt pension plans.

The difference between 7.5% and 2% is huge when it comes to pension calculations. Using expected future return on assets, the total liability of U.S. state pension plans is about $1.4 trillion (according to the Pew Charitable Trusts), while utilizing a risk-free rate of 2% yields a liability estimate of more than $4 trillion (according to the American Legislative Exchange Council as well Moody's Investors Service). Again, the average 10-year return as of June 30, 2018, for the country's three largest public plans was 5%.

Table 1 uses the two different discount rates to show both the pension debt (liabilities minus assets of the pension plan) and the funded ratio (assets as a percentage of the total obligations) of the five states with the frailest public pension systems in the country. It should be noted that even when the pension plan-friendly expected future return on assets is used, the unfunded liability of $1.4 trillion for all pension plans nationwide constitutes a major public policy concern.

The danger of clinging to the expected future return on assets is clear: higher expectations lead state pension fund executives to often "embrace overly aggressive investment strategies, exposing taxpayers to additional risk," the American Legislative Exchange Council pointed out in a recent report. Making matters worse is the fact these investment portfolios can easily become victims of economic downturns, like the Great Recession that began in 2008, cutting deeply into fund assets. On the other hand, opting for the lower, more conservative risk-free rate will dramatically increase annually required pension contribution for many states, pressuring already stretched budgets.

Which discount rate, then, is the better choice for state pension plans to adopt? The question must be resolved state-by-state since each approach carries its own insights and advantages. An optimal approach, therefore, might be to publicize both rates with clear, non-jargony explanations by the actuaries of the short- and long-term fiscal implications; explanations that are intelligible to even a knowledgeable layperson. This way, government decision-makers and their staffs can understand the risks and outcomes from each point of view and proceed to make well-informed decisions that are beneficial to their pension plans and participants, as well as to taxpayers.

Thomas J. Healey, is a partner at Healey Development LLC, Morristown, N.J. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.