Once purely the province of actuaries, pension-liability discount rates, oddly, have become a political issue in the United States.
The charge has been led in recent months by academics who say that state and local public pension plans are misleading taxpayers by understating their liabilities by billions of dollars.
How so? Pension plans must estimate the current value of the stream of payments they will be making for the next several decades to their members. As in any calculation of this sort, these future payments need to be discounted to present-day dollars using some sort of interest rate.
While corporate pension plans use an interest rate pegged to high-grade bonds -- typically in the 5 per cent to 6 per cent range, public pensions use their assumed investment return as a discount rate. And most public plans have stuck to assumed annual investment returns of 7.5 per cent to 8 per cent or more, even after a volatile decade that has seen little long-run gain in equities.
So? Well, the higher the interest rate used to discount future payments, the smaller the number today. Associate Professor Joshua Rauh of the Kellogg School of Management at Northwestern University told Congress in February that while public pensions estimate their cumulative deficits at $1.3-trillion (U.S.), he and a colleague have instead estimated the shortfall to be more than $3-trillion, using U.S. Treasury bill rates.
Conservative politicians, eager to scale back public employee compensation in the name of taxpayer defence, have embraced these studies: The U.S. House of Representatives has a bill before it that would require state and local governments to use the rates from Treasuries to discount pension liabilities; any who refuse would lose the ability to issue tax-exempt debt.
Into the fray last week stepped Monique Morrissey of the left-leaning Economic Policy Institute. In a research paper, Ms. Morrissey said one of the chief arguments for using the Treasury rates for discounting -- that pension liabilities are essentially fixed and "riskless" -- isn't entirely true, as some governments have begun trimming benefits in response to their shortfalls.
And, she says, "Since pension contributions are adjusted periodically based on realized returns, and since outlays are a small fraction of pension fund reserves, it is reasonable for funds to invest in moderately risky portfolios even if liabilities are 'riskless.'"
While many question whether an assumed 8 per cent rate of return is appropriate, Ms. Morrissey notes that "pension fund critics generally avoid discussing actual investment strategies and expected rates of return, presumably to avoid tripping over their bullish expectations about stocks in other contexts." One public-pension critic expressed no doubts about the long-term benefits of stock investing when he was advocating the privatization of Social Security, she said.
Ultimately, it's unfair to taxpayers, as well as the benefit recipients, to overstate liabilities by discounting them with a rate lower than what the pensions expect to earn. "Simply discounting with a risk-free rate does not actually safeguard returns or encourage prudent investment practices, it just makes all pension funds appear underfunded."
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