Valuing Pension Funds
October 20, 2015
Depending on whom you ask, the 50 states have accumulated pension debt of anywhere between $500 billion and $5 trillion. To put it mildly, that is a massive range of opinion about the level of unfunded state pension liability.
The principal cause of this variation between estimates is the discount rate being used in the forecast of pension finances. The discount rate is a critical factor for determining how much gets saved today to pay pensions in the future. The higher the discount rate employed, the lower will be the net present value of anticipated pension benefits, which are also known as accrued pension liabilities. The lower the present value of the accrued pension liabilities (i.e. the value of all future pension benefits measured in today's dollars), the less the government and employees will need to pay into pension coffers today to cover those promised benefits when they come due.
The status quo approach to selecting discount rates for state and local governments is completely backward. Using the expected rate of return on assets to discount liabilities considers the risk of assets instead of the risk of liabilities. Public officials should instead adjust their discount rates to reflect the time value of money to their employees and the risks of the streams of cash payments to retirees.
Public officials should look carefully at their discount rate policies, and adopt the best practice that is politically and fiscally possible. Ultimately, the main objective should be for pension plans to shift toward having discount rates reflect the risks of liabilities -- not the potential performance of assets. This is one of the most critical remedies to protect the future of public sector pension plan solvency.
Source: Anthony Randazzo et al., "Best Practices for Setting Public Sector Pension Fund Discount Rates," Reason Foundation, September 24, 2015.
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