Download Estimating future costs at public pension plans: Setting the discount

Estimating future costs at public pension plans:
Setting the discount rate
concluded that public pension plans follow a
“deeply flawed” funding approach. According
to this report, “Strengthening the Security of
Public Sector Defined Benefit Plans,” the problem stems in substantial part from mismeasurement of the costs of pension funding by the
pension plans themselves. The “proper way to
value future cash flows such as pension benefit
payments is with discount rates that reflect the
risk of the payments. This is separate from the
question of the rate pension funds will earn on
their investments.” Although the Rockefeller
Institute is careful to state that a risk-free bond
rate should not be used as a funding requirement, the bond rate should nevertheless be
used to disclose the “full cost” of pension benefits.
By Peter Mixon
April 29, 2015
For decades, public pension plans in this country
have estimated future benefit liabilities using a
discount rate that is based on estimated future investment returns of fund assets. This approach,
an “assumed rate of return” method, has come
under mounting criticism by financial economists
and public policy groups. Using work developed
by these economists, many argue that a rate based
on investment return assumptions vastly understates pension liabilities. In their view, the rate
should be based on low risk, or even risk-free,
bond rates. Today, these bond rates are substantially lower than the assumed rates of return used
by most public pension plans.
Last fall, the Government Accountability Office stepped into the fray and issued its own report summarizing expert views. Its conclusion is
that opinions are deeply divided between the
“assumed-return approach” and the “bond
based approach.” Noting that the different approaches can, and typically do, produce vastly
different estimates of liabilities, the GAO nevertheless made no recommendations.
These disparate views can be disconcerting,
at best, for public pension plan trustees.
Looking more closely at the views of financial economists, it becomes clear that using an estimated rate of return to discount future pension
liabilities is not misleading. This discount rate actually reflects the costs of funding pension benefits far better than using a risk-free or low-risk
bond rate of return. If appropriately set, the former will reflect an estimate that is much closer to
The result? A huge disparity in the estimated
liabilities of public plans. In one analysis, two financial economists, Robert Novy-Marx and
Joshua Rauh, argue in “The Liabilities and Risks
of State-Sponsored Pension Plans” that the collective liabilities of public plans in this country using
a risk-free bond rate are approximately $5.17 trillion. In contrast, the authors state, the aggregate
liabilities estimated by public plans using assumed rates of return is $2.87 trillion — more than
$2 trillion less than the “true” liabilities. The conclusion of many political and economic commentators is that public pensions and their public
employer plan sponsors are facing a “tsunami” of
unrecognized debt that will eventually swamp
state and local governments.
The Rockefeller Institute of Government
recently adopted this view in a new report and
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As the Rockefeller Institute explains: “Pension liabilities … must be estimated based on
the benefits expected to be paid — i.e., future
cash flows. Financial economists and analysts
ordinarily value future cash flows using a discount rate that reflects the riskiness of the payments. … This is a tenet of modern finance.
Amounts that are extremely likely to be paid
will have lower risk, and therefore a lower discount rate, than amounts that are less likely to
be paid.”
the actual cost of pension benefits and therefore
the liabilities of the system. In contrast, discounting these liabilities using a hypothetical bond rate
reflects an estimate of the future value of these
benefits to plan members. The latter valuation is
important: Employers and taxpayers should
know the value of pension benefits received by
public employees. But estimating this benefit
amount does not reflect the actual costs of funding public pensions.
Defined benefit plans are designed to be
pre-funded. Contributions are held in trust, and
invested, in the present to pay for future benefits.
This pre-funding of future liabilities is almost
unique in public finance. Most liabilities of state
and local governments are funded on a “pay as
you go” basis. The costs of policing the streets,
teaching students and administering the courts,
other than associated pension costs, are paid by
tax revenues at the time they are incurred. Public
works projects are often funded through the issuance of municipal bonds. Thus, these costs (including the interest costs of borrowing money)
are funded on a dollar-for-dollar basis: Every dollar spent is a tax dollar collected.
Because public pension plan payments
have very little risk of not being paid, under
“tenets of modern finance” a risk-free bond rate
should be used to discount public pension liabilities — in other words, a bond rate that reflects little or no risk to the buyer, the
Rockefeller Institute report concludes.
But estimating the present value of a future
stream of cash flows is not the same as estimating the future costs of paying for them. This distinction is illustrated by an example used in the
Rockefeller Institute report. “If the government
has a firm commitment to pay you $1,000 in fifteen years, you will use a lower discount rate to
determine the value of the promise today than if
your shiftless brother-in-law promises to pay
you the same amount.” Of course this is true, if
the discount rate is used to value the benefit to
the recipient. On the other hand, this calculation will not, at least not necessarily, reflect the
cost, in today's dollars, of paying out $1,000 in 15
years. The cost to the obligor, either the government or the brother-in-law in the example, will
depend upon how much is earned on the $1,000
over the course of 15 years. If the brother or the
government earns only a risk-free rate of return,
then the present value should be calculated using a corresponding bond rate. If the government earns a higher rate of return, then a
corresponding higher discount rate will be
used. In either case, the rate of investment return is the appropriate discount rate.
The premise of the Rockefeller report is
that the promise to make future payments of
benefits is the same as the promise to pay a note
or a bond. In other words, the price at which the
pension liabilities would trade in the open market if they were packaged as bond or a note. But
In contrast, the costs of pension benefits are
not solely funded by tax revenue. Tax dollars in
the form of employer contributions may be invested, and earn returns, to help pay for these
benefits. On average, well over 70% of the total
costs of pension benefits are paid by investment
earnings.
Nearly all public plans invest their assets in a
diversified portfolio. This asset mix typically includes stocks, corporate bonds, real assets and
private equity funds. It is beyond dispute that the
returns actually generated by these investments
will actually fund future benefit payments, or liabilities, of the plan. Thus, the estimated future cost
of these liabilities should be discounted using an
estimated rate of actual returns.
Financial economists such as Messrs.
Novy-Marx and Rauh argue that using an assumed investment rate of return is inappropriate
because it does not reflect the risk or, more accurately, the lack of risk that plan participants will
not receive the stream of promised benefit payments.
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estimated liabilities of a pension plan are nei- mon stocks) will yield higher levels of returns.
They also agree that higher-risk portfolios generther bank loans nor are they bonds.
Unlike banks, plan members do not lend ally have greater volatility in returns. For many
money to their pension plan (or employer) at an plans, higher volatilities might threaten the
agreed-upon interest rate. This interest rate is es- long-term soundness and health of the plan. Disentially the product of two factors: 1) the costs of versification of assets can mitigate some volatility
capital to the lender bank and 2) the profit the risk but trustees should also evaluate the compobank expects to earn on the loan. Public pension sition of the current investment portfolio, the curplan members are not in the money-lending busi- rent funded status, and key plan and sponsor
ness and certainly do not earn a profit on their un- characteristics. These characteristics should include:
paid benefits.
Similarly, the financial marketplace does not
price these future cash flows because they are
non-transferrable. Unlike bonds or commercial
notes, unpaid pension obligations cannot be
bought or sold in the market. Because the sponsors of governmental pension plans — the employers — are clearly “going concerns,”
liquidation and transfer of their liabilities is not realistically feasible. Instead, estimated pension liabilities are just that — estimates of future
obligations that are primarily funded through investment returns.
Finally, using a discount rate that is based on
the credit-worthiness of the pension system (or
the plan sponsor) creates an anomalous result:
Plans that are poorly funded will record lower liabilities than those that are well-funded. Because
the risk of not receiving future benefit payments is
higher with underfunded plans, a “bond rate”
will also be higher. A higher discount rate results
in lower estimates of future liabilities and, if the
rate is used to calculate contributions, lower levels
of contributions. The result: Poorly funded systems will report lower liabilities and will receive
smaller contributions than well-funded plans.
Estimating an investment rate of return for
plan assets is not an invitation to act imprudently.
Unreasonably high discount rates can artificially
depress expected costs and contribute to plan
underfunding. The rate should be set using a diligent and thorough evaluation of the amount of investment risk the plan can prudently assume and
reasonable estimates of future investment performance.
Investment experts generally agree that over
the long term higher-risk investments (like com-
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Plan size. A large plan, especially one with
larger unfunded liabilities, with a relatively
small plan sponsor (in terms of tax revenues)
might have great difficulty handling large investment losses in any particular year.
l
Plan maturity. An older plan with fewer new
members will have greater liquidity needs
than a younger plan. Investment losses in
any one year will therefore have a greater
negative impact on the funding of future liabilities.
l
Plan sponsor strength. A sponsor with strong
revenues is better positioned to handle investment risks than a poorly funded one.
l
Correlative risks. A financial market downturn might decrease both asset values of the
plan and the financial health of the plan
sponsor. Plans might thus raise contribution
rates at a time when plan sponsors can least
afford increases.
Each of these factors may be evaluated using
stochastic and stress-testing models. Identifying
these risks, designing an asset allocation that
meets them and then setting a realistic expected
rate of return will do more to meet the plan's obligations than using a hypothetical discount rate
based on the value of benefits to plan members.
Peter Mixon is the former general counsel of the California Public Employees' Retirement System and is
currently a partner at K&L Gates LLP. The views expressed in this article are his own and do not reflect
those of his current or former employer.
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