Another point of view on the pension obligation discount rate

31 Mar 2010 by Jim Fickett.

In an earlier post I argued that the expected rate of return was not the main issue for state pension funds. Here a substantial argument for using a more conservative rate is presented.

First a word on terminology. Most states use their expected rate of investment returns as a discount rate, meaning that they work backwards from future liabilities to present cash needs based on that rate.

In a paper published last fall, Robert Novy-Marx of the University of Chicago, and Joshua D. Rauh of Northwestern University, argue that the 8% discount rate used by many states is far too high. I attempt a concise summary of the main argument here, but please see the paper for all the details.

First, benefits already earned would be very hard to wiggle out of:

[among several possible accounting methods] the state could view its pension liability as though all of its workers were going to quit work today, wait until the retirement age, and collect their promised benefits.

This method is called the Accumulated Benefit Obligation (ABO) measure. …

Consider payments that the states have promised employees for years of work already done—that is, the payments that give rise to the basic Accumulated Benefit Obligation liability. From the state’s point of view, these cash flows are extremely likely to be incurred. First, state constitutions in many cases provide explicit guarantees that public pension liabilities will be met in full (Brown and Wilcox, 2009). Second, state employees are a powerful constituency, making it hard to imagine that their already-promised benefits would be impaired. Third, the federal government might well bail out any state that threatened not to pay already- promised pensions to state workers. In practice, Accumulated Benefit Obligation pension liabilities are probably the most senior of all unsecured state debt.

In contrast, consider future benefit accruals. Given the difficulties of state pension funds described throughout this article, state workers would be unwise to assume that all future retirement benefits will accumulate according to the existing formulas. After all, states can change the benefit formula for future accruals. From the state’s point of view, these pension obligations that have yet to arise can be trimmed.

Second, it is not sufficient to look at the expected rate of return, which is an average of different possible outcomes. Instead, if one's future obligations are essentially certain (as just argued for the already-earned benefits), then one's investment returns must also be essentially certain.

a highly risky asset allocation strategy might allow pension assets to reach [the needed funding goal] on average, even though the pension funds might be underfunded 99 percent of the time and massively overfunded 1 percent of the time. …

As of September 30, 2008, state pension funds were invested approximately 53 percent in public equity, 8 percent in private equity, 7 percent in real estate equity, and the remaining 32 percent in fixed income securities, according to Pensions and Investments magazine. …

What does the distribution of future outcomes look like if states continue with current investment policies? …

As shown in Table 3, the median 15-year outcome under current investment strategies is a shortfall of $2.8 trillion. The 25th percentile outcome is a shortfall of $3.4 trillion, the 10th percentile is a shortfall of $3.8 trillion, and the 5th percentile is a shortfall of $4.0 trillion. There is a less than a 5 percent chance that the current pattern of pension fund investments will meet the needs of retirees in 15 years. Under current state accounting rules, this distribution is deemed to be underfunded by only $1 trillion.

Finally, they show that if one uses the return on Treasury bonds (by way of one example of a fairly safe investment), instead of the 8% in common use now, the underfunding is closer to $3 trillion than the $1 trillion commonly reported.

This is a sobering argument.

In my opinion, the first priority of the states should be to make more realistic promises. Every day that state workers continue to earn unrealistic benefits increases budget difficulties and acrimonious disputes in the future. The second priority should be to make at least the currently required contributions to retirement funds; if these required contributions are too low, it only makes the argument stronger. Novy-Marx and Rauh do make a strong case that the action in third place, to use a more conservative discount rate, should also be a high priority.

Investors need to stay tuned to progress in all three areas.