18 Oct 2010 by Jim Fickett.
Most pension plans are probably too optimistic about investment returns, when measuring whether current savings are adequate to meet future obligations. The two most important consequences of such optimistic assumptions are that (1) planners are leaving no margin of safety, leading to a risk that bad years in volatile investments could leave funds at least temporarily insolvent, and (2) if returns fail to live up to expectations, future taxpayers (for public funds) or shareholders (for corporate funds) could have to make up for a lack of previous saving.
The discount rate of a retirement plan is the rate of return on investments that is assumed, when measuring whether current savings are adequate to meet future obligations. Discount rates are highly controversial, and there are good reasons to think they are often set too high.
Few taxpayers or shareholders think carefully about discount rates, but they make a major difference. For example, a $1000 obligation due in 30 years requires setting aside $309 now with a 4% discount rate, but only $99 now with an 8% discount rate.
Naturally, politicians (for public plans) and CEOs (for corporate plans) tend to gravitate towards high discount rates, as it frees money for other purposes today. If actual returns fail to live up to expectations, however, the plan may have to make up the lack by placing excessive burdens on future payers, or may even become insolvent. Further, plan administrators may be tempted to take excessive risks to meet high expected returns.
Corporate plans often use the AA corporate bond rate as their discount rate, in keeping with international accounting standards. But the AA bond rate is higher than the risk-free rate for a reason – to account for the risk of default. So many argue that the risk-free (say, Treasury) rate should be used instead.
State pension plans (and many other public plans) use discount rates that cluster around 8%. Plan administrators argue that this is not far from historic average returns. There are two arguments that, even so, such a rate is too high.
The simple argument is that history may not repeat; the Financial Times comments, on California's largest plan, “Calpers actually has earned its target rate in the past 20 years, but this was a decent period for equities and a great one for bonds.” The more complex but also more telling argument is about volatility. Higher returns tend to be associated with higher volatility. Even if average returns come out on target, volatility may mean a high probability that in some years the plan will be seriously underfunded. Funds do not provide any risk analysis of temporary insolvency due to volatility. The conservative course would be to use low risk investments and a corresponding lower discount rate.
There is a new Reference page with source material on this topic, Retirement fund discount rate.