Retirement fund discount rate

This page summarizes the key points of contention around choosing a discount rate to figure the net present value of future retirement obligations.


17 Oct 2010.

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.


Clippings below covered through 6 Apr 2010.

Historical returns (17 Oct 2010)

  • UK pension funds, real returns: 2000-2009 1.1%; 1963-2009 4.2%.
  • US state pension funds, nominal returns. The National Association of State Retirement Administrators says, “since 1985, a period that has included three economic recessions and four years when median public pension fund investment returns were negative (including the 2008 decline), public pension funds have exceeded their assumed rates of investment return.” Unfortunately, data for only this one starting year is given, so it is hard to tell if this is really a meaningful result.

See also

Recent commentary

  • Pension funds: rate of return is not the main issue Historical returns have been larger than the assumed future rate of return. History is no guarantee of future results. In any case, even more important is that states (1) make their contributions, and (2) stop making even more unrealistic promises.
  • Another point of view on the pension obligation discount rate Fund managers often argue to use the expected return rate as the discount rate. Novy-Marx and Rauh point out that even if expected returns are indeed the mean of the distribution of outcomes, many quite likely outcomes may return far less than the mean. Since payouts are guaranteed, one should not take this chance.
  • Retirement savings, projected investment returns, and volatility Sales pitches for retirement savings plans often include dazzling projections of modest savings magically grown by 7-9% compound returns over decades. State pension plans likewise project optimistic views of their solvency by assuming 8% annual returns forever. A major problem with both views is volatility – if the market is down when the money is needed, one has a problem. For state pension plans, if one projects the value of current savings forward using the risk-free rate, the underfunding is $3 trillion rather than $1 trillion.
  • Low yields are a big problem for corporate pension plans Corporate pension plan underfunding is a chronic problem, but is showing a worse status than usual. The issue is partly investment losses in the last 3 years, and partly that low bond yields make the net present value of future obligations look worse. Companies will likely have to make higher contributions, which will hit income and dividends. If you buy stocks, check that the companies chosen do not have major problems in this area.

Clippings below were used in the construction of this page

Complaints about the discount rate are common -- a random example

21 Jun 2009.

“Optimistic sums risk BA landing in a pensions hole. Tony Jackson”

“British Airways' annual report. In the chairman's statement and chief executive's review, the pension scheme is nowhere mentioned …

Yet BA's gross pension assets, at pound(s)12.2bn, are larger than its operating assets of pound(s)10.5bn. And the company expects to pay pound(s)320m into the pension fund over the next year - rather more than last year's net operating cash flow of pound(s)133m. …

BA would doubtless argue that its stated pension deficit is relatively trivial, at a mere pound(s)600m. But that figure is an accounting fantasy. …

First, an asset must exist that will guarantee a future return equal to the discount rate.

Second, the money must be there to buy enough of that asset. If it is not - if the fund is in deficit - it makes no sense logically to apply the discount rate to all the liabilities. …

The discount rate is 7 per cent - the yield on AA corporate bonds, as international accounting rules allow. … AA bonds do not in fact return 7 per cent over a long period. That figure allows for default and other risks. If we want a reliable return, we must use the Treasury bond yield of 4 per cent. …

But the discount rate is the key. And the rate applied by BA to arrive at its mere pound(s)12.8bn of liabilities is - yes - 7 per cent.”

Public-sector pensions remain generous because taxpayers are in the dark

11 Jul 2009. Economist p15

“Dodging the bill”

“Perhaps the real reason why public-sector pension costs have not been tackled is that the full bill has never been revealed to taxpayers. Calculating the cost of a pension scheme depends on two key assumptions. The first is the potential longevity of the employees; the second is the discount rate applied to future benefits. The higher the discount rate, the smaller the liability appears to be. There is a lot of debate about the right discount rate to use, but the conservative approach is to take the cost of government borrowing. Use that rate, and the liability of American state and municipal pension schemes may be $3 trillion—three times the value of all the authorities’ existing debts. In Britain the liability adds up to 85% of GDP. ”

Actual pension fund rate of return (UK)

22 Feb 2010. International Financial Services London

“Pension Markets 2010”

“BNY Mellon estimated that the nominal rate of return of UK pension funds rose by 14.0% in 2009, implying a real increase of 14.8%, as retail prices fell by 0.7% on average during 2009 (Chart 9). The rate of return was lifted by the recovery in equity markets and also by the depreciation of sterling which increased the sterling value of returns from overseas investments. However, a total of four years of negative returns over the past decade mean that real returns have averaged only 1.1% a year between 2000 and 2009. Over the 46 years since 1963 UK pension funds have generated real returns averaging 4.2% a year.”

Pension funds: UK real rates of return		
% change each year			
	Average			Annual
	pension		Price	real
	fund		inflation	% change
	index		RPI	
1994	-3.0		2.4	-5.3
1995	19.6		3.5	15.6
1996	10.4		2.4	7.8
1997	16.8		3.1	13.3
1998	14.9	114.9	3.4	11.1
1999	20.4	120.4	1.5	18.6
2000	-2.7	97.3	3.0	-5.5
2001	-8.8	91.2	1.8	-10.4
2002	-13.9	86.1	1.7	-15.3
2003	17.0	117.0	2.9	13.7
2004	11.2	111.2	3.0	8.0
2005	20.1	120.1	2.8	16.8
2006	10.5	110.5	3.2	7.1
2007	7.0	107.0	4.3	2.6
2008	-10.3	89.7	4.1	-13.8
2009	14.0	114	-0.7	14.8

One approach based on historical returns

5 Mar 2010. FTUSA p2.

“California dreaming no more”

“California's mammoth public pension fund Calpers …

is already less sanguine than most, assuming 7.75 per cent compared with a median of 8 per cent nationally. …

A good proxy would be rates on investment-grade corporate debt. Using 6 per cent instead of a typical 8 per cent over 15 years boosts assumed future pay-outs by a third.

Then the returns. 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. Assuming 2.5 per cent inflation plus the real return since 1928, a nominal return of 7 per cent for a portfolio half in Treasuries and half in equities seems prudent. Yet no other state is so pessimistic.”

[Chart shows distribution of current discount rates:

7.25% 2 states
7.5%  7 states
7.75% 7 states
7.8%  1 state
8.0%  22 states
8.25% 6 states
8.5%  5 states


Actual historical US state pension fund returns

16 Mar 2010. National Association of State Retirement Administrators research report.

“NASRA Issue Brief: Public Pension Plan Investment Return Assumptions. by Keith Brainard, Research Director”

“The issue of the investment return assumption used by public pension plans has been the focus recently of increasing attention. This brief explains the role this assumption plays in pension finance, how it is developed, and compares this assumption with public funds’ actual experience.

Some members of the media, academics, and policymakers recently have questioned whether public pension fund investment return assumptions are unrealistically high. If this were true, it could encourage these funds to take too much risk in investing pension fund assets, or it could understate the cost of pension liabilities, reducing their current cost at the expense of future taxpayers. Alternatively, an investment return assumption that is set too low would result in overstating liabilities, which would overcharge current taxpayers. …

Although public pension funds, along with most other investors, have experienced sub‐par returns over the past decade, median public pension fund returns over longer periods exceed the assumed rates used by most plans. … For example, for the 25‐year period ended 12/31/09, the median investment return was 9.25 percent. …

Since 1982 (when the U.S. Census Bureau began reporting public pension fund revenue data), public pension funds have accrued an estimated $4.4 trillion in revenue, of which $2.64 trillion, or 60 percent, is estimated to have come from investment earnings. Employer (taxpayer) contributions account for $1.2 trillion, or 27 percent of the total and employee contributions total $578 billion, or 13 percent. …

Empirical results show that since 1985, a period that has included three economic recessions and four years when median public pension fund investment returns were negative (including the 2008 decline), public pension funds have exceeded their assumed rates of investment return. As the standard disclaimer says, past performance is not an indicator of future results. However, considering that public funds operate over very long timeframes, actuarial assumptions with a long‐term focus should also be established and evaluated on similar timeframes. Viewed in this context, compared to actual results, public pension plan investment return assumptions have proven to be conservative.”

[Emphasis added.]

Application of Rauh/Novy-Marx approach causes a stir

6 Apr 2010. NYTimes

“Analysis of California Pensions Finds Half-Trillion-Dollar Gap. By MARY WILLIAMS WALSH”

“An independent analysis of California’s three big pension funds has found a hidden shortfall of more than half a trillion dollars, several times the amount reported by the funds and more than six times the value of the state’s outstanding bonds. Justin Sullivan/Getty Images

The analysis was commissioned by Gov. Arnold Schwarzenegger, who has been pressing the State Legislature to focus on the rising cost of public pensions.

Graduate students at Stanford applied fair-value accounting principles to California’s pension funds, using a method recently devised by two economists working in Illinois, Joshua D. Rauh of Northwestern University and Robert Novy-Marx of the University of Chicago. …

The Stanford project focused on California’s big state-run employees’ pension fund, known as Calpers; a second large fund for teachers, known as Calstrs, and the University of California Retirement System. The three funds serve more than 2.6 million public employees and retirees.

Smaller public pension funds in California, run by cities and some counties, were not included in the analysis. …

After the researchers applied a risk-free rate of 4.14 percent, equivalent to the yield on a 10-year Treasury note, the present value of the promised benefits ballooned. The researchers came up with a $425 billion shortfall for the three funds.

As of July 1, 2008, the funds officially reported they were $55 billion short. They have not issued financial statements since then, but have said informally that they lost a total of $110 billion.

The researchers concluded that their estimate of the gap would also have grown by roughly $110 billion, to more than half a trillion, today. Their full report is expected to be released this week on the Stanford Institute for Economic Policy Research Web site.

Calpers challenged the research, saying it was “out of sync with governmental accounting rules and actuarial standards of practice.” ”