An Important Pension Lesson: Why You Shouldn’t Use ‘Discount Rate’ and ‘Investment Rate’ Interchangeably

Much is written about the shortfalls in state and local pension systems—in many states the unfunded liabilities are very significant—and if computed properly they would be even larger. For this discussion, I want to focus on two terms crucial during pension discussions: discount rate and investment rate.

Perhaps more than any other decision the rate used for these two items has a significant impact on determining the amount of money that should be appropriated each year to fund properly pension commitments.

Many people use the two terms interchangeably—and use the same rate for both decisions. But, in fact they are not the same. When used properly the investment rate—better referred to as assumed investment rate of return—refers to the assumption used to project current and future investment income. For example, a state pension fund may assume that its portfolio of investments will earn 7.5 percent. The discount rate refers to the rate used to estimate today’s value of future pension liabilities.

A critical job of the actuary is to project the liability of the pensions system. This requires projecting benefits paid in the future and “discounting” those projected benefits to the present —and using a proper discount rate is critical.

The Problem in Using Rate of Return as the Discount Rate

Using the assumed rate of return for the discount rate—as many pension systems do—is  is a deeply flawed approach and contrasts significantly with finance theory in that a proper discount rate should reflect the riskiness of the liability and not the riskiness of the assets. (It also contrasts significantly with how private firms and other countries value pensions.) Specifically, because pensions are generally protected by law and are likely to be paid even if poorly funded, this means the discount rate should reflect bond-market rates for low-risk assets, such as Treasury bills. Ordinarily these rates will be far lower than the assumed investment return on a portfolio that includes stocks and bonds, because the latter rate assumes the portfolio will earn more, but at some risk.

Why would a higher discount rate be used for projecting liabilities? According to a report issued by the State Budget Crisis Task Force in 2012, a higher than appropriate n inflated discount rate has at least three impacts: (1) it creates pressure to invest in riskier assets; (2) pension plans appear healthier thus potentially creating incentives to reduce contributions or enhance benefits; and (3) it keeps employer contributions, and therefor appropriations, artificially low.

Using a lower discount rate properly reflects the liabilities of the pension system. There is no consensus among finance experts as to what specific discount rate reflects the riskiness of pension liabilities, but also no disagreement that reflecting pension riskiness using the lower rate is the correct approach.

GASB Guidance

No federal agency or board issues rules for how state and local governments must fund their systems. However, the Government Accounting Standards Board (GASB) issued accounting and actuarial guidance effective fiscal year 2015 that, as a general rule, requires that an assumed investment rate of return (7.5% as an example) can be used for calculating liabilities. 

However, there is a major exception for plans that are projected to run out of money. Such plans must use a blended rate that reflects an averaging of  (a) the assumed rate of return and (b) a municipal bond rate for a 20 year tax-exempt bond with  a rating of AA/A or higher (perhaps 3.5% today). The averaging calculation reflects when the plan is projected to run out of money (the further in the future, the more the averaging reflects the assumed return and the less it reflects the municipal bond rate.)

Impact of GASB Guidance

Clear? I doubt it. Could anything be more confusing?  Instead all state and local governments should be required to use a more risk-free discount rate to determine liabilities—a logical conclusion, but not the rule. Rather we have a mixture of “rules” with the lower blended rate required only for those states that have the worste funded pension systems. The impact: estimated liabilities for poorly funded plans have increased, while estimated liabilities for some “more stable” pension plans have not —or only partially.

A result is that reports issued by most organizations reporting on pensions, use these different criteria when comparing the level of unfunded liabilities—in effect, comparing apples and oranges. Granted under any criteria the states with poorly-funded pension systems, such as those in Illinois, Kentucky, Connecticut and New Jersey, will still be at the bottom of the list but how far they really are compared to those in the other states cannot be readily determined.

Moody’s Investor Service  which keeps close tabs on pension data todoes prepare reports using a consistent and more proper discount rate to insure comparability among states—the correct way to report. This ‘adjusted’ data developed by Moody’s indicates the real total unfunded liability for all states is $3.9 trillion rather than the reported $1.6 trillion that is typically come up with —when using more favorable discount rates.

GASB should issue new guidance that requires a risk low discount rate for all. (See below for further discussion.)

Observations and Recommendations

A report entitled, Strengthening the Security of Public Sector Defined Benefit Plans, prepared by the Nelson Rockefeller Institute of Government at the State University of New York, reinforces these observations and draws several important conclusions: 

• Pension liabilities are universally underestimated by discounting with an assumed investment return rather than a discount rate reflecting risk of benefit payments.
• Pension accounting and funding standards and practices encourage investing in risky assets to reach projected yields.
• Workers, retirees and taxpayers ultimately bear the risk.
• The risks are poorly disclosed and understood.
• Governments are not sufficiently disciplined to make adequate contributions –and consequently push significant costs onto future generations.

Based on these observations, the report suggests the following:

• Pension funds of all state and local government should value liabilities and expenses with a low risk rate—not the assumed investment rate.
• Pension funds must disclose more fully the consequences of investment risk.
• There needs to be an external downward pressure on investment risk.
• Governments must keep their end of the bargain and make realistic actuarially determined contributions.

Many state and local governments continue to make promises that cannot be kept and face increasing pension payments that are consuming more and more of annual budgets—thus either “crowding out” critical program needs or requiring tax increases. This problem is further exacerbated by state and local government pension funds using assumed rates of return for the investments which are too aggressive and by using discount rates for liability calculations that are significantly overstated. Unfortunately because of these poor policy choices many governments might very well need to re-think the size and scope of their pension systems and make significant changes.