Tag Archives: Discount factor

Bankrupt US Public Sector Pension Schemes

In a Hoover Institution Essay, Joshua Rauh describes the extent to which US states and communities under fund public sector pensions.

Even under states’ own disclosures and optimistic assumptions about future investment returns, assets in the pension systems will be insufficient to pay for the pensions of current public employees and retirees. Taxpayer resources will eventually have to make up the difference.

Despite the implementation of new Governmental Accounting Standards Board (GASB) guidelines, most public pension systems across the United States still calculate both their pension costs and liabilities under the assumption that their contributed assets will achieve returns of 7.5–8 percent per year.

But new GASB disclosures allow Rauh to estimate the size of the funding gap. He finds

unfunded accumulated benefits of $3.412 trillion under Treasury yield discounting. These are the unfunded debts that would be owed even if all plans froze their benefits at today’s promised levels.

Discounting Pension Liabilities

In a recent NBER working paper (“Discounting Pension Liabilities: Funding Versus Value”), Jeffrey Brown and George Pennacchi discuss the appropriate choice of discount factor to discount pension liabilities. They conclude that it depends.

… if the objective is to measure pension under- or over- funding, a default-free discount rate should always be used, even if the liabilities are themselves not default-free. If, instead, the objective is to determine the market value of pension benefits, then it is appropriate that discount rates incorporate default risk.

… the use of a default-free discount rate is informative to participants who want to know how much money the plan would need to be assured that the plan will be able to pay promised benefits. This would also be a relevant measure if the plan wished to offload its liabilities to an insurance company that intends to make good on the future benefit payments.

… there are also cases for which the market value of the liability is important. Current or potential plan participants might want to know the market value of pension liabilities (rather than the promised value) when they are making decisions about the value of pension benefits…

… the market value of the liability can have odd properties as a system of funding measurement: specifically, the size of the total (funded plus unfunded) liability can vary with the degree of funding, and that funding levels asymptotically approach 100 percent as assets approach zero.

Brown and George Pennacchi also discuss how the appropriate discount rate may be measured and how cost-of-living adjustments may be accounted for.