Everybody Likes A Good Discount

So with all the discussion about PERA, one key aspect of pension accounting hasn’t yet been mentioned: the discount rate.  Now before you go all accounting-comatose on me, understand how important this is.  Because with all the talk of how underfunded PERA is, it’s actually even more underfunded than you think.

Basically, if you have an obligation to meet, the discount rate is the rate you use to see how much money you need to have now in order to meet that obligation.  So if you’re going to have to make good on a $100,000 obligation 10 years from now, and you use a 4.5% discount rate, you need to have about $65,000 now.  If you use an 8% discount rate, you only need about $46,000.

Of course, the discount rate isn’t arbitrary.  It represents a concept.  The discount rate is the required rate of return, the return that an investor in that project requires, given the level of risk that he’s taking on.

The problem here, and how this relates to PERA (and many, many other public pensions), is that PERA is using the wrong discount rate.  Instead of using the 4.5% discount rate, they’re using the 8% discount rate, which makes them look even less underfunded than they are.

Andrew Biggs at the American Enterprise Institute has done yeoman work on this subject, but here’s my stab at it.

PERA’s reasoning (and that of its apologists) goes like this: if I’m going to average 8% return on my investments, then I need to have a level of investment that, given an 8% return, gets me where I need to be.  So I should use an 8% discount rate to see how close I am to being funded.

But that’s not the definition of the discount rate.  The discount rate isn’t the expected return on my investments, it’s the required rate of return by my investors.  In this case, being an investor means being a PERA shareholder, someone who expects to receive those benefits down the line.  The level of obligation of those pensions is similar to that of long-term general obligation debt.  So the level of return that I should be willing to accept is comparable to that level of risk.  Right now, in Colorado, long-term general obligation debt is running about 4.5%.  As an investor in the pension fund, I should expect a 4.5% return, and PERA should use that as its discount rate.

Eight percent is the average rate of return of US stocks over the last 140 years. When a business is evaluating a project, it uses an 8% discount rate, because that’s the rate of return that investors in its stock expect.  If the project I’m evaluating will return 14%, that’s a good investment.  If it will only return 6%, probably not a good investment, since my investors won’t see the return they expect.

But when private pensions evaluate their level of fundedness, they use a basket of high-grade corporate debt.  Not because they invest their pension fund money in corporate bonds, but because the level of obligation is high, on a par with high-level investment grade corporate debt.  You can see statements to this effect in the financial statements of every company that has a private pension or other post-retirement plan.

And this makes sense from another point of view as well.  If I can use the higher discount rate merely because I’m investing in higher-yield instruments, I have every incentive to invest in the highest-risk investment-grade securities I can find.  Why stop at 8%?  I can, in effect, increase my level of fundedness by taking on additional risk, which from an economic point of view makes no sense at all. But as we’ve seen in the earlier post, additional risk carries, well, additional risk that you’re going to miss the expected returns, that you’ll find yourself out of money when it comes time to make a payment.

Public pensions aren’t required by law to do this.  They’re allowed to use the higher discount rate, and while I’ve seen a number of rationalizations for it, I have yet to see a very good reason.

Even if we do manage, through some combination of benefit cuts, transition to defined contribution, and higher contributions, to make up the difference as stated, we’re still going to find ourselves short if we don’t start using the right discount rate.

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