On Sunday night’s Backbone Business<\/a>, we discussed the problems with (mostly) public pensions.\u00a0 PERA, Colorado’s Public Employee Retirement Administration, is not exempt from these issues.\u00a0<\/p>\n

The biggest issue with public pensions is that, for some reason, they’re allowed to game the number that describes how much money they need to have in hand in order to cover future expenses.<\/p>\n

We should always discount future cash flows according to the required rate of return of the project.\u00a0 In this case, the project, a government guarantee, should be discounted at the same rate as comparable government bonds.\u00a0 Corporate pensions, a company guarantee, discount at a rate equivalent to a basket of highly-rated corporate bonds, since that closely matches their obligation.<\/p>\n

The economic reason for this is that a lower interest rate is associated with lower risk.\u00a0 If you discount at a lower rate, it implies a higher level of safety, and therefore,\u00a0creates an\u00a0obligation to have more money on hand to cover those expenses.\u00a0 Since the level of risk associated with a state pension is the same as the level of risk associated with a government bond, they should be discounted at the same rate.\u00a0 Otherwise you have equivalent risks paying different returns which creates all sorts of arbitrage opportunities.<\/p>\n

The problem is that government pensions are allowed to discount at the expected rate of return of their investments, in effect presenting a risky investment as though it were a\u00a0sound one, and therefore underfunding the plan.<\/p>\n

Currently, PERA takes full advantage of this loophole, and discounts its obligations at 8%, the expected return on its investments.\u00a0 Needless to say, despite whatever reforms were passed in the last session,\u00a0it’s not enough, and the taxpayers are going to be left holding the bag.<\/p>\n

Eventually, we are going to have to transition to a defined contribution plan, and with the unfunded obligation growing rather than shrinking, the sooner we make that decision, the less painful it will be.
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