Not well. According to its latest Comprehensive Annual Financial Report, PERA has an unfunded liability of $25 billion, up from $15 billion last year, mostly because of a dismal rate of return in 2011, roughly 1.9%. Much of the criticism of public pensions has centered on their unrealistic expected rates of return, 8% in PERA’s case. This is certainly a cause of concern. While 8% is not unrealistic for equities historically, most people consider it to be wildly optimistic, certainly for the near future. And in any case, a constant rate of return doesn’t take into account the volatility of those returns.
But there’s a second rate, the discount rate, which PERA also has to estimate. It signifies something else altogether, and like the discount rate, PERA’s assumptions regarding the discount rate serve to make the fund look more solvent than it actually is.
What is a discount rate?
Another term for the discount rate is the “required rate of return,” not by the plan, but by the investors in the plan. In some sense, you can think of it as the Rate of Return in reverse.
The Rate of Return is used to estimate how much today’s investment will be worth tomorrow. PERA assumes an 8% rate of return, and for the moment, let’s humor them. This means that $1,000 today will be worth almost exactly $10,000 in 30 years.
The discount rate works in reverse. If I know that I’m going to need $10,000 in 30 years, then I can run that number in reverse, discounting by 8% each year, until I see that I need $1,000 in the bank today to be able to meet that obligation.
PERA, like most government pensions, uses the assumed Rate of Return as the Discount Rate. If you have $1,000 in the bank, after all, you have enough to cover a $10,000 obligation.
Because in this case, the discount rate is supposed to discount back obligations, not assets. It is suppose to represent the required Rate of Return of the investors, in this case, the pensioners. And since the pensioners’ assets (their PERA benefit) is the same as PERA’s obligations, PERA should use the Rate of Return that pensioners should expect on their investment.
What rate is that? Basic economics says that risk needs to match return. The market should price assets with the same risk at the same Rate of Return. Otherwise, for two assets with the same risk, an investor could sell the one at the lower rate of return, and buy at the higher rate, and not have any risk at all. Obviously that’s not sustainable.
So the trick is to find an investment with roughly the same risk as PERA, and use its return as PERA’s discount rate. PERA is a contractual obligation by the state, much like a long-term bond. It can probably change the terms of PERA more easily than it could default on a long-term bond, but again, let’s assume that these are pretty close to having the same level of contractual obligation, and therefore, from the investors’ point of view, the same risk.
This is what private pensions have to do. A corporate pension would use, as its discount rate, a mix of high-quality corporate debt, because that’s market-traded debt at the same level of obligation as its pension obligation. It’s only by the grace of the Government Accounting Standards Board (GASB), that PERA and other public pensions can get away with the higher discount rate.
Right now, according to MunicipalBonds.com, Colorado has long-term revenue bonds trading between 4,5% and 5%. Conveniently, if we use 4.75%, a $10,000 obligation translates to $2500 today.
So What Does This Mean?
Well, in our example, it shows how the level of fundedness is dependent on the choice of discount rate regardless of whether or not the 8% Rate of Return is realistic. If PERA has $1,000 in stocks, and chooses a discount rate of 8%, it looks as though it’s fully-funded. But if PERA is forced by accounting standards to choose the (more correct) discount rate of 4.75%, it’s underfunded by $1500, and is only 40% funded – even if we can realistically expect 8%.
That’s because the two rates really don’t have anything to do with each other. One is the rate of return PERA expects on its assets from its own investments. The other is the rate of return that pensioners expect on their investment. What PERA invests its money in is a policy decision. It may be good or bad policy, but pensioners expect to be paid, just the same as bondholders do, and that’s what determines the riskiness of the pension as an investment, not whether or not management puts it in gold bars or decides to go to Vegas and put it all on Red.
Ideally, PERA would match its return to its obligations. It would invest at something that also returned 4.75%, and have $2500 in the bank to be able to cover the $10,000 obligation, 30 years from now.
When it’s allowed to select a higher discount rate, though, it can get away with looking fully-funded with a much less money. Obviously, it has every incentive to do that. To do that, it has to seek investments with higher expected return. But in chasing higher returns, it’s also taking on additional risk.
Not only does the higher discount rate make PERA look more solvent than it is. It also encourages it to make riskier investments with its pensioner’s money.