Discount That Optimism

On Sunday night’s Backbone Business, we discussed the problems with (mostly) public pensions.  PERA, Colorado’s Public Employee Retirement Administration, is not exempt from these issues. 

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.

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

The economic reason for this is that a lower interest rate is associated with lower risk.  If you discount at a lower rate, it implies a higher level of safety, and therefore, creates an obligation to have more money on hand to cover those expenses.  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.  Otherwise you have equivalent risks paying different returns which creates all sorts of arbitrage opportunities.

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 sound one, and therefore underfunding the plan.

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

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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