Alica H. Munnell of the Brookings Institute came out with a book this month (State and Local Pensions: What Now?) that promises to be a useful overview of the crisis. I ordered the book and expect a great read but one thing bothered me from the free chapter online: that riskless rate argument.
I get that liabilities in most public plans need to be valued using real-world earnings assumptions but that’s because of what these severely underfunded plans are likely to earn and not because …
economists argue that because pension benefits are guaranteed under most state laws, the appropriate discount factor is a riskless rate.
This is a book that starts off chronicling the pension defaults in Prichard, Al and Central Fall, RI and then notes the elimination of cost-of-living-adjustments in many states (most recently New Jersey). What happened to the guarantees there?
Of course liabilities of most public pensions systems should be valued at lower interest rates than are being used now but the reason, as I went into previously, is that a plan like New Jersey’s, which is about 30% funded, will only get earnings on 30% of the assets that should be there. When setting interest assumption it needs to be decided what the trust can reasonably be expected to earn on the money it has to work with (taking into account the need for liquidity) and then that rate should be multiplied by the funded ratio – .3 in New Jersey’s case. So if you expect to earn 8% on assets then 2.4% is what should be used to value the liabilities. Using an 8% rate effectively requires that 30%-funded plan to make 26.7% to keep up.
The riskless rate concept, as popularized by Professor Joshua Rauh, is both confusing and wrong. Public pensions will continue to default and promises will continue to be broken. Face up to that or risk the consequences.