The Riskless Rate Conundrum

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.

20 responses to this post.

  1. Posted by Tough Love on September 25, 2012 at 11:50 pm

    John, I too have struggled with the risk-free rate concept (for discounting) being consistent with the “guaranteed-benefit” argument … but at the same time, far from the likely outcome (especially over the long term).

    I like your approach, and its result is not much different than one of the options considered by the NEW GASB rules (where upon the unfunded portion of Plan liabilities are discounted at the risk free rate).

    Personally, I like the idea of simply presenting the results under multiple scenarios say 2%, 4%, 6%, and 8%, because regardless of which side of the argument you stand, they are STILL just estimates.


    • The problem with the risk-free rate argument is when assets do actually make 8% (albeit through the fog of alternative investments) and Rauh and others have to defend why using 8% is bad.

      Granted it’s a bit of a thought puzzle that you really need an understanding of commutation functions to fully grasp but if you’re going to argue for valuing liabilities correctly, this makes a lot more sense than the fiction that public pensions are guaranteed which I never felt comfortable with.


      • Posted by TREEeditor2 on September 26, 2012 at 9:56 am

        i still remember the multiple scenarios put forth to our company’s employees by the outside 401k retirement plan managers back in the eighties. The scenarios were based on 8%, 10%, 12%. of course we all looked at the 12% rate of return, signed up whole heartedly and smiled comfortably. BTW almost 30 years later, I am still working. maybe another 30-40 years and i can finally retire from the private sector.


        • But what you didn’t get in those presentations was how much the presenters were going to make off of it (about 2% annually whether the assets made 8% or 12% or 2% or lost 10%) and until very, very recently (last month) they didn’t even have to tell you. It’s like DeCottis selling solar panels where the numbers are now in and that’s the next countywatchers blog.


  2. Posted by Eric on September 26, 2012 at 12:01 am

    NJ needs to find many Apple stocks instead of bankrupt casinos in order to generate the 26.7%.


  3. Posted by Larry Littlefield on September 26, 2012 at 7:56 am

    The problem is that that actual rate is lower than the purported risk free rate. Stock prices are still inflated and executives are still pillaging profits by issuing each other stock, reducing future capital gains. The dividend yield is low. And normal interest rates would mean insolvency for most institutions in the debt-riven U.S., which means ultra low rates could persist for some time.


    • Posted by TREEeditor2 on September 26, 2012 at 10:02 am

      not true about low rates could persist. When the lending market starts to evaluate the cash flow to payback ratios, they may get very jittery at the higher risk being taken on. Ratings agencies are indeed lowering the rank even for the USA.

      Then the borrowers will actually have to offer higher and higher rates to convince the debt buyers to buy more. Unknown the inflection point when this will happen, but the precious metals market just may be forecasting something in the wind. So far though you are ciorrect and we have been dodging the bullet, but all that does is give our elected officals a false sense of security and damn the torpedoes in the future.


  4. One thing you know for sure, John, is that the probability of corruption, abuse, misfeasance and malfeasance is near 100 percent. How do you price that in? The fundamental problem now is that all risk is borne by taxpayers, who are the only ones not at the table. As long as that continues, the entire system will spiral inexorably toward collapse.


    • Posted by TREEeditor2 on September 26, 2012 at 10:05 am

      we need a joe mccarthy type to do the witchhunt not of communists but of internal govt corrupters. That would be sheer entertainement daily for the next 20 years. Maybe sentence them all to NJ and put a fence around the state. Where’s Snake Pliskin?


  5. Posted by Eric on September 26, 2012 at 9:40 am

    “Normal” interest rates are not only a death knell for most institutions, but also for the US government despite the printing presses. This is why cost of living adjustments for seniors do not consider the high costs of food and energy and would be at 10% were the stats calculated the same way in the 1980s. See John Williams Shadowstats.
    Remember Ronald Reagan’s “Misery Index” which he used to defeat Jimmy Carter?


  6. Posted by eatingdogfood on September 26, 2012 at 11:00 am

    RICO Conspiracy; The Democrats and Their Union Bosses !!!


  7. There is no dispute among financial economists that the expected rate of return and the liability discount rate have nothing to do with one another. Pension plans look to identify a long-term expected rate of return on investments, advocates of the market valuation of liabilities take a point-in-time measurement of the risk-free rate. This horizon mismatch is problematic, but we know the best discount rate is probably somewhere between the current ultra-low risk free rate and the expected investment return.

    Rauh and Novy-Mark have an excellent example to illustrate why the expected return and discount rate are unrelated. They write:

    “If households could use the GASB accounting system, then they could write down the value of their mortgages by simply reallocating their savings from a money market account to an investment in the stock market. By doing so, they would increase the expected rate of return on their assets, and get to use this higher rate to discount their debts. If state and local governments took further advantage of this system, they could make their liabilities essentially disappear by taking on risky investments with high average returns and high risk”

    The high liability discount rate distorts downward the value of the pension payments and allows elected officials to believe pension funding levels are better than they are. It is time for state and local officials to roll up their sleeves and understand the math behind the ticking time bomb of public pensions.


    • Posted by Tough Love on September 26, 2012 at 3:38 pm

      Beyond just “understanding” the math, they need to DO SOMETHING to address it. And since service cuts or Tax increases necessary to fully fund these promised pensions would be unconscionable, the solution MUST include (at a minimum) very substantial (50+%) reductions in the rate of pension accrual for FUTURE service for CURRENT (yes CURRENT) workers.


      • Going beyond understanding the math and DOING SOMETHING goes without saying. But as a local elected official, I know first hand that many city councilmen and county legislators don’t want to do the work to understand the pension problem; many don’t even want to know the truth.


        • Posted by Tough Love on September 26, 2012 at 4:56 pm

          And they “don’t want to know the truth” because they like accepting Public Sector Union campaign contributions and election support knowing that in exchange they must favorable vote on pay, pensions, and benefits.

          In any other venue that’s considered bribery and both the giver & receiver would be jailed.


  8. Posted by Javagold on September 26, 2012 at 4:42 pm

    just bet the entire pension on red on a rouletter table in AC, if they lose , its great for AC bottom line and the taxpayers have to make up the losses


  9. […] the real unfunded liabilities public pension systems are accruing (albeit through a fallacious riskless rate theory) could be undone as the two professors, in a recent book of essays edited by Aaron S. Edlin and […]


  10. […] The Financial Economics folk then make the argument that “because pension benefits are guaranteed under most state laws, the appropriate discount factor is a riskless rate” which is where they lose me. […]


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