Pensions and Investments editorialized about public plans needing to use lower interest rates for valuing their liabilities noting that:
Robert Novy-Marx, professor of business administration at the Simon Business School, University of Rochester, N.Y., in a September 2013 research paper, explained why risk-free benefits should be discounted in value at risk-free rates.
“Payment streams should be valued using discount rates that reflect the cash flows’ risks,” Mr. Novy-Marx wrote. The research paper was written for the Pension Research Council of the Wharton School and posted on the website of the Pension Benefit Guaranty Corp.
The economic concept is not new, even if it has been ignored by public pension systems.
Donald L. Kohn, then-vice chairman of the Federal Reserve Board of Governors, said in a 2008 speech to the National Conference on Public Employee Retirement Systems, that “public pension benefits are essentially bullet-proof promises to pay.” In the public sector, unlike in the private sector, “accrued benefits have turned out to be riskless obligations,” Mr. Kohn said. Among economists, the “only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate.”
Of course liability values for the vast majority of public pension systems in this country are severely understated (for political reasons) but the idea that these benefits are ‘bullet-proof’ is ridiculous. Retirees in Prichard, Central Falls, Detroit , and soon San Bernardino know about benefits being arbitrarily cut and it seems every state is targeting cost-of-living-adjustments, regardless of what any employee handbook (or law) might say.
There is a real reason for using lower earnings assumptions and it has to do with the math.
Four years ago I provided an example of the math as it relates to underfunded pensions but I will put it another way by looking at a simplified situation with a population of one – a retiree, hired at age 45, retired at age 65, and entitled to $10,000 per year for life.
If you were to get no earnings at all over the course of the retiree’s life you would need $200,000 assuming an expected life span of 20 years.
Now assume you will get 8% earnings on the money you start off with based on your diligent saving to get that $98,181 into the plan.
Now we get to the situation with public plans where, because of a series of actuarial games and outright reneging on contributions, many plans only have $50,000 to pay that retiree. If the interest rate continues to be 8% instead of making 20 years of payments you will run out of money in year 7 with $224,572 needing to come from somewhere else (we will see below from where) if all 20 payments are to made:
To be able to pay that $10,000 annually over 10 years the interest rate would need to 19.426%:
Turning to the accumulation stage the converse applies. Again assuming an 8% interest rate annual contributions of $2,145 would get us to the $98,181 that needs to be in the fund to pay out that $10,000 annually at retirement:
Finally, the twist: If you assume 3.3% earnings on the trust during the accumulation period you will need to deposit $3,544 annually to get that same $98,181:
But if you know you will be earning 8% then why contribute the $3,544 annually instead of the $2,145? Because that difference ($1,399 in this example) is not going toward paying for that one person’s benefit but rather toward making up the shortfall in earnings for other retirees so they get all 20 years of payments instead of being cut off at year 7.
It is because of the massive underfunding that public plans like New Jersery’s have developed which requires that interest rates be artificially adjusted downward if everyone is to be paid. Nothing to do with that silly riskless-rate myth.