The Detroit police and fireman retirement system assumed an 8% expected return for [its] assets and liabilities in 2011. An 8% return is very optimistic going forward. That assumes the 21st century will experience the same growth as the 20th century did. If the investment returns turn out to be lower, the pension fund will run out of money. The whole point is that is uncertain. Even if that 8% return is realized, on average, using it as the discount rate doesn’t account for the risk that in some years returns will be lower. Financial economists believe that the discount rate shouldn’t be the rate of return; it should be the price that reflects the costs of providing the benefits each year. That might be the treasury rate, if the benefits will always be paid, or maybe the municipal bond rate, what the states pay to borrow money. Some actuaries claim the expected return is fine for state pensions because you only need to earn 8% on average, some years you earn more others less. The problem with that is it’s much more expensive to raise capital, if you don’t have enough assets, when markets are down. Jeremy Gold’s research shows that using the expected return as a discount rate effectively shifts the cost of providing the guaranteed benefits to future generations, even when the average return is realized.Cate Long reckons the right discount rate is a matter of opinion. But using a risk-appropriate discount rate is standard in finance and has been for decades, otherwise states are pretending the guarantee is free. If the fund doesn’t get an 8% return and Detroit can’t rely on its taxpayers, people like Dennis will be vulnerable to even larger benefit cuts in the future.
As the struggle over pensions spreads, a solid understanding of pension financing will be crucial to following state and municipal government responses to the crisis. This piece is a good primer on the basics of pension funding.