Current public sector practices involve discounting a liability according to the assumed investment returns of plan assets, typically around 8 percent. Yet with discount rates tied to expected investment performance, plan sponsors can easily take on greater risk in order to make liabilities appear smaller. This reduces the resources required today to pay for the promises of tomorrow.Accurately accounting for a pension system’s liability requires incorporating the nearly certain nature of benefits. That is, once promised, the chances that benefits will not have to be paid are extremely low.A fair-market valuation does away with optimistic investment return assumptions and instead uses a rate that reflects the risk of the liability itself. One common approach, taken here, is to discount liabilities according to the yield of a 15-year Treasury bond.
We’re not actuaries, and we’re not sure whether the the rate of return will be as low as the risk-free rate suggests. Nonetheless, it’s obvious that the rates of return used by cities and states are far too high, and given the problems we’ve seen with underfunded pensions, it’s probably prudent for states to err on the side of caution when it comes to calculating the rates of return on pension investments.[Stock graph image courtesy of Shutterstock]