July 20, 2013
Mary Williams Walsh seriously misrepresented the issues in discussing the debate over the discounts rates that public pension plans should use in assessing their liabilities. The goal of any formula for funding pensions should be to maintain a relatively even flow of funds into the pension in order to avoid sharp disruptions to government budgets.
The formula that pension funds typically use, which involves a smoothing process and discounts liabilities based on the expected rate of return of assets accomplished this purpose. An analysis based on the last 110 years of financial market fluctuations shows that this method rarely leads to sharp changes in the amount of required contributions. (It is important that the expected rate of return be adjusted with price to earnings ratios in the stock market. Many pension funds absurdly assumed that equities could provide a 10 percent rate of return in the 1990s stock bubble, even as price to earnings ratios crossed 30.)
By contrast, the discount formula clearly advocated in this piece would lead to sharp fluctuations in required contributions, assuming that pension funds continued to invest in stocks. This discount formula would require state and local governments to make large contributions to their pensions so that they could be fully funded using the risk free interest rate to assess liabilities, then they would be able to maintain minimal levels of payments since most of the contributions would come from the excess of the return on the fund’s assets over the assumed discount rate.
This would be similar to building up a large trust fund to pay for education in future years so that people could pay lower taxes two or three decades from now since the cost of the schools would be paid out of the trust fund. While that may be a nice thing to do, it would mean higher than necessary taxes on current workers. This is the predicted outcome of the discount method advocated in this piece assuming that pension investment patterns do not change.
Of course if the riskless discount rate was chosen as the basis for assessing these funds, then it is likely that pension managers would change their investment behavior and stop investing in stocks. There is no doubt that stock is a risky asset that provides far more volatile returns than bonds. If pensions are not allowed to factor in the increased return from stocks in assessing their financial state, there would be no reason for a pension fund manager to invest in them.
By investing in stock, pension fund managers would be taking the risk that a downturn will leave the pension plan appearing underfunded. This means that they would face the downside risk, but get none of the upside benefit. The likely outcome in this case would be that pensions would invest almost entirely in bonds or other low-yielding assets.
This would lead to an absurd situation in which collectively invested pension funds are held in safe assets, while individuals hold risky stock in their 401(k)s or other retirement accounts. These implications should have been clearly explained in any discussion of the choice of discount rates.
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