Public Pension’s Incorrect Discount Rates and Intergenerational Risk Sharing

From “How Public Pension Plans Can (and Why They Shouldn’t) Ignore Financial Economics”, by Lawrence N. Bader¹,

It is a truth universally acknowledged (in the universe of financial economists) that the value of a secure, fixed future payment is determined by discounting at a default-free rate. Why then do US public pension plans discount their liabilities and base their funding on rates in the range of 7%–8% at a time when long-term US Treasuries yield less than 3%?

Although this article focuses on the United States, the problems it addresses are found in most of the world’s developed countries, particularly in Western Europe. Public pension plans exist in many forms, funded and unfunded, backed by a central government or by a local government. But almost everywhere, public pension liabilities are discounted at rates that greatly exceed the local default-free rate, with a consequent failure to recognize and manage the true cost of these plans.

Surely this is an issue in need of greater attention?

But that is not the only concern. In a previous post, “Asset Allocation With Yourself As a Factor” I wrote,

Although here is where I depart slightly in agreement, because the suggestion below does not consider inter-generational wealth, for example, if investors are concerned with building wealth for their descendants.

This research suggests that equity allocations should change over time as human capital is consumed (or depleted), taking the shape of a “guide path” that is common in target-date investments today.

I don’t know whether as a generation, we are all just not that concerned for the future generations, but far worse than not caring about building wealth for the future generations is actually ‘hijacking’ the risk premium from the future generations.

Bader in fact, gives an example of this intergenerational risk premium in his paper,

Generation 1 takes credit for the risk premium by discounting the $108 pension payment at the 8% expected return and contributing $100 to the pension fund. After Generation 1 departs, any surplus or deficit belongs to Generation 2, which thus bears all the risk but has an expected risk premium of zero. Generation 1, which bore no risk, confiscated the expected risk premium to reduce its own contribution. (Even if the plan used a “conservative” 5.5% discount rate, Generation 1 would pocket a 2.5% risk premium, leaving Generation 2 with 100% of the risk and only 50% of the risk premium.)

In this one-year example, the risk premium is only 5% of the pension cost, but with compounding for pensions payable decades into the future, the risk premium hijacked by the current generation can far exceed 50% of that cost. This example enlightens us about the intergenerational sharing of risk premiums, as practised in the public plan sector: The current generation takes the premium; the next generation takes the risk. Of course, the next generation can “share” in the same way with its successor, and so on. This “sharing” can continue for quite a while, so long as there are future generations willing and able to participate.

Insurance companies cannot run their annuity business this way, because they cannot persuade future customers to pick up the losses incurred in providing annuities to current and prior customers. But governments can ignore financial economics and, within limits, compel future taxpayers to cover earlier losses. The benefit of the long government time horizon is not that it overcomes risk but, rather, that it delivers a steady supply of future involuntary risk bearers on whom the government can exert its taxing power.

These potential victims face a distinct lack of symmetry in their risk bearing. There will be no meaningful surpluses to cushion long-term declines, because the political process will sweep winnings off the table (in the form of lower contributions or higher pensions) while letting losses run. In the worst cases, future victims could include not only taxpayers but also plan members themselves and municipal bondholders. In such cases that have occurred to date, the judiciary has favored plan members over bondholders. Investors in municipal bonds may begin to demand better information and become more cautious about governments whose pension plans are poorly funded.

In my opinion, this is a long term, intergenerational economic problem that would require a political solution.

For a Ramsey extension of an “altruism, bequests, and infinite horizons” model, click below.

[1] Financial Analysts Journal Volume 71 · Number 5 2015 CFA Institute


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