It’s depressing how little investment knowledge most so-called financial professionals have. (I have theories why this is the case, but those are for another post.) One recent, real-world example of a severe lack of financial knowledge is the ongoing dispute about how state and local pension liabilities should be valued.
In one camp, we have our so-called financial professionals arguing the current methodology is appropriate. This methodology is best described by a snippet from a recent CFA Magazine article on public pension underfunding: “Currently, public pension plans can discount future pension benefits using an assumed expected return on their pension assets, and most plans assume returns between 7 and 8.5 percent.” I would hope that even a finance undergrad student at Indiana Basin Silt College could tell me why this is a ridiculous statement. Here are the two biggest:
Earning Power Doesn’t Matter
When valuing a debt, what you can earn on your assets has NOTHING to do with that valuation. All that matters is the likelihood you’ll repay your debt. For example, the fixed income market expects the U.S. government will repay all its debts and, therefore, values U.S. Treasury bonds highly. On the other hand, in 2008 the market noted that Lehman Brothers was unlikely to fully pay its debts and priced Lehman’s bonds accordingly. One could certainly argue that state and local pension payments are generally likely to be paid and should therefore be valued using relatively low discount rates.
Even if you should factor in what you could earn on assets (and to repeat: You shouldn’t!), exactly what low-risk investments do these plans own that can be expected to earn 7 percent to 8.5 percent over the long term? You would struggle to find more than a handful of fixed income securities that could be expected to earn such a return and none in the high-quality portion of the fixed income marketplace. Further, most practitioners would argue that the expected return on developed market stocks is probably no more than 7 percent to 8 percent, and we all know that isn’t guaranteed.
You may ask why all this matters. The CFA Magazine article noted that, for the state of New York’s pension plan: “a reduction from the current assumption of 8 percent to 5 percent, all things being equal, would increase fiscal year 2011 employer contributions from more than $3 billion to about $14 billion, close to a 300 percent increase.”
In other words, public pension liabilities are severely understated at the higher discount rates, and using more realistic rates would substantially increase funding requirements. For those of you interested in further exploration of this topic, Professor Joshua Rauh at Northwestern University’s Kellogg School has published a number of papers exploring state and local pension liability valuation.
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