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Pick Your Favorite Discount Rate
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.
 
Unrealistic Projections
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.
 
Copyright © 2011, Buckingham Family of Financial Services. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

Comments

Even when they know better ...

From Wendy J. Cook: Great commentary. This issue played out in Oregon not very long ago, much to my chagrin. Here's a link to Oregon live coverage: http://bit.ly/ped7HH. Per the article, even though the plan's citizen board expressed "doubt the pension fund's investments will generate returns averaging 8 percent annually over the long haul," they still voted to keep the assumption in place, in part over concerns over funding expressed here, and also because their "experts" told them so. The article said: "While board members expressed doubt about returns, they said they would defer to professional forecasts." Harumph. Perhaps those professionals should head to Indiana Basin Silt and stick to their hoops.
at 1/13/2012 1:43 PM

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