Much of Eileen and Ben’s recent work has focused has focused on public defined benefit pensions and the problems that are common in public pension accounting. This post will explore some of the theoretical foundations that lie behind their arguments for reform. These principles might be foreign to people who haven’t studied economics or accounting, but all state taxpayers and public employees depend on responsible pension fund management. The second post in this short series will outline some of the incentives that policymakers face in managing pension funds.

Determining the amount of money that goes into a public pension fund requires an understanding of the time value of money, or an investment’s net present value. Because of the time value of money, funds in a savings account or invested in bonds earn interest; people prefer to have money now rather than later. In order to get a loan, borrowers must pay interest for the service, and conversely, savers are compensated for not spending their money today.

Net present value means that a fund’s outgoing payments and incoming payments must be adjusted to the present value. Calculating the net present value of pension obligations requires selecting an appropriate interest rate. This interest rate is called the discount rate.

In the case of public pensions, the appropriate discount rate to value fund liabilities, or outgoing payments is the risk-free discount rate. Unlike other retirement vehicles in which savers decide what level of risk they would like to take on, defined benefit pensions are typically guaranteed by the states and municipalities that provide them. As such, using any discount rate other than the risk-free rate unfairly transfers risk to taxpayers.

We can easily determine the risk-free discount rate by looking at the interest rate of Treasury bonds. The right bond to look at is the 15-year Treasury bond because this is the midpoint of the stream of cashflows that goes to pension fund beneficiaries. Currently, this rate is about 2.25%.

Unfortunately, defined benefit public pensions do not use this discount rate. Instead, they choose higher discount rates based on the return on investment that they hope their funds will earn. Most states assume a rate of return of around 8%. This higher discount rate leads states’ unfunded pension liabilities to appear smaller than they actually are, masking their true bill.

Assuming a lower discount rate leads to a lower Net Present Value of the fund and thus a higher liability. Elected officials and fund managers may view the risk-free discount rate as making retirement benefits cost more because it unveils the true size of unfunded liabilities. In reality though, the risk-free discount rate provides an honest assessment of how much funding these plans require.

By banking on higher returns than the risk-free discount rate, fund managers opened the door for the possibility that they are now experiencing: large unfunded liabilities. Both the net present value of pension funds and of pension liabilities must be valued with the appropriate risk-free discount rate for states and municipalities to get out of the current funding gap and to ensure that the problem is avoided in the future. Without proper accounting methodology, defined benefit pension funds expose taxpayers and beneficiaries to high levels of risk, as these benefits are supposed to be guaranteed by the government, putting taxpayers on the hook.