What Does An Artificially High Discount Rate Mean?

The appropriate discount rate to be used in valuing public pension liabilities might seem like an arcane and technical question. I suppose it is. But thanks in large part to the indefatigable work of Eileen, her coauthor Andrew Biggs, and professors such as Novy-Marx and Rauh, it is a technical debate that has actually been covered by mainstream media outlets. In short, the official actuaries who value these liabilities use what is known as a high discount rate while most economists—Eileen included—believe that it is more prudent to use a low discount rate. The choice makes a big difference: with the high rate, state public pension systems appear to be underfunded to the tune of about $1 trillion; while with a low rate, they are underfunded by about $3 trillion.

What, exactly, does a low discount rate mean? More importantly: what does a low rate say about the assumptions of those who prefer to use it?

To get at this question, we first need to talk about why anyone uses a discount rate in the first place. The rationale has to do with the fact that the big costs of public pension systems will not be felt for a number of years (interestingly, some have looked at the modest current costs of pensions and concluded that state finances are perfectly healthy; but that is like looking at my child’s current college tuition expenses—which are $0—and pretending that her education isn’t going to be expensive). In any case, the big costs will not be felt for a number of years, and so we need some way to make sense of future costs in today’s context.

The way economists (and accountants, and financial analysts) do this is with a discount rate. This is a number that helps us figure out what we need to put aside today in order to pay for a liability down the road. We call it a “discount” rate because it discounts future costs in order to make an apples-to-apples comparison with current costs. In other words, paying $50,000 in tuition 18 years from now is not as difficult as paying $50,000 in tuition today (because I have 18 years to save for it). So to make sense of that future cost, I discount it. And the larger the discount factor I use, the smaller that liability looks.

Now according to economic theory, the discount rate should take account of the likelihood that a future cost will actually occur. If it is unlikely that my daughter will go to college, then I should use a larger discount rate in valuing the expected costs. In other words, I should discount those costs more than I would if I thought it a certainty that she’ll go.

So, what does it mean when people argue for a high discount rate in valuing pension systems? It means that they don’t think it is very likely that we will actually honor our promises to public employees. Thus, they believe we should discount those costs accordingly. They won’t say this, but this is exactly what such an assumption means. Conversely, people like Eileen who feel it is more prudent to use a low discount rate are saying that we should count on actually having to pay these pensions; that we should plan to honor our commitments.

As if the mathematics weren’t confusing enough, the politics are enough to drive one to distraction. For some reason, those who favor a low discount rate (i.e., those who think we should actually plan to live up to our promises) are often painted as anti-worker. This is because these cold-hearted economists’ calculations come to the conclusion that public employees’ pensions are expensive. Meanwhile, some groups defend a high discount rate. They do this so that they can claim that public employee pension systems aren’t a big factor in states’ fiscal woes. And for this, they are often characterized as pro-worker. In reality, though, their accounting assumes that we should leave workers out to dry.

I’d be grateful to anyone who could help me make sense of that!