Why are defined benefit pension plans so under-funded?

States still have defined benefit pension and medical benefit plans that promise future payouts to state and local employees. To determine how much they have to save, they calculated the present discounted value of the future liabilities and compare it to current savings. Nashville's pension liabilties, for example are about 90% funded. Pittsburgh's are about 30% funded.  Neither saves for the medical benefits.

So what discount rate should they use? Most use discount rates near 8% because they expect to earn 8% on their investments. A recent paper blamed some of the under-funding on the use of discount rates based on the characteristics of the invested assets:

• the use of higher-than-appropriate discount rates reduces the value of the pension obligations that is reported to the public, and thus likely reduces the contributions that sponsors feel they must make to pre-fund their pension obligations.
  
  
• the link between the discount rate and the expected return on plan assets mayencourage sponsors to invest in riskier portfolios than they would otherwise choose in order to justify a higher discount rate, and thus a lower contribution into the pension trust.
  
  
• these rules may encourage fiscal gaming in the form of “Pension Obligation Bonds.” These devices allow governments to borrow, invest in risky assets through the pension trust, and treat the difference between the expected asset return and the bond interest rate as “found money.”
  

So what rate should they use? The paper recommends a rate equal to 30 year treasuries, adjusted upwards to account for their tax free status. Today's risk-free rate of 4.29% is equivalent to a taxable rate of 6.55%, given a marginal income tax rate of 35.5%.