QUESTION: Most city pension funds use an 8.25% to discount the future pension liability. What are the consequences of this high discount rates?
ANSWER: (from earlier blog post) 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 may encourage 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.”