Monday’s WSJ has a story about a move by the new House Republican leadership to put pressure on state and local public-employee pension authorities. Buried inside the political fights is an important valuation question: what is the right discount rate to use when valuing the liabilities of a public pension plan? The Government Accounting Standards Board has a project to review this issue.
Risk is a key element of many of the arguments. Proponents of the relatively high discount rates argue that (1) the right rate is determined by the return one can expect on the money invested to payoff the future liability, (2) a high rate of return can be reliably expected given a long time horizon, and (3) state and local governments have a long (endless?) life. Point #2 is a fallacy, but one that continues to have many adherents. This poor understanding of how risk compounds over time undermines many valuations. A number of articles by Paul Samuelson, Robert Merton or Zvi Bodie address this fallacy in various manifestations. A good one by Samuelson is here.
For another approach to critiquing the current practice, see the testimony of my colleague, John Minahan. Thanks also to John for suggesting this comprehensive introduction to the conflict between the historically received pension model and modern financial economics: a paper by Bader and Gold on “Reinventing Pension Actuarial Science.”