Public sector plans are in trouble because for years they have valued their liabilities as though they are risky investments. The practical result of using a high discount rate - on average 8 percent - is that it results in a smaller present value for the liability and requires less money be set aside today to grow into tomorrow's benefit.
This practice, flowing from GASB 25, has been criticized many times. The practical problem facing governments is this. If plans go with the advice of economists and use discount rates based on Treasury bonds that will require a steep increase in contributions today. While no plan has acknowledged the fundamental problem with selecting discount rates to value liabilities based on expected asset returns many recognize one of the results.Those 8 percent expected asset returns aren't a guarantee. Some governments are starting to rachet down assumed asset returns (and thus discount rates) for pension plans to the 7 percent range.
It's the right direction for the wrong reasons.
The effect of dropping discount rates is not an easy one for governments to manage. CalPERS may reduce the assumed discount rate a mere half point, from 7.75 percent to 7.25 percent. That means next year they will have to kick in a further $425 million to the state's pension system. The total annual contribution will amount to $3.9 billion. The move affects municipalities and school districts which must also contribute more to the system.
The Sacramento Bee highlights the hazard of the method governments use to value liabilities which muddles assets and liabilities for the purposes of valuation. It has produced bad incentives and worse habits in terms of plan management. There is no easy answer to the valuation problem as a practical budgetary matter. The math is unforgiving - as officials from California to Rhode Island and New York are beginning to discover.
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