Valuing Liabilities in State and Local Plans

by Alicia H. Munnell, Richard W. Kopcke, Jean-Pierre Aubry, and Laura Quinby

June 2010

SLP#11

Introduction

To measure the liability of a pension plan requires discounting a stream of promised future benefits to the present. For public sector plans, what discount rate to use in this calculation is a subject of great debate. State and local plans generally follow an actuarial model and discount their liabilities by the long-term yield on the assets held in the pension fund, roughly 8 percent. Most economists contend that the discount rate should reflect the risk associated with the liabilities, and given that benefits are guaranteed under most state laws, the appropriate discount factor is a riskless rate, roughly 5 percent, as discussed below. Thus, the economists’ model would produce much higher liabilities than those currentlyreported on the books of states and localities. The intensity of the debate is fueled by the assumption that the magnitude of the liabilities dictates the size of the funding contribution and even how the pension fund assets should be invested.

This brief attempts to separate the question of valuing liabilities from the questions of funding and investment. As background, it explains the current approach to valuing liabilities in the private and public sectors. Second, it discusses why, given their guaranteed status, state and local pension liabilities should be discounted at a riskless rate and shows how much measured liabilities would increase by applying such a rate. Third, it argues that valuing liabilities is only one factor entering the funding calculation, and that using a riskless discount rate does not necessarily mean that contributions should increase immediately.

For full brief