While discount rate can refer to several things, in terms of pension fund planning, it refers to the assumed rate of return a pension’s investments will generate over the coming period, which is then compared to the plan’s obligations to its pensioners.
Q. We all know about the Fed “discount rate”, but this is a different one, right, because of our last guest.
A. Yes, this discount rate is the key issue in pension plan funding. Of course, actuaries tell us what our future obligations are going to be. So the question is, how much will our investments earn between now and then to fund those obligations. That’s the discount rate: the higher it is, the less we have to put in (or the less underfunded we look); the lower, the more we have to put in, and the more underfunded we look.
Q. And so there’s a lot of pressure in the public arena to assume pretty high rates…
A. There sure is: assuming too high a discount rate really helps you disguise how bad the situation really is… and for the states, its really bad. Weirdly, most states actually require an 8% discount rate to be used. So, how many folks are making 8% guaranteed these days? By the way, this is one of those little noticed consequences of the Fed’s ZIRP … savings rates are super low, and that effectively increases the underfunded nature of these pension plans.
Q. So is there pressure to change that number to something more realistic?
A. Sure, the Government Accounting Standards Board is trying to implement rules that would force states to use more realistic numbers. That, of course, would force them to increase their stated levels of underfunding for pension plans, which Pew says is already $757 billion… and that doesn’t count medical benefit promises. Pew says on 11 states are doing a pretty good job managing their pension liabilities.
Q. And as we heard earlier, partly as a requirement to earn more and bring their underfunding levels down, we’re seeing more allocation to alternatives by state pension plans, right?
A. Yes. Again, given ZIRP and the state of the bond market, you can’t expect to make much progress there. So we’re seeing a lot more interest in other income producing categories, from MLPs to RIETS, and also alpha-seeking strategies. Just starting to see a touch of pickup in the market for PE, too: there’s some bargain hunting going on there because illiqudity premiums have gotten so high. The good news for these pension plans is that they generally have some time before these shortfalls actaully result in failure to pay benefits.