Public plans needn’t use a risk-free rate of return
Recently I was asked about an assertion in a paper issued by an affiliate of the University of California that a public pension system with less than a 100 percent funding ratio must use a risk-free rate of return as the discount rate. That is not correct.
Under GASB 68 a pension fund employs a discount rate reflecting (i) the pension fund’s long-term expected rate of return on pension plan investments to the extent that the pension plan’s fiduciary net position is projected to be sufficient to pay benefits and (2) a tax-exempt, high-quality municipal bond rate to the extent that the conditions for use of the long-term expected rate of return are not met. Under that rule CalPERS and CalSTRS are permitted to use expected rates of return as discount rates.
The paper also muddies who is at risk when pension obligations are underfunded. They fall into two groups: (1) employees of governments or agencies that can go out of business and (2) future generations.
When governments or agencies with underfunded pension systems go out of business, retirees can suffer cuts in benefit payments. Recent examples include Loyalton and East San Gabriel Valley Human Services Consortium. An increasing number of California agencies and governments are at risk to similar failures that would be of great consequence to their retired employees.
When governments or agencies (such as states) cannot go out of business, the consequences of underfunded plans fall on citizens, whose services are cut to make room for greater pension payments. Ironically one example is UC, where the paper was published. UC gets funding for its undergraduate program from the State of California, which has underfunded pensions and cannot go out of business. The consequences for UC have been severe:
State spending on pensions grew 76 percent over that period, nearly three times the rate at which state revenues grew, leaving less for UC, CSU, welfare, parks and courts. Those programs will face even more crowd-out going forward because state pension funds are even less well-funded now.
It didn’t have to be that way. Defined benefit pension plans work just fine when properly funded. Journalists and elected officials must be sure they understand the rules governing pension accounting and on whom the consequences of pension underfunding fall.