It's high noon in the showdown over public pension accounting methodologies. On one side we have actuaries, who say that pension liabilities should be discounted at the rate historically returned by the funds' assets – 8 percent. On the other side are economists, who say this is nonsense – a risk-free rate, currently around 3.5 percent, should be used in the discounting calculation.
At stake is $2 trillion dollars. That is the approximate difference in just how underfunded our state pension systems are depending on which calculation you favor.
Both approaches have merits, according to a recent paper, "Valuing and Funding Public Pension Liabilities" by John Minahan, a senior finance lecturer at the MIT Sloan School.
The actuaries, so far, have had the upper hand; their approach is endorsed by Generally Accepted Accounting Principles. What ultimately matters, however, is whether the triumphant accounting method in this struggle leads pension funds to set aside enough funds to meet future promises to retirees. On that score, a risk-free approach may provide a more realistic assessment of future needs.
State pension systems currently have about $2 trillion saved up, but actuaries using traditional accounting standards estimate that states really need a total of $3 trillion nationwide, suggesting a fiscal gap of about $1 trillion before the pension plans can be considered fully funded. Minahan and other economists, however, argue that the amount that state pension systems should really set aside is closer to $5 trillion.
To illustrate the debate over accounting methodologies, Minahan uses the example of an employer who promises to pay an employee $100 one year from now and says that he will "fully fund" that promise. If the employer is able to earn 5 percent per year by investing in a "risk-free" asset such as U.S. Treasury bonds, this means he would only need to set aside $95.24, the amount that if increased by 5 percent, would equal $100. This changes, however, if the employer decides to invest in riskier assets, such as stocks. Suppose the employer decides to invest in an asset that has a 50/50 chance of earning as much as 8 percent per year, or as little as 4 percent per year. Actuaries using accounting methods currently favored by pension managers would say that the employer could assume a 6 percent return on average, and thus could set aside just $94.34. According to Minahan, however, the employer would really have to set aside $96.15, the amount that if increased by just 4 percent would equal $100, in order to guarantee full funding even in the worst-case market scenario.
