Understanding the valuation of public pension liabilities: Expected cost versus market price

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Article Highlights

  • Market-based measurements ignore expected investment earnings.

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  • Current valuation practice provides information about expected actual cost to the employer and, ultimately, to the taxpayer.

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  • Current valuation practice qualitatively and quantitatively incorporates more information than the market-based method.

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With US state and local economies in slow recovery, workforce costs—including pensions and other benefits—remain front-page news. Taxpayers and public officials want to know the size of their financial obligations to employees and retirees for retirement benefits to assess how much it will cost—today and in the future—to meet those obligations.

Determining these obligations should be straightforward because governmental accounting standards and professional actuarial standards outline accepted methods for measuring pension liabilities. In particular, current practice measures pension obligations using long-term assumptions and methods, including an expected rate of return on plan assets. But alternative measures of pension liabilities are increasingly reported in the press. One measure might peg the size of the liability as two or even three times the size of the liability measures currently in use. As a result, a great deal of confusion and controversy has resulted over which measure is “correct.”

The controversy around measuring pension liabilities centers on a familiar subject for sponsors of public pension plans: the applicability of what is called the “market value of liabilities” (MVL) to public-sector pension obligations.[1] This paper explores the conceptual differences between two competing measures of liabilities: current practice versus the market-based measure. It also examines which measurement is most useful for public-sector decision makers. Finally, it reviews some of the issues that have yet to be resolved regarding measuring these pension obligations.

Background: Current Practice versus Market-Based Measurement

Current practice for measuring the pension liabilities of public-sector pension plans provides information to plan stakeholders and decision makers about how much it will cost over time to satisfy the financial obligations to participants. This is accomplished by calculating what is called an actuarial accrued liability (AAL), which is based on both current information and reasonable expectations of future events.[2] The AAL measure is based on long-term methods and assumptions. It not only takes into account the service and pay earned by employees, but also anticipates future service and pay raises, which will increase the plan’s obligations. Current practice also incorporates information about the future investment earnings of the plan’s assets when selecting what is called the “discount rate.”[3] In determining the AAL, the discount rate used to calculate public-sector pension liabilities is the long-term expected investment return on the plan’s investment portfolio.

The MVL approach differs from the AAL approach in important ways, especially when it comes to the discount rate. MVL measurements ignore expected investment earnings, and instead use current market rates of interest on relatively secure fixed-income instruments (for example, US Department of the Treasury rates or high-grade corporate bond rates). As I discuss in the next section, the theory behind the MVL measure is that because public-sector pension benefits are fairly certain to be paid, they should be valued the same way that the market prices securities that have a similarly low “default risk” are valued. This would indicate the use of the lowest current market interest rates, which are often called “risk-free” rates. Note that “risk-free” does not mean such rates are free of investment risk, but rather that they are the rates implicit in the market pricing of securities that, like public pensions, have low default risk.

There are other important differences between the AAL and the MVL. For instance, the MVL uses a much narrower definition of future benefits to calculate a plan’s liabilities, one that assumes that pay and service are frozen at current levels.[4] However, our discussion will focus on the current controversy surrounding the discount rate: when measuring public pension liabilities and costs, should future benefit payments be discounted by using the expected long-term return on plan assets or by using current market interest rates?

Notes

   1. For an introduction to the MVL approach to valuing pension liabilities, see The Segal Company, “Market Value Liability and Public Pension Plans: A Continuing Controversy,” January 2009, www.segalco.com/publications/publicsectorletters/jan2009.pdf.
    2. The AAL is the liability for all service to date. A pension valuation also determines a “normal cost” for active members, which is the cost for the next year of service. For active members, the AAL is the current value of the normal costs for past years of service. For inactive members, the AAL is simply the present value of their future benefits.
    3. Any current measure of a pension plan’s liability is essentially a calculation, in current dollars, of some portion of the value of future benefit payments. In recognition of the time value of money, future benefit payments must be “discounted” to arrive at a value today.
    4. For a detailed description of these differences, see The Segal Company, “Market Value Liability and Public Pension Plans.”

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