Most public-sector employees participate in traditional defined-benefit pension plans, which promise them a fixed monthly retirement benefit for life. These benefits are generally calculated as some percentage of the employee’s final salary multiplied by the number of years of employment. Defined-benefit pension plans differ from defined-contribution ones such as 401(k) and 403(b) plans that are common in the private sector, in which the employer contributes to the employee’s investment account each year but makes no promises regarding the actual benefit the employee will receive at retirement.
Accounting for the finances of defined-benefit pension plans requires comparing the assets the plan holds today with a stream of benefits that can extend decades into the future. Making such comparisons requires “discounting” future benefit liabilities to the present, a process that subtracts annual interest from the future dollar amount until a “present value” is determined. The policy debate regards the appropriate discount rate to utilize in making such calculations. A higher discount rate will reduce the present value of plan liabilities and, all other things equal, portray a plan as being better funded. Likewise, lower discount rates generate higher measured liabilities and lower levels of plan funding.
Determining the appropriate discount rate to use is a function of the goals of pension policy as a whole. Pension accounting and funding rules should be designed to help plan stakeholders better achieve their policy goals. These stakeholders can include pension managers, elected officials, public employees and retirees, holders of state and municipal bonds, and taxpayers, all both present and future. In the public pensions accounting debate, however, these policy goals are often left unstated. Making these goals explicit illustrates the deficiencies in the current
pension accounting rules and points the way toward better methods.
This paper first reviews how public pensions value their liabilities under current GASB rules. Next, it outlines the standard approach to valuing liabilities from an economic point of view and what this market-based approach implies for public-sector pensions and their funding levels. Following that, the authors provide examples designed to better convey the qualitative principles regarding the economic approach to pension liability valuation.
The emphasis here is not on detailed calculations of how fair-market valuation would affect pension funding in states and cities around the country, nor the increased budgetary burden the pensions might impose. Likewise, the emphasis is not on how defined-benefit pensions might be reformed in light of information conveyed via more accurate accounting rules.
Rather, the intent is to provide readers with a better handle on the simple intuition that lies behind the economists’ call for fair-market valuation of public pension liabilities. Those who follow the debate are aware that economists argue for using lower discount rates to value public pension liabilities but often are unaware of why economists believe what they do. This paper aims to better articulate those beliefs.
Other reports in this series:
- Understanding the legal limits on public pension reform
- Understanding the valuation of public pension liabilities: Expected cost versus market price