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What is the value of your liabilities? This is a question that should be easy to answer. After all, we read articles daily that discuss the funded status of various pension plans. Obviously, in order to state the funded status, someone must have been able to figure out the difference in the value of plan assets and plan liabilities.
Yet here is the rub: The “value” of your liabilities is not the same thing as the liabilities themselves. For most American pension plans, if you know you have to pay a pipefitter $50,000 in the year 2031, you also know that number will not change. Whatever happens to interest rates over the next 20 years, you know that you owe that pipefitter, $50,000. That is your liability.
Yet, when you need to state the “value” of that liability in today’s dollars, that is where the difficulty begins. Let’s assume the pipefitter is 55 years old, is expected to retire at age 65, and is expected to live to be 85 years old with no survivors. Also, let’s assume that your pension plan has just frozen, so the pipefitter is no longer able to accrue additional denned benefits. If you use the interest rate on AA-rated corporate bonds as prescribed by the Pension Protection Act, the present value of that liability is approximately $349,000.
However, let’s assume that the pipefitter is a state employee. In that case you—the pension plan—do not use AA-rated corporate rates to value liabilities; you use your expected rate of return on assets. For most states, that is somewhere around 7.5%. So, the same pipefitter with the same life expectancy and retirement age with the same $50,000 annual payments due from age 65 to estimated age 85 has a value of about $256,000. In each case, the actual value of the obligation is the same—20 x $50,000, or $1 million. So why should the present value of the liability be different?
This is more than an academic question. The Pension Protection Act essentially requires the use of AA-rated corporates for private-sector plans. Government accounting standards, however, rely on the expected rate of return on assets. Legislation has been proposed in Congress that would force states to publish their liabilities using corporate rates. This all leads to the question: What really is the right rate? Or is there really only one right rate?
It is appealing to argue that states should value their liabilities the same way corporate pensions do, and this certainly has some merit. But, in the end, it is somewhat facile to simply make this assertion and leave it at that. That assertion assumes that the way corporates measure liabilities is the right way. Is it? If it is the right way for corporates, does that necessarily mean it is right for public plans? Or should liability valuation differ depending upon who is asking and why?
Corporations are required to use specified discount rates for multiple purposes. The accounting standard allows various companies to be evaluated by investors in a consistent way. Since a pension promise is an obligation of the corporation, it should be treated the same as any other corporate debt and should be valued as such. Using AA-corporates as a surrogate for cost of capital may be a little conservative, but that helps lead to better funding, and it is more akin to the way that an insurer would look at the liabilities. Moreover, since corporations are not perpetual and always face the risk of bankruptcy, it is important that accounting standards and public policy encourage high degrees of funding so that, in the event of bankruptcy, the PBGC is not burdened unfairly.
States, on the other hand, have a different cost of funds, perpetual existence, the unlikelihood that an insurance company will ever take over their liabilities, and a clear understanding that time and investing are part of how they intend to meet their obligations. They do not report earnings per share, and you cannot own shares in them. States argue that achieving a 7.5% rate of return is realistic, particularly over decadeslong time horizons. According to Callan Associates, median public pension fund investment returns were 8.7% and 8.8%, respectively, for the 20-year and 25-year periods ending December 31, 2010. The problem in state plans generally has not been the long-term performance of the assets. It has been a problem of proper funding.
It is obvious that many states will face tremendous pressures regarding pensions in coming years. Many are facing them right now. Solving them, however, has less to do with the selection of the correct interest rate and more to do with proper funding practices, fund structures, and investment policies. Whatever the interest rate, we still have to pay the pipefitter.
Charles E.F. Millard was director of the U.S. Pension Benefit guaranty Corporation from 2007 to 2009 and is now a Managing director leading Citigroup’s Pension relations team.
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