Public Employee Retirement Plans and the Myth of the Risk-Free Rate

May 2, 2011 ( - For a few years now, with increasing intensity over the past couple of years, there have been calls for public employee retirement systems to determine and disclose liabilities using what proponents, in a cavalier manner, call the “risk-free rate.” 

These proponents, many of whom have direct (or at least indirect) ties to the investment banking community, have been putting a full court press on the Governmental Accounting Standards Board (GASB) to alter generally accepted accounting principles for public retirement plans, the end result of which would be accounting for liabilities based on a “risk-free rate.”  While they made some headway, apparently the current direction of the GASB does not meet with their approval so they have turned to Congress.  Think about that. Having failed to intellectually persuade the most highly recognized authorities on governmental accounting theory and practice, whose mission is to establish and improve standards of state and local governmental accounting and financial reporting, they have resorted to the political arena to further their cause. There are good reasons for having divorced governmental accounting standard setting from politics and those reasons are as strong today as they have ever been.

Einstein said we should make everything as simple as possible but not simpler.  In the simplest terms possible, there is no risk-free rate.  The term has great marketing appeal, which I suspect is why the proponents selected it, but even they have to know that any rate used will result in risks of some type associated with the functioning of defined benefit plans, in the plan sponsor’s personnel management objectives, and in the long-term cost to the taxpayers. 

A common approach to responsibly funding public retirement plans is to pursue intergenerational equity, meaning that the cost will be equitably shared over decades of time, with cost typically expressed as a percent of active participant payroll and targeted at being as low as is reasonably possible.  A number of assumptions (economic and demographic) must be made in arriving at the current required contribution and, in the aggregate, those assumptions must produce results that are reasonable.    With respect to intergenerational equity, if the assumptions are too aggressive, the current contribution rate will be too low and, if the assumptions are too conservative, the current contribution rate will be too high. 

The proponents of the use of a so-called risk-free discount rate maintain that current assumptions are too aggressive and could result in a burden on future generations if they have to make higher contributions than the current taxpayers.  As evidence, they commonly refer to public fund performance during the first decade of this century which included two periods in which equities lost about half of their value.  Beyond that, they reference the capital market expectations of investment consultants who predict market performance that is lower than presently being assumed in actuarial calculations.  As to the first piece of evidence, it is a prime example of data mining.  Regarding the capital market expectations of experts, those are typically presented as predictions over the next five to ten years.  While a period that short is useful as a point of reference it is important to remember that the discount period applicable in actuarial calculations for defined benefit pension plans is commonly eighty years or more.  Considering current common public fund asset allocations, the U.S. capital markets over the last eight decades have performed very much in line with current assumptions. 

However, for the sake of discussion, let’s assume that public plans revert to the “risk-free” rate for disclosure purposes.  From that point, it is reasonable to assume that if it is going to be used for disclosure it will ultimately be used for funding which logically would lead to portfolios structured for consistency with the assumptions, meaning laddered portfolios of treasury securities. (Coincidently, that transition should generate a boatload of commissions for certain interested parties and produce new found demand for U.S. treasury securities.)

The concept of pension plan sustainability has been getting a lot of lip service of late.  In the simplest terms, in order for a defined benefit plan to be sustainable the benefits cannot be too high or too low and the cost cannot be too high.  With the change in the discount rate being advocated, there is not much question that current benefit levels (even  in the bulk of the plans where they are quite reasonable) would be deemed to be too costly.  That would lead to calls for substantial reductions in benefit levels, likely to a point where they would not be viewed as being valuable by the employees.  With this outcome, what are the new risks?

  • If the benefits are not deemed valuable by the employees, there should be an expectation of higher rates of employee turnover.  The public employer becomes a training ground for the private sector which leads to higher costs and lower productivity for each full time equivalent position.  Remember, defined benefit plans are intended to attract and retain employees.  If the retention feature disappears then the employer might just as well eliminate the plan, thus making public employment even less attractive.
  • Employees who do stay but who have inadequate retirement benefit accruals are going to need to work well beyond their peak productivity years and eventually be dependent on entitlement programs for bare necessities in their retirement years.  (Those who suggest that they should just save on their own have not looked at the reality of public sector pay levels recently.) Entitlement programs for the elderly can be demeaning to the recipients and, from the taxpayer perspective, they are the most expensive form of public retirement plan in that they are totally unfunded.
  • The solution offered by some is to simply replace all public sector defined benefit plans with defined contribution plans which advocates suggest will shift the risk from the employer (taxpayer) to the employee.  There again, they have a very parochial view of what constitutes risk and must be completely oblivious to what has happened in the 401(k) world.  Higher than expected unemployment rates is a risk area if older employees who are about to retire find that they can’t live on depleted accounts and stay on the job, whether they want to be there or not.  For each one who should have retired but could not afford to do so, there is a younger person for whom there is not a position in the workforce, resulting in the risk of higher unemployment insurance rates and increased pessimism about the viability of the economy.

These are the obvious potential risks and I’m sure there are others.


Are there Reasonable Solutions

The common condition seems to be to address compensation issues on a piece meal basis where cash compensation and benefits are dealt with separately.  There are compelling reasons for evaluating matters on a total compensation basis where a price tag is applied to the fringes so that all parties are conversant with total personnel costs. Considering the magnitude of personnel costs as a percent of the total cost of government, this is a matter deserving of more than just a passing glance. 

One approach that may merit consideration would involve the establishment of a non-partisan task force made up of representatives of management and labor from the governmental entity plus individuals from the private sector who have a strong working knowledge of personnel and total compensation issues.  The work product of such a group would ideally be a process for the ongoing evaluation of total compensation with recommendations for changes being developed and presented to policy makers when warranted.  Among the key features of such a work product would be identification of the appropriate mix between current and deferred compensation.  In this instance, the deferred portion would consist of targets for appropriate levels of retirement and other post-employment benefits, based on years of service, with clear understandings of their related costs. (Here the costs should be determined on the basis of what is achievable and not using fabricated discount rates that bear no relationship to historic reality or future prospects.)

Next:  The 401(k) Myth

- Gary Findlay, Executive Director, Missouri State Employees’ Retirement System (MOSERS).   

Mr. Findlay is executive director of the Missouri State Employees' Retirement System (MOSERS), a position he has held since 1994. Prior to that, he spent 16 years as an administration and benefit consultant with Gabriel, Roeder, Smith & Company, a national actuarial and benefits consulting firm that specializes in serving the needs of public employee benefit plans. He was CEO of that firm from 1986 until he joined MOSERS.