Public-Sector pensions are using risky projections to calculate their future liabilities, according to a new report from the C.D. Howe Institute. In “Managing Uncertainty: The Search for a Golden Discount-Rate Rule for Defined-Benefit Pensions,” authors Stuart Landon and Constance Smith find that the high discount rates used by many public sector pension plans increase the risk they will have insufficient assets to meet their future obligations.
“Employers and employees have an incentive to keep the discount rate high in order to reduce the contributions they pay today,” said Smith. “But the use of a higher discount rate increases the risk a plan will not have sufficient assets to meet its future obligations.”
Pension fund sponsors use a discount rate to determine the value of assets they must set aside today to pay for promised benefits in the future. If the rate is too high, the assets are too meagre, and vice versa. The authors examine whether there is an optimum discount-rate rule that strikes the right balance. The choice of discount rate can have a dramatic effect on the value of a pension plan’s liabilities and, therefore, the assets needed to meet plan obligations. In a world with no uncertainty, if the discount rate is the same as the rate of return on pension plan assets, the projection of future liabilities would be equal to the value of plan benefit payments made in the future. However, pension plan assets and obligations are inherently unpredictable and their future value uncertain. As a consequence, the assets accumulated by a pension plan can differ markedly from the assets required to meet actual future payments.
The study analyzes six discount rate types, or rules, and assesses each rule’s success in meeting the competing objectives of minimizing the accumulation of excess assets and ensuring a high probability that future benefit obligations are met. If approximately equal weight is given to achieving these two objectives, the best performing rules are a 10-year moving average of the high-quality corporate bond yield and an inflation forecast supplemented by a constant real interest rate. Both of these rules yield average discount rates below the expected rate of return on assets, but higher than the riskless rate of interest.
While many public-sector pension plan sponsors in Canada prefer a relatively high pension plan discount rate, such as the expected return on plan assets, the authors find that the use of this higher discount rate generates a substantial likelihood that these plans will not accumulate sufficient assets to pay promised benefits.
“There is a need for prudent regulation of pension plan discount rates,” said Landon. “Public-sector pension plans receive little guidance on the choice of discount rate, in practice, many such plans use a rate higher than our best performing rules.”