Understanding the argument for market valuation of public pension liabilities

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Article Highlights

  • Public-sector pensions need improved accounting rules.

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  • Pension accounting and funding rules should be designed to help stakeholders better achieve their policy goals.

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  • Arguments around fair-market pension valuation are often misunderstood.

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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.

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About the Author

 

Kent
Smetters
  • Kent Smetters is the Boettner Chair Associate Professor at the University of Pennsylvania's Wharton School and a faculty research fellow at the National Bureau of Economic Research. He previously served as deputy assistant secretary for economic policy at the U.S. Treasury. He coauthored Fiscal and Generational Imbalances: New Budget Measures for New Budget Priorities (AEI Press, 2003) and coedited The Pension Challenge: Risk Transfers and Retirement Income Security (Oxford University Press, 2004). He has published academic articles in leading journals, including the American Economic Review, the Journal of Political Economy, and The Quarterly Journal of Economics. He is often cited in major media outlets.
  • Phone: 215-898-9811
    Email: ksmetters@aei.org

 

Andrew G.
Biggs
  • Andrew G. Biggs is a resident scholar at the American Enterprise Institute (AEI), where he studies Social Security reform, state and local government pensions, and public sector pay and benefits.

    Before joining AEI, Biggs was the principal deputy commissioner of the Social Security Administration (SSA), where he oversaw SSA’s policy research efforts. In 2005, as an associate director of the White House National Economic Council, he worked on Social Security reform. In 2001, he joined the staff of the President's Commission to Strengthen Social Security. Biggs has been interviewed on radio and television as an expert on retirement issues and on public vs. private sector compensation. He has published widely in academic publications as well as in daily newspapers such as The New York Times, The Wall Street Journal, and The Washington Post. He has also testified before Congress on numerous occasions. In 2013, the Society of Actuaries appointed Biggs co-vice chair of a blue ribbon panel tasked with analyzing the causes of underfunding in public pension plans and how governments can securely fund plans in the future.

    Biggs holds a bachelor’s degree from Queen's University Belfast in Northern Ireland, master’s degrees from Cambridge University and the University of London, and a Ph.D. from the London School of Economics.

  • Phone: 202-862-5841
    Email: andrew.biggs@aei.org
  • Assistant Info

    Name: Kelly Funderburk
    Phone: 202-862-5920
    Email: kelly.funderburk@aei.org

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