Understanding the valuation of public pension liabilities: Expected cost versus market price

i4lcocl2 / Shutterstock.com

Article Highlights

  • Market-based measurements ignore expected investment earnings.

    Tweet This

  • Current valuation practice provides information about expected actual cost to the employer and, ultimately, to the taxpayer.

    Tweet This

  • Current valuation practice qualitatively and quantitatively incorporates more information than the market-based method.

    Tweet This

Subscribe to AEI's retirement emails
Articles and events on retirement, pensions, Social Security, aging, and entitlement programs. Published approximately twice a month.

First Name:
Last Name:
Zip Code:

With US state and local economies in slow recovery, workforce costs—including pensions and other benefits—remain front-page news. Taxpayers and public officials want to know the size of their financial obligations to employees and retirees for retirement benefits to assess how much it will cost—today and in the future—to meet those obligations.

Determining these obligations should be straightforward because governmental accounting standards and professional actuarial standards outline accepted methods for measuring pension liabilities. In particular, current practice measures pension obligations using long-term assumptions and methods, including an expected rate of return on plan assets. But alternative measures of pension liabilities are increasingly reported in the press. One measure might peg the size of the liability as two or even three times the size of the liability measures currently in use. As a result, a great deal of confusion and controversy has resulted over which measure is “correct.”

The controversy around measuring pension liabilities centers on a familiar subject for sponsors of public pension plans: the applicability of what is called the “market value of liabilities” (MVL) to public-sector pension obligations.[1] This paper explores the conceptual differences between two competing measures of liabilities: current practice versus the market-based measure. It also examines which measurement is most useful for public-sector decision makers. Finally, it reviews some of the issues that have yet to be resolved regarding measuring these pension obligations.

Background: Current Practice versus Market-Based Measurement

Current practice for measuring the pension liabilities of public-sector pension plans provides information to plan stakeholders and decision makers about how much it will cost over time to satisfy the financial obligations to participants. This is accomplished by calculating what is called an actuarial accrued liability (AAL), which is based on both current information and reasonable expectations of future events.[2] The AAL measure is based on long-term methods and assumptions. It not only takes into account the service and pay earned by employees, but also anticipates future service and pay raises, which will increase the plan’s obligations. Current practice also incorporates information about the future investment earnings of the plan’s assets when selecting what is called the “discount rate.”[3] In determining the AAL, the discount rate used to calculate public-sector pension liabilities is the long-term expected investment return on the plan’s investment portfolio.

The MVL approach differs from the AAL approach in important ways, especially when it comes to the discount rate. MVL measurements ignore expected investment earnings, and instead use current market rates of interest on relatively secure fixed-income instruments (for example, US Department of the Treasury rates or high-grade corporate bond rates). As I discuss in the next section, the theory behind the MVL measure is that because public-sector pension benefits are fairly certain to be paid, they should be valued the same way that the market prices securities that have a similarly low “default risk” are valued. This would indicate the use of the lowest current market interest rates, which are often called “risk-free” rates. Note that “risk-free” does not mean such rates are free of investment risk, but rather that they are the rates implicit in the market pricing of securities that, like public pensions, have low default risk.

There are other important differences between the AAL and the MVL. For instance, the MVL uses a much narrower definition of future benefits to calculate a plan’s liabilities, one that assumes that pay and service are frozen at current levels.[4] However, our discussion will focus on the current controversy surrounding the discount rate: when measuring public pension liabilities and costs, should future benefit payments be discounted by using the expected long-term return on plan assets or by using current market interest rates?


   1. For an introduction to the MVL approach to valuing pension liabilities, see The Segal Company, “Market Value Liability and Public Pension Plans: A Continuing Controversy,” January 2009, www.segalco.com/publications/publicsectorletters/jan2009.pdf.
    2. The AAL is the liability for all service to date. A pension valuation also determines a “normal cost” for active members, which is the cost for the next year of service. For active members, the AAL is the current value of the normal costs for past years of service. For inactive members, the AAL is simply the present value of their future benefits.
    3. Any current measure of a pension plan’s liability is essentially a calculation, in current dollars, of some portion of the value of future benefit payments. In recognition of the time value of money, future benefit payments must be “discounted” to arrive at a value today.
    4. For a detailed description of these differences, see The Segal Company, “Market Value Liability and Public Pension Plans.”

Read the full report.

Other reports in this series:


Also Visit
AEIdeas Blog The American Magazine

What's new on AEI

Love people, not pleasure
image Oval Office lacks resolve on Ukraine
image Middle East Morass: A public opinion rundown of Iraq, Iran, and more
image Verizon's Inspire Her Mind ad and the facts they didn't tell you
AEI on Facebook
Events Calendar
  • 21
  • 22
  • 23
  • 24
  • 25
Monday, July 21, 2014 | 9:15 a.m. – 11:30 a.m.
Closing the gaps in health outcomes: Alternative paths forward

Please join us for a broader exploration of targeted interventions that provide real promise for reducing health disparities, limiting or delaying the onset of chronic health conditions, and improving the performance of the US health care system.

Monday, July 21, 2014 | 4:00 p.m. – 5:30 p.m.
Comprehending comprehensive universities

Join us for a panel discussion that seeks to comprehend the comprehensives and to determine the role these schools play in the nation’s college completion agenda.

Tuesday, July 22, 2014 | 8:50 a.m. – 12:00 p.m.
Who governs the Internet? A conversation on securing the multistakeholder process

Please join AEI’s Center for Internet, Communications, and Technology Policy for a conference to address key steps we can take, as members of the global community, to maintain a free Internet.

Event Registration is Closed
Thursday, July 24, 2014 | 9:00 a.m. – 10:00 a.m.
Expanding opportunity in America: A conversation with House Budget Committee Chairman Paul Ryan

Please join us as House Budget Committee Chairman Paul Ryan (R-WI) unveils a new set of policy reforms aimed at reducing poverty and increasing upward mobility throughout America.

Thursday, July 24, 2014 | 6:00 p.m. – 7:15 p.m.
Is it time to end the Export-Import Bank?

We welcome you to join us at AEI as POLITICO’s Ben White moderates a lively debate between Tim Carney, one of the bank’s fiercest critics, and Tony Fratto, one of the agency’s staunchest defenders.

No events scheduled this day.
No events scheduled today.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.