Making sense of the pension gap

Canada, the U.K. and the Netherlands, all countries dependent on defined benefit retirement plans, assume rates of returns on plan investments that are far less generous than the 7.5 to 8 percent U.S. public pension plans tend to expect.  

That’s the lead observation offered in a new report from the Government Accountability Office, based on its review of how public pension plans assess and report their future liabilities. It conducted the review at the request of retiring Sen. Tom Harkin, D-Iowa.  

Canada, the GOA said, requires use of multiple measures of plan obligations, based on both assumed returns and high-quality bond rates and annuity prices.  Also read: Stockton restructuring plan approved  The Netherlands requires that plan obligations be measured based on market interest rates, but allows the use of assumed returns for determining plan contributions or developing recovery plans.  

In the U.K., discount rates are determined on a plan-specific basis and can include some allowance for assumed returns in excess of high-quality bond rates, depending on plan characteristics and the strength of the sponsor.  

To the extent that plans in these countries use long-term assumed rates of return, they are generally lower than the returns used by many U.S. public plans under recent market conditions, the GAO said.   All defined benefit plans use interest rates to “discount,” or value, future benefit payments in today’s dollars. Discounting is based on the idea that $1 paid in the future is worth less than $1 invested today because the invested dollar will grow with interest. But how that dollar will grow, and which interest rates should be used to project growth, are subject to significant debate.  

The “assumed-return approach” is based on the average rate of return on pension assets, which typically include a significant mix of stocks, and, these days, lower-yielding bonds. The “bond-based approach” sets a discount rate based on market prices for bonds, annuities and other fixed-income instruments. 

The difference in projecting liabilities between the assumed-return and bond-based approach can be huge. 

The GAO said the future liabilities for a plan could be 80 percent higher for a bond-based discount rate, compared to an assumed-return rate that expects 8 percent returns. 

In today’s low-interest rate world, that means plans using bond-based discount rates could be healthier then they appear – once interest rates go up.