Public pensions are being overly optimistic

This column often tackles controversial issues: race, gender, crime, the tragedy of people who order steak in restaurants.

Today, however, we’re going to have some real fireworks. We’re going to talk about the appropriate discount rate for public-sector defined-benefit pension plans.

Do I really dare to go there? Oh, yes, my friends, I dare. But first a little background.

Why we’re talking about this

The proximate cause of this column is an article in the New York Times, detailing the travails of a tiny government office that decided to withdraw from Calpers, the California state pension system, in order to switch to a 401(k) system. Officials at the office thought this would be a simple matter, since their members were fully paid in. Only it turned out it cost them more than $500,000 to make the switch, because when they went to leave, Calpers said “We meant fully funded if you stay, not fully funded if you leave.” In economist-speak, they used a different discount rate to calculate the termination value of the plan.

But as much as my heart goes out to the six participants in the pension fund of Citrus Pest Control District No. 2, their plight is not really why I decided to write a whole column. This is actually a hugely important issue for everyone — because while taxpayers remain oblivious to terms like “discount rate” and “hypothetical termination basis,” these terms are sneaking up and preparing to thwack them hard, in the wallet.

What is a discount rate?

It is not the 20 percent savings you got by buying a new washing machine on Black Friday last year. A discount rate is a way of accounting for the fact that dollars in the future are not quite the same as dollars you have right now.

You know this, don’t you? Imagine I offered to give you a dollar right now, or a dollar a year from now. You don’t have to think hard about that decision, because you know instinctively that the dollar that’s right there, able to be instantly transferred into your sweaty little hand, is much more valuable. It can, in fact, be easily transformed into a dollar a year from now, by the simple expedient of sticking it in a drawer and waiting. It can also, however, be spent before then. It has all the good stuff offered by a dollar later, plus some option value.

Even if you’re sure you don’t want to spend it in the next year, however, a dollar later is not as good as a dollar now, because it’s riskier. That dollar I’m holding now can be taken now, and then you will definitely have it. If you’re counting on getting a dollar from me a year from now, well, maybe I’ll die, or forget, or go bankrupt.

The point is that if you’re valuing assets, and some of your assets are dollars you actually have, and others are dollars that someone has promised to give to you at some point in the future, you should value the dollars you have in your possession more highly than dollars you’re supposed to get later.

The rule for establishing an exchange rate between future dollars and current ones is known as the “discount rate.” Basically, it’s a steady annual percentage by which you lower the value of dollars you get in future years.

All you need to remember is two things: the longer you have to wait to get paid, the less that promise is worth to you today. And the higher the discount rate you apply, the lower you’re valuing that future dollar.

Two possible rules for discounting pension plans

Now, we’ve been discussing future dollars as if they were an asset you will eventually have. But of course, if I’m the one who has to give you those dollars, then to me, they’re not an asset; they’re a liability, a debt I’ll have to repay. The math is the same regardless. But the incentives to choose a discount rate are a little different.

As Citrus Pest Control District No. 2 discovered to its dismay, Calpers was actually using two different methods to estimate its pension liabilities. The first method was used to estimate how close the plan was to being “fully funded” — able to pay all obligated benefits. That’s the number Calpers tells the public. However, when District 2 went to close out its pension, Calpers used a different method. One that said the plan was roughly $500,000 short of meeting its obligations.

These two different methods reflect a larger debate among actuaries over how we should be valuing public pension plans. One way is to discount the future payments you’ll have to make by something approaching the average annual profit you’d expect to earn by investing in a broad portfolio of stocks and bonds. I do, in fact, expect to invest my pension fund in a broad portfolio of stocks and bonds. That money will grow over time. I can therefore invest much less than a dollar today, and still deliver the promised dollar later. So if I discount the money I owe in the future by something like my expected investment returns, I’ll get a relatively good estimate of how much money I need on hand right now to ensure that those payments are eventually made.

The other way is to treat those future payments as if they’re a guaranteed income stream that has to be paid even if all the fund’s investments go to heck in a hand basket. And therefore, to use a very low discount rate to assess how big the fund’s liability is.

Imagine that you wanted to make absolutely certain that your investments paid out exactly $50,000 a year every year for the rest of your life. You’d want to stick the money in something really, really safe. Something like U.S. government securities. Which are currently paying 2.43 percent.

That money will be as close to a sure thing as we can get in this vale of tears. But it isn’t going to grow much, which means that if you want to generate, say $50,000 a year for 35 years, you’ll need to sock away more than $1 million right now. On the other hand, if you were expecting a 7 percent return, you’d only have to put away a little over $640,000.

The exact same math applies to discounting your future obligations, instead of calculating your future returns. When I’m trying to figure out how much I need to set aside now to pay what I’ll owe in the future, the size of the discount rate will tell me if the answer is “a little” or “oh, boy, time to sell the cat.”

If I am fond of my cat, however, I will have a strong urge to use as large a discount rate as possible.