Discount Rate for Public Pensions: A Case Study from Alabama

A recent study by Eileen Norcross at the Mercatus Center looks at Alabama’s public pension systems and shows how flawed accounting of pension liability obscures the true debt picture and creates perverse incentives for pension plan managers.

Most public pensions, following the Government Accounting Standards Board (GASB) guidelines, use the expected return on pension assets as the discount rate to value pension liabilities. According to the study, this practice is faulty. Economic theory holds that the discount rate must reflect the risk of the liability, not the expected return of the assets that finance the liability. Using the expected return of the asset to value the liability is equivalent to using the expected performance of a mortgage-holder’s investment portfolio to determine the value of the home mortgage, and this is clearly incorrect. In terms of risk, public pensions are comparable to government debt, because the pension benefits are protected under state law. Therefore, the appropriate discount rate for public pension liabilities should be close to the “risk-free” rate.

Using a discount rate much higher than the risk-free rate artificially reduces the value of pension liabilities, thereby reducing contributions below sustainable levels and creating a perverse incentive for plan managers to take excessive risks. It also conceals the real funding gap, making pension reform appear less urgent than it is. The study also debunks the claim that pension money invested in “economically targeted investments” (ETIs) brings great benefits to both the pension fund and the local economy.