Rockefeller Institute Gets it Right

 

In January of 2014, The Nelson A. Rockefeller Institute of Government issued a report titled “Strengthening the Security of Public Sector Defined Benefit Plans”.[1]

The report makes a compelling argument that the proper rate for valuing pension liabilities on financial statements is separate from the question of what pension funds assume they will earn on their investments.

A More Accurate Estimate of Ultimate Cost

Rather than valuing future liabilities based on the “assumed rate of return” declared by the pension system, the report says a fairer picture of the true cost of the plan for all stakeholders would be a discount rate tied to some instrument like high quality municipal bond rates.

It is important to emphasize that this study, and others like it, aren’t opposed to retirement systems setting target or “assumed” rates of future return for investment purposes. The important distinction is that, for financial statements, it would be far more reasonable to use a discount rate from actual market instruments, instead of some “assumed” long term rate in the future.

Nothing to be Afraid of

Unfortunately, many public retirement systems have taken a negative view of this proposal.   The fear seems to be that taxpayers and other stakeholders will be shocked by what they see as the potential long -term cost of the plan, when measured more conservatively. In that regard, the study does not argue for valuing such plans on a “risk free” rate of return, as have some other similar studies. Instead, it advocates for the use of a discount rate on high quality municipal bonds, or something similar.

Administrators of public retirement systems should not fear using such a measurement.   In actuality, it would  help the longer- term health of these plans if there was a more frank and realistic discussion of what the costs of these plans could be, particularly if they are not managed prudently. It would also make politicians less likely to skip or reduce required pension payments since it would highlight the impacts of under-funding more significantly.

Stakeholders deserve a more honest assessment of what these plans will likely cost. Shareholders in a corporation may vote with their feet by selling shares in a company that is not properly managing its pension liabilities. Taxpayers, on the other hand, can’t opt to do the same thing unless they pick up and move to another locality, which can be a costly and impractical proposition.

Being Well Informed is Better Than Ignorance

Since as much as 70% of the benefits from a retirement system can be derived from investment returns, it is of course important to maximize earnings as prudently as possible. However, it is equally important to minimize risk, and to evaluate those risks in the most realistic fashion. Keeping stakeholders in the dark about the true ultimate costs of these plans will only increase the negative feelings and apprehension that has been building against public sector defined benefit plans for the past decade. A more honest and forthright estimate of potential costs will serve to benefit public employees in a number of ways, including making required funding payments and avoiding political tampering with benefits and cost estimates. In the long run, that will not only bolster the financial security of these plans, but also make them more respected for being prudently managed.

I encourage you to read the full report at www.rockinst.org.

Gregory Seller Consulting, LLC

All rights reserved. May not be reprinted in whole or in part without written permission. Provided for information only and is not legal or investment advice. Plan sponsors should seek their own legal and investment advice on this issue.

 

 

 

[1] The Nelson A. Rockefeller Institute of Government is the public policy research arm of the State University of New York. The full report may be accessed at www.rockinst.org