A Pension Promise Valued on a Return It May Not Earn
Public pension funds report their health using an assumed rate of return on their investments. A small change in that assumption moves the reported shortfall by enormous amounts.
The Promise and the Pile of Money
A defined benefit public pension promises retirees a specified payment, usually based on salary and years of service. To fund it, the government sets aside contributions and invests them. The question that determines whether the system is solvent is whether the invested assets, plus future contributions, will cover the promised payments.
Answering it requires comparing two things measured at different times: assets held today and payments owed over decades. Bringing future payments back to a present value requires a discount rate, and the choice of that rate is where the trouble lives.
The size of a pension shortfall is not mainly a fact about the pension. It is largely a consequence of the rate chosen to value the promises, and that rate is chosen by the people the number reflects on.
Why the Discount Rate Dominates
Pension liabilities extend far into the future, and discounting compounds. A payment owed in thirty years, discounted at 7 percent, has a present value less than a third of the same payment discounted at 4 percent.
Because the liabilities are so long dated, a small change in the rate produces an enormous change in the reported liability, and therefore in the gap between assets and liabilities.
| Assumed rate | Reported liability | Funded status |
|---|---|---|
| Higher (optimistic) | Smaller | Looks healthier |
| Lower (conservative) | Larger | Looks worse |
The Practice That Draws Criticism
Public pension funds in several systems have traditionally set the discount rate equal to the expected return on their investments, often in the range of 7 percent, reflecting a portfolio of equities and other risky assets.
Financial economists have long objected. Their argument is that the discount rate should reflect the risk of the liabilities, not the risk of the assets. The pension promise is close to a guaranteed obligation, so it should be valued using a low, safe rate comparable to government bonds, regardless of how the assets are invested.
Using the expected return on risky assets to discount a near guaranteed promise assumes the risky returns will be earned, which is precisely what is uncertain. It reports the fund as healthier by assuming away the risk that the assumption fails.
The Incentive Problem
The reason the optimistic practice persists is that the parties choosing the rate benefit from the answer it gives.
A higher assumed return produces a smaller reported liability, which means smaller required contributions today. For a government facing competing demands on its budget, a higher rate lowers the pension bill now and pushes the cost into the future. The officials who benefit from the lower contribution are frequently not the ones who will be in office when the shortfall becomes undeniable.
This creates a structural bias toward optimism that has nothing to do with a genuine forecast of returns, and it explains why reforms to lower assumed rates are resisted despite the economic argument being widely accepted.
The Risk of Reaching for Return
There is a second effect that compounds the first. If a fund needs a 7 percent return to make its assumption true, and safe assets yield far less, the fund must take investment risk to have a chance of hitting the target.
This pushes public pensions toward equities, private equity, real estate and other risky assets, not purely as an investment judgement but because the reported funded status depends on assuming the higher return. The assumption drives the portfolio, rather than the portfolio informing the assumption, which is backwards.
When markets fall, these funds take losses on portfolios sized to hit an aggressive target, and the shortfall the optimistic rate concealed becomes visible at the worst moment.
Why It Matters Beyond the Fund
An underfunded public pension is a claim on future taxpayers. The promised payments must be made, and if the assets fall short, the difference comes from future budgets through higher contributions, higher taxes or reduced services.
Because the shortfall is obscured by the discount rate, the true scale of these claims is understated in official figures, and the adjustment when it arrives competes with every other public spending priority. The gap does not go away by being valued optimistically. It is transferred to a later generation and a later government.
The Bottom Line
Public pension health is reported using an assumed return that also serves as the discount rate, and because the liabilities are long dated, that single assumption dominates the reported shortfall. Setting it to the expected return on risky assets makes the fund look healthier by assuming the risk away, lowers contributions today, and pushes the portfolio toward risk to justify itself. The economic case for a lower, liability matched rate is strong and resisted, because the optimistic number serves the people who choose it and the cost of the truth falls on a later budget.