Are Public or Private Pension Funded Ratios Caused by their Discount Rate?

Do particular accounting measures cause certain levels of funded status for pension plans? This is the underlying question in a study from the Society of Actuaries, which looks at both public sector and private sector pension plans. Specifically, they look for a statistical relationship between the funded ratio of a pension plan — that is, measure of assets in a pension fund compared with the retirement promises made — and the “discount rate” that pension plan uses. A discount rate is a tool in the process of estimating the value of promised pension benefits. Actuaries use the discount rate as a way to translate future promised pensions into the value of money today.

The Society of Actuaries paper finds that that as a group, staten and local pension plans tend to use higher discount rates than private plans, and they also have lower funded ratios (generally speaking). Since higher discount rates tend to make funded ratios look stronger, all else equal, this is a troubling find. However, the Society of Actuaries paper does not find a statically causal relationship between plans with low discount rates and high funded ratios. Instead, they surmise there is an indirect relationship.

A likely explanation for the phenomenon where higher discount rates are generally associated with pension plans that have low funded ratios is that retirement systems using those high discount rates are probably also using other aggressive or optimistic actuarial assumptions. And these other assumptions may have a closer relationship to the growth of unfunded liabilities and decline of funded ratios. For example, with public pension plans we know that high discount rates are a result of high assumed rates of return (because public pensions almost always just copy the assumed rate of return on assets when deciding on a discount rate for valuing benefits). Higher assumed rates of return could suggest a pension board’s asset allocation has trended away from safer, fixed income investments, and is thus more exposed to market volatility and investment return underperformance. And underperforming investments have been the largest driver of unfunded liabilities. Similarly, a plan that is willing to use a high discount rate may also be willing to use an aggressive payroll growth assumption or use an open amortization method. And this is also a driver of pension debt.

Thus, while the Society of Actuaries report does not find a direct relationship between funding status and discount rate, that doesn’t mean there isn’t an observed indirect relationship between high discount rates and relatively lower funded ratios.

When it comes to funding defined benefit pension plans, it is commonly understood that the discount rate used to compute liabilities plays a significant role. For any given pension plan, a lower discount rate results in a higher liability, which means a lower funded status. Discount rates, however, are only one of a multitude of factors involved in pension funding. Other factors include the approach to plan and risk management, methods for computing assets and liabilities, the length of time and methods for amortizing unfunded liabilities, and the way that contributions are determined.

This article compares the recent historical relationship between pension plan funded status and discount rates used to compute liabilities for funding purposes.1 Comparisons include all three major categories of defined benefit pension plans in the United States: single employer (SE) plans, multiemployer (ME) plans, and state and large city public plans (PP).2 Reflection is limited to the question of whether discount rates were driving the differences in funded status, without any attempt to explain why funded status differs. […]

Here is a summary of key findings from 2009-2014:

– In general, funding discount rates for PP and ME plans were significantly greater than those for SE plans, with PP discount rates having been somewhat greater than ME rates.
– Although the category with the greatest discount rates (PP) was the least well funded, statistical analysis reveals that discount rates were probably not driving the differences in funding levels. While they are not explored in this article, many other factors involved in pension plan funding also differed among and within pension plan categories, including methods for computing unfunded liabilities, overall approaches to plan and risk management, and the way that contributions are determined. […]

Discount Rates for 2014
The theoretical basis for selecting discount rates to calculate funding liabilities differs among plan categories and is subject to ongoing debate. SE plans are legally required to use a modified market-based discount rate, while ME and PP actuaries typically use an expected-return approach to set the discount rate. Usually, expected-return discount rates are greater than market-based discount rates, resulting in lesser liabilities for a given plan.

The following graph compares the frequency of discount rates for funding purposes for 2014, the most recent year available for all three categories of plans.3Note that when the liability-weighted average differs significantly from the median, it is usually because the rates of the largest plans differ significantly from those of most plans.