Valuing Liabilities in State and Local Plans

Source: Alicia H. Munnell, Richard W. Kopcke, Jean-Pierre Aubry, and Laura Quinby, Center for Retirement Research at Boston College, SLP #11, June 2010

From the abstract:
To measure the liability of a pension plan requires discounting a stream of promised future benefits to the present. For public sector plans, what discount rate to use in this calculation is a subject of great debate. State and local plans generally follow an actuarial model and discount their liabilities by the long-term yield on the assets held in the pension fund, roughly 8 percent. Most economists contend that the discount rate should reflect the risk associated with the liabilities, and given that benefits are guaranteed under most state laws, the appropriate discount factor is a riskless rate, roughly 5 percent, as discussed below. Thus, the economists’ model would produce much higher liabilities than those currently reported on the books of states and localities. The intensity of the debate is fueled by the assumption that the magnitude of the liabilities dictates the size of the funding contribution and even how the pension fund assets should be invested.

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