How to Keep Pension Promises: Be Reasonable

People are living longer, but the same stamina doesn’t exist for pension promises.

World Population Density Map

World population density map with vector characters located in the most populated ares white background

Great news, reader: Your generation will live a lot longer than your parents’! Not-great news: Your longevity will sow the seeds of a global population catastrophe that will probably destroy social services as we know them and unravel the very foundation of governments by siphoning away precious resources to pay for legacy pension and health care promises.

Hyperbole? Maybe. But answer me this: Who is going to pay for the commitments we’ve made to the rising generation of nanobot-infused centenarians? You? Me? This question is about as easy to answer as “What should we do about climate change?”

Politicians would no doubt prefer to spend today’s resources on today’s problems rather than allocate those resources to cover a distant liability due in decades. But is that the right thing to do with climate change or for legacy costs? Probably not. That doesn’t stop the current generation of leaders from accepting useful fictions in the pursuit of present-day policy objectives.

Consider first the climate change debate. Yes, my friends, climate change is real. The gases pouring into the atmosphere don’t lie. And yet many on the right still deny climate change: A 2011 study found that conservative white American males were far more likely than other Americans to deny climate change. Why? Denying climate change allows them to maintain their free market identity and ontology. In short, it’s a useful fiction.

Now let’s look at the case of pension promises, where a similar fiction has taken hold — this one in the form of an augmented discount rate. Many left-leaning stakeholders hold on to flimsy arguments in order to justify high expected return targets. In case readers aren’t familiar with the way U.S. public pensions calculate their future liability, here’s how it works: The higher the target returns set by the board, the higher the discount rate used by actuaries to assess the liabilities, the lower the recognized liability and the lower the short-term cost to the government sponsor. So if a pension fund can assume a rate of return above 8 percent — which it can only do through a very aggressive allocation to high-risk assets — the sponsor can minimize the present-day cash outflows to fund the pension.

This, I hope, helps explain how you get a median return assumption among U.S. plans of around 7.75 percent, which is far beyond any reasonable estimates for long-horizon investment performance. To be clear, this discount rate implies that equity markets will deliver almost 10 percent. Every. Year. Sorry, my left friends, that ain’t happenin’.


But the fiction continues. I have personally seen state and local funds where the board, actuaries and consultants set expected return targets to protect the interests of their plan sponsors. It’s not overt, but it’s done. It reminds me of my days as an investment banker when my boss would tell me what multiple he wanted on a company’s valuation up front, and I’d have to “goal seek” throughout my model’s assumptions in order to get what was desired. The entire exercise was, similarly, a fiction created to win a client’s business.

For a lesson in common sense discounting, take the case of the (aptly named) Ontario Teachers’ Pension Plan. Here’s how this sophisticated investment organization thinks about expected return targets and discount rates: “The discount rate reflects what the plan’s assets can reasonably be expected to earn over the long term. From this are subtracted the cost of running the pension plan and provisions for major adverse events, such as the 2008 financial crisis and the tech bubble in 2001.” In other words, Teachers’ explicitly considers the capabilities of its fund (which are very strong) and then overlays what is reasonable given market movements. And what number does all that lead OTPP to assume?

The plan’s forecast is 4.8 percent (2.75 percent real), which is a full 3 percent lower than its American cousins’. Now consider that U.S. plans are 74 percent funded based on that 7.75 percent discount rate, and you’ll start to get a sense for the size of the problem. We’re talking about trillions of dollars of unrecognized costs looming.

These useful fictions — from climate change deniers on the right to discount rate inflators on the left — exist for personal and often political gain. It’s a form of “motivated reasoning,” and, sadly, it has nasty consequences over the long term. Just as people point to the environmental damage being wrought by the climate crisis, I constantly see the economic damage wreaked by improperly elevated discount rates.

Consider how this all plays out with an example:

A government exerts undue pressure on a board to maintain a high discount rate, which keeps the reported liability small and frees space in the government’s budget for other spending (or simply maintains a credit rating). The discount rate may be a fiction drawn from a goal-seeking exercise, but the ends — the politicians tell themselves — justify the means.

In order to make this fiction plausible, the board has to “work” with the actuaries and consultants to set an asset allocation policy that can actually justify the high discount rate. This means asking the plan to take on much higher risk, which is the only way to increase expected return. The board may or may not realize that its fund is not equipped to handle this risk, but it is willing to push forward (probably because it can blame the consultants if the thing blows up). The fiction is maintained.

The board thus tells the management team to overweight alternative assets, such as private equity and hedge funds, as that’s where the consultants say past returns were sufficiently high to warrant optimistic expected returns. It doesn’t matter that past performance is not a predictor of future performance; the fiction continues.

Accessing these alpha-generating managers is difficult and costly, which means using more intermediaries to fill up their buckets full of alternatives. Enter funds of funds and fees on top of fees. While alignment of interests and even a basic understanding of the underlying investments have been lost to the altar of alpha, the fiction, through it all, is maintained.

And because we haven’t yet really thought about risk or cost (let alone alignment), our understaffed pension management team is destined to underperform. And — surprise, y’all — that’s precisely what the research shows is happening: As public pension funds push into riskier assets to increase their expected returns, their actual, real-world performance suffers. In short, the nonfiction liabilities become less secure as we pursue the fiction.

This is crazy. But it happens; this is real. Even though some funds’ discount rates have crept lower under the intense pressure of stakeholders, by and large, the fiction remains intact.

So, how do we change all this? I will echo the seminal paper by Exley, Mehta, and Smith from 1997 in which the authors make a simple point: What a pension fund does with its assets clearly affects its ability to pay pensions, but the discount rate should be separate from asset allocation choices.

To be clear, I didn’t write this to promote the idea of using a risk-free rate for discounting liabilities. Calling for a risk-free discount rate, as some financial economists have said is appropriate, is about as sane as my students calling for a complete divestment from fossil fuel companies to ameliorate climate change. It’s just too far.

We haven’t mandated an end to all carbon emissions to prevent a climate crisis, and we need similar flexibility here. A government is not an insurance company. A government is not a corporation. We should consider its unique nature when we think about the discount rate for this form of liability. That being said, I do believe something has to change.

The tail is very clearly wagging the dog, and this has tons of negative implications for the way money is actually invested. In fact, I think the alternative-asset managers of the world are benefiting from a massive government subsidy in the form of this inflated discount rate, which forces pensions to fill buckets full of crappy alternative-investment products that do not merit the risk or the cost. Can you point to a single politically motivated decision that has created more billionaires in America while diverting capital to short-horizon, high-risk bets? I can’t.