State pension funds have long struggled with being underfunded — a problem that has led them to increase contributions and set return hurdles that are challenging to meet.
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This One Trick Could Improve Funded Status for Almost All State Pensions
Researchers have found a new way to determine discount rates and allow pension funds to get a more accurate picture of their financial health.
But according to researchers at Florida International University, there could be a better way to determine funded status that would not only improve the accuracy of these calculations, but also the health of the funds. The researchers say that their method could bolster the funding ratio of 94 percent of state pension funds.
This is important, because the United States faces an interest rate regime shift and a potential recession, both of which could shake up funded status for pension funds. This could result in increased contributions from states or higher pressure on investment teams to achieve better returns.
At present, state pension funds calculate their funded status by using discount rates, which determine their future liabilities, based on the pension’s historical performance.
“These rates are generally overstated, creating the appearance of a healthy funding ratio at the cost of future underfunding,” according to the paper, which was published in February by Robinson Reyes-Peña, Krishnan Dandapani, and Edward R. Lawrence, who work in FIU’s department of finance.
Academics who study pensions have been working for years to find a better way to calculate funded status, with some suggesting that these funds use U.S. Treasury rates instead of the discount rate. But the paper’s authors argue that doing so would make funding gaps look larger, particularly in zero-interest-rate environments like those seen in the years following the global financial crisis.
Instead, the model they’re proposing sets a lower limit on the discount rate. The new model ensures that the discount rate won’t dip below a metric called the value at risk return, which quantifies the extent of potential portfolio losses. The researchers propose that investors use this metric along with modeling the least risky portfolio allocation that a pension would use to still generate a reasonable return.
Their goal is to avoid using portfolio allocations — such as 100 percent invested in cash, for instance — that the pension fund isn’t likely to use.
According to the researchers, this in turn avoids the overstatement of required contributions, which shows up when funds use Treasury discount rates. “Hence, the implementation of a Treasuries discount rate could be less problematic for pension plans,” they wrote.
The authors tested whether this would be more appropriate using data from the Public Plans Database, collected via a project run by Boston College’s Center for Retirement Research. The sample-set includes data from 219 pension plans across the United States from 2001 through 2020.
The researchers say that their method would improve the funding ratio of 94 percent of state pension funds, with the lowest increase in contributions compared to several alternative methods. By comparison, using current practices, just 13 percent of funds are able to increase their funding levels.
They also estimated that the need for an increase in contributions using their method is 52.5 percent lower than it is when using the 10-year Treasury rate.
There are, of course, barriers to implementation. State pension funds can move slowly, and it can be tough to encourage boards to consider new research.
In addition, the researchers noted that further study would be needed to determine if moving to this new measurement process would be affordable.