- Using asset returns to discount liabilities has important behavioral implications
- Choice of a discount rate should not impact investment strategy
Pensions and endowments might create issues for themselves by relying on high expected returns
How do you think the following conversation with your mortgage banker would go? You give him a call and say that according to your most recent statement, you owe the bank a hundred thousand dollars. However, you have decided to invest all the assets you own in equities, junk bonds and this hot new hedge fund that everyone thinks will return 20% per annum. Therefore, instead of one hundred thousand dollars, you feel that you owe the bank only sixty thousand dollars.
The most likely outcome of this conversation would be your mortgage banker hanging up and flagging you as a high risk borrower.
As absurd as this may sound, some of the largest borrowers in the world are playing this exact game. Pension plans are generally allowed to select what rate they would like to discount their future obligations in order to determine liabilities. Selecting the appropriate discount rate has real economic and political decisions tied to it, and choosing a discount rate that makes liabilities look smaller plays into our human behavioral biases.
Theoretically, the present value of liabilities ought to be calculated using a risk-free interest rate for each point in time that the cash flows are expected to occur. This value of liabilities would represent how much money you would need to set aside today and not have to worry about the “what ifs”, except perhaps potential changes to actuarial assumptions. This number might even resemble something similar to what an insurance company might be willing to accept to take on similar future obligations.
However, discounting using a risk-free rate can make the result look ugly for entities such as public pension plans, which are allowed to use their expected return on assets as the discount rate. As an illustration, if we use data from an excellent paper on pubic pension plans by Joshua Rauh and Robert Novy-Marx the funded status for public pension plans in the US would fall from about 62% to about 44%.
In dollar terms, this is material – Using Rauh and Novy-Marx’s data for state pension plans from 2009, that almost doubles the stated shortfall of $1.2 trillion to $2.48 trillion!
The behavioral benefit/pitfall of using expected returns
This type of human behavior is one of the typical human biases that Dan Ariely refers to in his book Predictably Irrational. However, when applied to the world of pensions, it can result in potentially flawed decision making.
For example, if you look at the hypothetical illustration below, a plan that is 68% funded using a risk-free rate of 3%, appears over 100% funded at a 7% discount rate. Similar to the business school students, even though economically we have done nothing different, a 68 does not look as good as a 100, and we don’t like that answer.
However, expected returns are not certain, and there is a chance that those expected returns are not achieved. Generally, higher returns are accompanied with higher risk. Therefore higher the expected returns, the higher the chance that we don’t achieve the returns, and even potentially lose money. However, the more risk we take, the more returns we can say that we expect to earn (note – its not more returns, but more expected returns) – and if we have greater expected returns, we just magically reduced our liabilities.
As a result, we have moved from a low funded status number that we didn’t like to a higher number that we like. But in the process, all we have done is fool ourselves. I am not saying that we may not be able to achieve the 10% annual return on equities, or a 20% return on alternatives – skilled investment managers and CIOs may have the ability to generate these returns. However, assuming that these returns are certain, and using these expected returns to discount liabilities distorts the picture.
Hiding the risk has important implications.
Hiding the risk has important implications. For example, contributions to pension plans are determined using funded status – Therefore if you have fooled yourself into thinking you are well funded, you will make a lower contribution. It can also work the other way – if you think you are well funded, you may determine you don’t need to take too much risk, and end up investing in less risky assets than what you might otherwise.
A more stable exercise might be to stick to a standard method of valuing liabilities, lets say using a risk-free discount rate. Funded status becomes the result of Value of Assets / Value of Liabilities. The pension plan can calculate how much better / worse off that number they would be based on scenarios or expected return assumptions that they want to use for their assets. Effectively, you would separate your asset return assumptions from liability discounting.
In an interview with Sal Khan of Khan Academy, Eric Schmidt of Google spoke about how Google conducts meetings – they first put the facts on the table, and then they start the debate on what to do given the facts. If we obfuscate the facts that are presented, its hard to move forward and have a quality debate.
Therefore, lets put the numbers as they stand on the table, and then make our investment decisions following that.
- Public Pension Promises: How Big Are They and What Are They Worth?
- Cash flows, returns and discount rates are probabilistic
Disclaimer: All views expressed in this article are that of the author and do not necessarily reflect the views of his employer or any of its affiliates. The author may be associated as an investor or as an advisor with certain companies mentioned in this article.
Also published on Medium.