{"id":256,"date":"2016-08-04T07:00:38","date_gmt":"2016-08-04T11:00:38","guid":{"rendered":"http:\/\/www.focus262.com\/blog\/?p=256"},"modified":"2016-08-03T13:38:05","modified_gmt":"2016-08-03T17:38:05","slug":"why-liability-discount-rates-matter","status":"publish","type":"post","link":"https:\/\/www.focus262.com\/blog\/2016\/08\/why-liability-discount-rates-matter\/","title":{"rendered":"Why liability discount rates matter"},"content":{"rendered":"

Earlier this year I had written about the behavioral implications of high expected returns (see High Cost of High expected returns<\/a>). Two recent articles in the Economist and Bloomberg Gadfly highlight the increasing awareness that a more informed dialog is needed.<\/p>\n

The Economist article<\/a> features a recent academic paper that shows that regulatory differences in valuing liabilities incentivizes public pension plans to pursue strategies that are riskier than private\/corporate pension plans.<\/p>\n

However, pursuing riskier strategies comes with, well er\u2026 risk, that you may not achieve the expected returns. With its recent investment performance Calpers\u2019 20 year investment returns have fallen well below its expected return of 7.5%. Lisa Abramowicz, in a recent column for Bloomberg Gadfly<\/a>, sums up the conundrum that this leads to:<\/p>\n

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“This is the conundrum that Calpers and other pension plans find themselves in. Without an adequate investment return over the long term, they could have trouble meeting their obligations to retirees. But achieving that return with a carefully diversified strategy is going to be incredibly difficult as central banks continue to suppress borrowing costs globally.\u00a0That leaves the sort of high-risk, high-reward swashbuckling that can end in disaster. Or a reality check on true returns and what that means for workers and retirees.”<\/div>\n
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The good news is that, as a recent report<\/a> by McKinsey highlights, some of the largest investors are recognizing that a different approach to liabilities is needed, with 92% of the largest pension investors indicating an increased investment in understanding their liabilities.<\/p>\n

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\"Increasing<\/a><\/p>\n

However, it was disappointing to read<\/a> that the Society of Actuaries had recently censored a paper authored by the Pension Finance Task Force that suggests discounting public pension liabilities at a risk-free rate.<\/p>\n

As I had highlighted in my post<\/a>, the choice of a discount rate does not cast any judgment on the ability of an investment portfolio to generate returns. What it does instead, is create a uniform framework to evaluate and compare objectives – in this case, the future obligations that need to be met. Whether its a corporation, or a government or an insurance company that has to meet this obligations should not change the value of these obligations.<\/p>\n

Once you have the facts on the table, then that allows you to select and debate an investment or contribution strategy. It is completely acceptable to have a view on investment returns or the economy, and construct a portfolio investment strategy based on that view.<\/p>\n

However, letting the choice of investments dictate the value of your obligations can be distorting, and\u00a0we are doing ourselves, investors and beneficiaries a dis-service.<\/p>\n

Eric Schmidt at Google has suggested that the best results occur when you put the facts as they stand on the table, and then debate what you do to achieve your objectives. Lets move this debate from a debate about the facts to a debate about what we need to do.<\/p>\n

Sources:<\/strong><\/p>\n