Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / Why Government Pension Math Is So Confusing
Transcript
- Lucas: So there's a number that determines whether a state pension fund is considered healthy or underwater, and it's not the stock market. It's an assumption called the discount rate. Luna: The discount rate. I've seen that in the news but never really knew what it meant. Lucas: Right. The discount rate is the expected annual return on the fund's investments. It's used to calculate the present value of all the pensions the state has promised to pay out over the next few decades. Luna: So it's like, if they think they'll earn more, they need to set aside less money today? Lucas: Exactly. If a fund assumes it'll earn 7 percent, it can discount those future payments at that rate. But if the rate drops to 6 percent, the present value of those same liabilities jumps by tens of billions. A one-point change is enormous. Luna: And I assume most funds use the higher number because it makes their shortfall look smaller. Lucas: That's the game. According to the latest data, the average public pension discount rate is around 6.9 percent. But that's way above what safe investments like Treasury bonds are yielding—more like 4.5 percent these days. So the question is, what's the right number to use? Luna: And that's where the politics come in. Lucas: Absolutely. If a fund lowers its discount rate, its funding shortfall immediately balloons, and state and local governments have to contribute more money each year. That's politically painful. So there's a huge incentive to keep the rate as high as possible. Luna: So they're basically kicking the can down the road. Lucas: Yeah, but the road is getting shorter. Take the California Public Employees' Retirement System, CalPERS, the largest public pension fund in the country. In 2016, they lowered their discount rate from 7.5 percent to 7.0 percent, and their unfunded liability jumped by about twenty-five billion dollars overnight. Luna: Twenty-five billion. Just from a half-point change. Lucas: And that's exactly why the debate is so heated. The choice of discount rate isn't just an actuarial detail; it's a policy decision with massive fiscal consequences. Luna: So what's the case for keeping it high? I mean, some funds still use 7.5 percent or even 8 percent. Lucas: The argument is that public pension funds have long time horizons and can take on more risk in exchange for higher returns. They're not like an individual retiree who needs the money next year. So most economists agree that using a risk-free rate like Treasury yields is too conservative. The real debate is where to set it in between. Luna: But if the actual returns don't match the assumption, you fall behind. Lucas: Exactly. And that's been the problem for the last couple of decades. The average public pension fund has earned about 7 percent annually over the long run, which might sound okay, but when you factor in the 2008 crash and other volatile years, the actual performance has been closer to 6 percent for many funds. So they're already falling short. Luna: So they set the rate at 7, earn 6, and the hole just keeps growing. Lucas: Right. And here's the thing—those returns aren't guaranteed. To hit 7 percent, funds are increasingly allocating to private equity, real estate, and infrastructure. Some of these assets are illiquid and hard to value. So the discount rate doesn't just affect the math; it shapes the entire investment strategy. Luna: I've heard that some funds have been moving into riskier stuff to meet those targets. Lucas: Yeah, it's a classic risk chase. And if those bets go bad, the shortfall gets even worse. But there's another side to this too—the human side. Because the discount rate is the lever that decides whether a city has to cut services or raise taxes to keep its pension promises. Luna: And we're not just talking about numbers on a spreadsheet. Lucas: Right. Those promises are what teachers and firefighters are counting on in retirement. So when a fund lowers its discount rate, it's essentially admitting that the future is more uncertain. And that's a hard truth to sell to a public that doesn't want higher taxes or reduced benefits. Luna: So what's the alternative? Some people argue for a risk-free rate, like the Treasury yield. Lucas: There's a strong case for it. If you use a risk-free rate, you're essentially saying the state should be prepared to fund the pensions with certainty. That would be the safest approach, but it would also require massive contributions today. For many states, that would be fiscally impossible without drastic cuts elsewhere. Luna: So it's a trade-off between honesty and affordability. Lucas: Exactly. And that's why the discount rate is so politically charged. It's not just an accounting detail; it's a decision about who bears the risk of uncertain returns. If you use a high rate, you're pushing the risk onto future taxpayers. If you use a low rate, current taxpayers and public employees feel the pain now. Luna: It's like they're gambling with the future. Lucas: And that's the core problem. The discount rate is supposed to reflect the riskiness of the investments, but it's also used as a political lever. Until that changes, we'll keep seeing these massive shortfalls and the constant pressure to either raise taxes or cut benefits. Luna: Listen, this has been genuinely eye-opening. I had no idea a single number could have such huge consequences. Lucas: It's one of those hidden levers of fiscal policy. And honestly, if today was useful to you, the way we keep these episodes ad-free is through listener support. If you want to help, you can buy us a coffee at buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small gesture but it really keeps us going. Lucas: So back to the discount rate. There's been a slow trend toward more realistic assumptions. Since 2017, the average discount rate has dropped from about 7.4 percent to 6.9 percent. But many funds still use 7 percent or higher, and a few are still above 7.5. Luna: And that gap between assumption and reality is the billion-dollar question. Lucas: Literally. Moody's has estimated that if all public pension funds used a risk-free rate, the collective shortfall would be over four trillion dollars. That's a number that would break most state budgets. So you can see why politicians are reluctant to go there. Luna: But at some point, don't they have to face the music? Lucas: They're starting to. A few states, like Kentucky and New Jersey, have been forced to lower their rates because their funds were in such bad shape. And we're seeing more discussion about pension reform, though it's still a third rail in most places. Luna: So what would a smarter approach look like? Lucas: Some economists suggest using a discount rate that reflects the actual risk profile of the fund's investments, rather than a single number for everyone. That way, if a fund takes on more risk, the discount rate would rise, but so would the required contributions. It's a more honest system, but it's also more complex and still politically difficult. Luna: So the problem isn't just math, it's governance. Lucas: Exactly. The discount rate is a tool, but it's being wielded by people who have to balance short-term budgets against long-term promises. And as long as that tension exists, we'll see these fights. The real question is whether we can find a way to make the math work for everyone—taxpayers, public employees, and the retirees who depend on those checks. Luna: And that's a question we'll be watching closely. Lucas: For now, the next time you hear about a pension fund's funding ratio, you'll know the discount rate is the rubber ruler behind it. Thanks for listening.