The high discount rates used by many Canadian public-sector pension plans increase the risk they won’t have enough funds to meet future obligations, according to new research by the C.D. Howe Institute
“Employers and employees have an incentive to keep the discount rate high in order to reduce the contributions they pay today,” said Constance Smith, co-author of the report, in a press release. “But the use of a higher discount rate increases the risk a plan will not have sufficient assets to meet its future obligations.”
Discount rates are what plan sponsors use to determine the value of the assets they have to save today in order to be able to keep future benefits promises. If that rate turns out to be an overestimation of the assets’ value, then the plan won’t have enough capital to meet its obligations. Since both pension fund’s assets and future benefits obligations are unpredictable, determining an optimal discount rate is a serious challenge, the report noted.
Many public pensions base their discount rate on the expected return on plan assets, which makes the rate unreasonably high, according to the report. Its authors tested six different types of discount rate, or rules, and how successful they each were at ensuring a higher probability that obligations would be met, as well as not accumulating too many assets overall. They determined the best rules to use in effectively balancing these two needs are a 10-year moving average of the high-quality corporate bond yield and an inflation forecast supplemented by a constant real interest rate.
“There is a need for prudent regulation of pension plan discount rates,” said Stuart Landon, co-author of the report. “Public-sector pension plans receive little guidance on the choice of discount rate. In practice, many such plans use a rate higher than our best performing rules.”
Plans using higher discount rates have argued that it keeps plans more affordable, noted the report.