How to Discount Pension Funds

The NYTimes has a good piece on the Dutch pension system which is characterized by sober calculation.

The Dutch central bank also imposed a rigorous method for measuring the current value of all pensions due in the future. Pensions are not supposed to be risky, Governors_of_the_Wine_Merchant's_Guildso the Dutch measure them the same way the market prices very safe bonds, like Treasuries — that is, by discounting the future payments to today’s dollars with a very low interest rate. This method shows that a stable lifelong benefit is very valuable, and therefore very expensive to fund.

Notably, the Dutch central bank prohibited the measurement method that virtually all American states and cities use, which is based on the hope that strong market gains on pension investments will make the benefits cheaper. A significant downside to this method is that it lets pension systems take advantage of market gains today, but pushes the risk of losses into the future, for others to cope with. “We had lengthy discussions about this in the Netherlands,” said Theo Kocken, an economist who teaches at the Free University in Amsterdam and is the founder of Cardano, a risk analysis firm. “But all economists now agree. The expected-return approach is a huge economic offense, hurting younger generations.”

Economists agree, the Dutch are correct. We know with high certainty the payments that pension funds will have to make in the future so they should be discounted at a relatively low, risk-free rate. Discounting at a risky rate implies that we can fund these pensions with risky assets but as I pointed out in Average Returns Aren’t Average most investors won’t achieve the average return (see also John Cochrane on this point) so the American system practically guarantees that lots of pension funds will run into severe problems.


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