Interest rates on government securities have reached generational lows, trading at levels not seen since the Great Depression. Today the yields on ultra-safe investments allowed for state and municipal treasurers are often less than 1 percent, and rarely average more than 2 percent. Yet actuaries who calculate the liabilities, costs and contributions for OPEB (other post-employment benefits plans) are still using numbers like 4 percent, which understates the liability and the true costs of the plans. That practice seems dubious in today's market. Even long-term Treasury bonds —which cannot be purchased by many public treasurers under their state laws or local investment policies governing allowable maturities in their General Fund — yield less than the numbers many actuaries have been using.
The Governmental Accounting Standards Board's rules are pretty clear. In its implementation guide for Statement 45, GASB notes that where there is not a qualified trust fund, the achievable interest rate permitted over time under the government's general purpose investment policy should be used to determine the discount rate. Although the actuary can arguably use an expected long-term trend for those returns, that does not mean they can necessarily use the long-term interest rate in today's markets if the public agency is limited in maturity by policy or law. Thus, if the outer limit for investments under a city investment policy is five years, that is a 1 percent rate of return for Treasury bonds today. It is not the 4 percent rate often used by actuaries for plans without a qualified trust fund.
I'm sure that a clever actuary can find a way to fudge the numbers by extrapolating the "spot curve" or "forward rates" or "swaps" to justify a higher rate on shorter-term paper sometime in the future, but isn't that missing the point? Today's public agencies can't legally invest in forward rates today to obtain those yields, and most are not investing anything at all. They are paying as they go, with nary a penny in the bank for most employers.
Long-term investments require a sacrifice of liquidity and an acceptance of market risk. The market rewards long-term investors through the liquidity premium and the risk premium over shorter-term yields. Actuaries who allow public employers to discount OPEB liabilities at an artificially higher rate based on higher subjectively expected future rates are ignoring two of the central tenets of the normal (upward-sloping) yield curve. They are confusing the market's embedded liquidity premiums and risk premiums with the implied forward rate. (See any standard collegiate Money and Banking textbook.)
History in this century has clearly shown that successive shorter-term investments do not capture the same total return as longer-term investments which must pay the liquidity and risk premiums. So, the maturity limitations of the investment policy have to be considered here. I'd encourage the profession to think twice about its current practices and shave those assumed rates to align with today's market realities. Nobody can quibble with the idea that 20 years from now the permitted investment rates will probably be higher. But today's average employee will be retired by then.
Most public employers are ignoring today's GASB 45 contribution rates for OPEB plans. They simply pay-as-they-go, leaving the bills to future taxpayers as the annual costs of retiree medical benefits continue to escalate on an ever-rising exponential curve. When these liabilities hit the balance sheets sometime around 2015, as many expect they will, it will be even uglier if the actuaries are compelled by professional standards to use more realistic, lower discount rates that reflect real-world economics. (Contrarian note: it's possible that future GASB standards for OPEB plans will follow their current thinking for pension funds. That would require use of a long-term municipal bond index rate when the plans are chronically underfunded, which would ironically bring us back to the 4+ percent world, and in some cases even higher. So the rules of the game are subject to big changes in the coming years.)
The real solution, of course, is to begin pre-funding these plans in a GASB-qualified OPEB trust, and thereby qualify for the higher expected return on long-term trust assets, similar to a pension fund. For now, however, the OPEB actuaries would do us a favor if they stop stretching the numbers to levels at least twice the rates that most public agencies are actually receiving on their cash portfolios. They might even wake up a few employers to the urgency of funding these plans properly.
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