Working Paper: NBER ID: w21276
Authors: Jeffrey R. Brown; George G. Pennacchi
Abstract: We argue that the appropriate discount rate for pension liabilities depends on the objective. In particular, if the objective is to measure pension under- or over- funding, a default-free discount rate should always be used, even if the liabilities are themselves not default-free. If, instead, the objective is to determine the market value of pension benefits, then it is appropriate that discount rates incorporate default risk. We also discuss the choice of a default-free discount rate. Finally, we show how cost-of-living adjustments (COLAs) that are common in public pensions can be accounted for and valued in this framework.
Keywords: pension liabilities; discount rate; funding status; market value; cost-of-living adjustments
JEL Codes: G20; H55; J26
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| default-free rate (E43) | accurate measure of funding status (G23) |
| default-risky rate (E43) | distorted perception of funding health (H51) |
| decline in pension assets (G23) | misleading conclusions about funding status (G32) |
| default-free rate (E43) | clear understanding of total liability (K13) |
| default-risky rate (E43) | potential misinterpretation of funding health (I18) |