Proposing a Funding Rate for US State Pension Plans

Abstract

US state pension plans generally use overstated discount rates based on historical performance, creating the appearance of healthy funding at the cost of future underfunding. Conversely, adopting a US Treasury discount rate, or another alternative suggested by previous literature, would cause overstated funding gaps and contribution increases, mainly due to statutory reserve regulation. For funding purposes, we identify a lower limit to the discount rate, defined as the Value-at-Risk return of the portfolio with the lowest risk assessment. Adopting this limit curtails intervaluation losses for 94% of funds, while entailing the lowest increase in contributions vi-à-vis any other alternative.

Keywords: State pension funds, funding shortfall, long-term discount rate, global minimum variance portfolio, investment risk, zero interest rate, discount rate, pension plans

JEL Classification: G11, G23, H55, H75, H79, J26