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Where should the discount rate for liabilities on a defined benefit pension plan be set? This sounds like a boring issue that should be solved by bureaucrats or actuaries. And yes it *is* boring, though nerds like me have a keen interest in the topic.

Here's the issue, who should bear the costs? Should it be future generations, or the generation that is receiving the benefits? I am guessing that most people reading this agree with me, and argue that the generation receiving benefits should bear the costs, and pre-fund their retirements.

But that has not been the case. Rather, the Baby Boomers and prior generations have pushed costs onto future generations. How did they do it? Parties that looked at the incredible returns of the 80s & 90s assumed that equity markets were magic, and always threw off large returns. These same parties were reluctant to recognize the 2000s. We've had a lost decade-plus, which has caused most DB plans to go into deficit.

But the assumed investment rate was high going into it: 8-10%/year. The is the danger of mindlessly importing returns from the past, without asking the question, "Was there anything special about the past that should lead us to adjust the past returns?" P/E multiple expansion would mean-revert. It usually does, and longer-term measures like the Q-ratio and CAPE10 showed that valuations at the peak were severely high. Since then, the market has treaded water, as the companies in aggregate grow into their valuations.

Financial markets cannot forever outgrow their economies. Eventually we rely on cash flows from businesses to validate the value of the underlying businesses. Dividends, buybacks, and mergers and acquisitions serve to distribute the value of what companies do for those who own them.

The high assumed investment rates forestalled corporations and governments from contributing to their DB plans. Why should they? After all, they expected to earn a ton of money off their investments.

But imagine for a moment that they had been reasonable, and said "we shouldn't expect to earn more than long Baa-rated bonds. That's still a little liberal for me, but an improvement on most current reasoning.

(click to enlarge)

The effect today would be to have discount rates around 4.6%. How many firms and governments do that? (Why do I hear crickets?)

If governments had followed a formula like "use the Long Baa bond yield for the discount rate," they would not have been as generous with pensions.

There is still time to make some Baby Boomers pay more in taxes (even me). It would be wise for younger people to urge the boards that run the DB pension plans of their municipalities to adopt a long Baa bond yield as their discount rate. The underfunding will be horrifying, but if investment return exceed that, contributions and taxes should decline.

Thus I say to the young; lobby for lower discount rates, that there might be more taxation in the short-run, and less in the long-run.

Source: Young People Should Favor Low Discount Rates