Nobel laureate William F. Sharpe spoke to the Financial Analysts Journal on how public pension plans use inappropriately high discount rates to understate their true liability:

Are public pensions a problem? You bet. Is this a disaster? You bet. The true liabilities of the public pensions in the United States—by which I mean governmental pensions—are, according to the actuaries, much larger than the assets. Using any sensible economic view of the value of those liabilities, the difference in value is astronomical. It’s a crisis of epic proportions.

Let me describe this more clearly. If the state has promised a worker certain payments in the future for having worked at least up to this date—so-called accrued benefits—and it is certain that those payments are going to be made, anybody, any economist, and probably most of you in this room would ask, how do you value that? It’s simple. You find US Treasury securities that would provide cash flows to match those payments. That is how you should value the liability.

As most of you know, that is not what the Governmental Accounting Standards Board and the state and local systems do. They value those liabilities at 7.5% or 8% on the grounds that they are pretty sure they’ll earn that in the long run. This is crazy. It gets even worse. Because they want to minimize the reported value of the liabilities, they want to use a high discount rate, and in order to justify it, they have to build really risky portfolios.

Consequently, they believe that one of the great things to do is put money in private equity, or maybe a hedge fund, because then they can assume an extra 300 or 400 bps of expected return for an illiquidity premium (or just because hedge fund managers are so smart). So, the tail wags the dog. Idiotic accounting drives even worse investment decisions.

This is the classic case of an organization that borrowed money while issuing purportedly guaranteed payments and then used the money to invest in risky securities. Where have we recently heard that this is not a good thing?

Of course, you can point to the politics to see why politicians might give benefits that are very large to employees, especially those who may be able to influence elections in various ways. By making sure the benefits are mostly in the future, politicians can pretend that they cost a lot less than they’re going to cost. It’s a very bad situation.

Sharpe’s view is shared by virtually all professional and academic economists, the Federal Bureau of Economic Analysis, the Federal Reserve Board, the Congressional Budget Office, and Moody’s Investor Services.

For example, Donald Kohn, then-Vice Chairman of the Federal Reserve Board, declared in a 2008 speech on public pensions:

While economists are famous for disagreeing with each other on virtually every other conceivable issue, when it comes to this one there is no professional disagreement: The only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate.

See the “Sidebar 1: What do experts say about pension accounting rules?” section of this paper for more quotes and citations from each of the organizations cited above.

A  recent paper published by the Federal Reserve Bank of Cleveland also confirmed the strong consensus that public pension plan’s discount rates are far too high, and highlighted a recently implemented GASB rule that states a 3.2% discount rate should be used to value pension liabilities. If California’s public pension plans were to adopt this rate, their liabilities would more than triple.

Public pension plans and their actuaries are the only group that disagrees with this consensus.