A Solution to the Discount Rate Fallacy

The key pad is mightier than the pen. 

Because we don’t know what is going to happen in a world of uncertainty we make assumptions.  That is reasonable and rational behavior.  Then we start treating those assumptions like facts and therein lies the problem.

President Obama has just signed the Highway Investment, Job Creation and Economic Growth Act of 2012 that will increase corporate earnings, increase taxes and decrease pension liabilities.  All this, with a stroke of the pen that simply changed the assumed discount rate from 2.56%  to 5.59%.  Another short term fix to a long term problem.

What this points out to me is the fallacy of using an assumed rate to determine how to properly manage a pension plan.  The actuary uses a highly sophisticated computer program to solve for the liability stream of payouts for the next 30 years or so.  The present value of the assets is known with certainty…well, excluding the illiquid assets lurking in the portfolio.   

What pension plan sponsors should demand is that actuaries SOLVE for the internal rate of return (IRR) that discounts the expected payouts to the present value of the assets.  This would be a meaningful number that would allow the plan sponsor to use a more realistic estimate of the rate of return needed in order to meet the projected liabilities.  Actuaries can do this with a stroke of the key pad on their computer and that will be an antidote to the illusion that the pension plan is funded when it is not.  It will also allow the consultant to measure risk relative to that IRR instead of to some market index that is totally unrelated to the liabilities.

About Frank Sortino

Frank Sortino is finance professor emeritus from San Francisco State University and Director of the Pension Research Institute which he founded in 1981. For 10 years he wrote a quarterly analysis of mutual funds for Pensions and Investments Magazine and he has written two books on the subject of Post Modern Portfolio Theory. He has been a featured speaker at many conferences in the U.S., Europe, South Africa, and the Pacific Basin. Dr. Sortino received his Ph.D in Finance from the University of Oregon and has carried out research projects with many institutions like Shell Oil, Netherlands and The City and County of San Francisco Retirement System.
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