Fireside Chat Follow-up – Question # 2

Are liabilities interest rate sensitive?

YES, the present value of pension liabilities is extremely interest rate sensitive if you use market interest rates as discount rates. This is certainly true for private pensions under FASB (ASC 715) accounting regulations. Unfortunately, GASB allows for the return on asset assumption (ROA) to be used as the discount rate for Public pensions, which is not interest rate sensitive.

However, GASB 67/68 opened the door to market rates by bifurcating the discount rate such that the ROA is used until assets are exhausted, and then you must use a 20-year AA muni index yield. The Society of Actuaries (SOA), in their 2004 white paper “Understanding the Principles of Asset Liability Management”, made it clear that GASB accounting rules can distort economic reality and, as a result, assets cannot function effectively vs. liabilities.

A current trend among public pension systems is to reduce the ROA, which increases the present value of liabilities. Just imagine that a 15-year duration public pension liability reduced its ROA by 50 basis points,  from 8.0% to 7.50%, while market rates for AA corporates went up 50 basis points from 3.50% to 4.0%. The ROA method would show a liability growth of  15.5% leading to lower actuarial funded ratio and higher contributions. The AA corporate method would show a liability growth of – 4.0% enhancing the true economic funded status. Which one is right? The proper discount rate is the one that can settle the liabilities, one that you can buy to defease the liabilities. The ROA is not purchasable and should be removed as a discount rate by definition.

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