The War Over the Discount Rate

by Reihan Salam

Though the rising cost of meeting state employee pension liabilities isn’t the most glamorous issue, it threatens to “crowd-out” spending on education, medical care, transportation, crime prevention, and other priorities. And so the Arnold Foundation, established by the energy trader John Arnold and his wife Laura to tackle issues like criminal justice reform and education, has devoted considerable resources to educating the public about the pension challenge and supporting reform efforts. As Imogen Rose-Smith reports in Institutional Investor, the Arnolds played a crucial role in Rhode Island, where they backed the state’s crusading General Treasurer, Democrat Gina Raimondo.

The Arnolds’ support for pension reform has attracted the ire of public employee unions, which have attacked the Arnolds for, among other things, supporting mark-to-market accounting for public pension funds. The unions maintain that mark-to-market accounting isn’t appropriate for state governments on the grounds that state government can’t go bankrupt. But the goal of a discount rate is to ensure that the entity that is obligated to pay out a stream of payments in the future has enough cash on hand to meet those obligations. While it is true that future state governments will be able to raise taxes to meet any shortfall, it doesn’t make much sense to all but guarantee a shortfall by using an inappropriately high discount rate because sharp and sudden tax increases, like those experienced in Illinois in the recent past, and quite possibly the near future, aren’t easy to swallow. (The higher the discount rate, the less cash you need to set aside now, hence state governments tend to use unrealistically high discount rates.) That is the basic idea that people Raimondo and Arnold are advancing, and it has been an unbelievably hard slog.