Pensions and discount rates

By Dave Anderson:

The Pittsburgh City Council has voted decisively against the Mayor's plan to lease the entire array of city parking assets to a consortium led by JP Morgan.  The lease was supposed to generate a one time payment of $452 million dollars for the next fifty years of cash flow from current and future parking assets.  The one-time payment was to pay-off Parking Authority debt and push the city's municipal pension fund balances to at least 50% funded before January 1, 2010. If the pensions was 50% funded or better, the state would not take over the plans. 

The pension funds in aggregate are funded at 27.5% as of the last state actuarial report.  That report used data that is over two years old.  I am betting that even if the market value of the pension portfolio grew at the assumed annual rate of 8.5% over the past three years instead of basically treading water with the market , the pension funds will be in worse shape due to a change in assumptions about the future discount rate. 

A dollar today is worth a little more than a dollar next year because that dollar today can be used to buy a good or service now instead of having to wait a year.  The question is how much more valuable is that dollar today instead of next year?  If the economy is strong, that dollar is more valuable now because it could be used to invest and generate more money for the dollar holder. If the economy is either shrinking or effectively moving sideways, next's year dollar loses is only a little weaker.  The discount rate for the future is the measure of how much less valuable a dollar next year.

A simple but methodologically soundl way to calculate a discount rate is to look at a long term US Treasury interest rate and plug it into a fairly simple equation to calculate the net present value.  Currently the US 30 year Treasury is yielding 3.69%.  The October 14, 2008 30 year Treasury was yielding 4.27% while the 20 year bond on the same day yielded 4.57%.  The December 30, 2007 30 year yield was 4.45%. 

The lower the discount rate, the more money one needs in the bank to cover future obligations.  For instance, if I owe someone $1,000 one year from today, using yesterday's 30 year yield as the discount rate, they would be willing to accept $963.10 today.  However if the discount rate was 4.45%, they would be willing to accept $955.50 to cover the $1000 obligation that was due a year from now. 

Over the short term of a year or two, 75 basis point changes in a discount rate don't matter too much.  However over a one hundred year time horizon changing the discount rate from 4.45% to 3.69% means the city would have to basically double its current cash reserves to maintain steady funding status, all else being equal.

I'm speculating now, but I wonder if this is part of the reason why the City Council, led by a councilor, Natalia Rudiak, who I know knows how to do these calcuations, is balking at the mayor's parking plan?  There is a decent chance that even if the Council approved the lease plan, the change in discount rate assumptions would still force a state take-over so the city would still be SOL and without a fairly valuable asset under its control any more.