Discount Rate

In Detail

The discount rate is perhaps the most contentious number in pension finance. It is used to convert future benefit payments — which may stretch out 50+ years — into a single present value. A higher discount rate produces a lower present value of liabilities, making the plan appear better funded. A lower discount rate does the opposite.

Public pension plans have traditionally used their assumed rate of investment return as the discount rate, typically 7-8%. Financial economists argue this overstates funded status because pension benefits are contractual obligations and should be discounted at a lower, risk-free rate closer to Treasury yields (around 4-5%). Using a risk-free discount rate would roughly double the reported unfunded liabilities of many public plans. Private-sector plans under ERISA must use corporate bond yields to discount their liabilities, which produces more conservative valuations.

The discount rate debate is not merely academic — it directly affects how much employers must contribute. A plan using a 7.5% discount rate will require lower contributions than the same plan using a 5% rate, even though the actual benefit promises are identical.