By Peter Whoriskey
Washington Post Staff Writer
Thursday, March 3, 2011; 1:04 PM
Exactly how much should a government set aside today if it wants to pay a pension for a worker years from now?
That simple question is at the root of a trillion-dollar argument over how much state and local pension plans cost taxpayers.
In essence, the debate revolves around the appropriate level for what is known in financial professions as the discount rate.
To understand the concept, consider that getting $100 today is better than getting $100 a year from now, because a person getting the cash today could invest it and earn interest.
To compare the present and future values, economists use a discount rate. For example, using a 5 percent annual discount rate, $105 paid a year from now has a value of $100 today. For a higher risk investment, economists employ a higher discount rate, reducing its value today.
This might sound like a minor detail, but setting the precise discount rate used in pensions has profound implications: Changing it by as little as one percentage point can change overall pension liability by as much as 25 percent.
Lowering the discount rate increases the value of those future payments and, in turn, raises the amount deemed necessary to fund pensions; on the other hand, boosting the discount rate decreases the value of those pension payments and makes pension funds seem healthier.
Currently, most government pension plans use a discount rate of about 8 percent, which is based on what they think they can earn through investment - and have, on average, in recent decades. But that rate involves the risk from the stock market and other investments that pension funds make.
To go back to the example of getting $100, the pension plans are in essence saying that to provide a $108 payout a year from now, they need only put in $100 today , because on average they will get an 8 percent return on their investments. This, they say, is especially safe across the long horizon of pension investments.
But some economists believe that that assumption is misguided. The pension payments are essentially risk-free - the government is in many cases required by law to make the - so they argue that the appropriate discount rate is the so-called risk-free rate, the rate on Treasury bonds, considered one of the safest investments, which is currently between 4 and 5 percent.