New York City’s pension actuary is “likely” to recommend a reduction in the interest rate used to calculate tax-funded pension contributions, the New York Post reported (not for the first time) yesterday.  A lower interest rate will lead to higher pension contributions, which are already factored into Mayor Michael Bloomberg’s fiscal projections.

screen-shot-2011-06-13-at-113319-am-1956144Yet state lawmakers have quietly introduced a bill that would freeze the interest rate at its current level of 8 percent for another year.

What’s going on here?  Less than meets the eye, actually. This is a routine one-year extender, which doesn’t preclude the actuary from recommending a lower discount rate later this year.  Meanwhile, it also extends the 1 to 1.25 percent interest credited to employee contributions to the fund.

The city’s projected tax-funded pension contribution for fiscal 2012 is up nearly $1 billion from the current-year level, in part due to an anticipated reduction in the discount rate, which is set by law based on the actuary’s recommendation.

Since a lower discount rate generally translates into higher current contributions from taxpayers, critics of the Bloomberg administration are suggesting the added pension reserve is unnecessarily siphoning money needed to prevent budget cuts.  They’re wrong, however.  Some further explanation from Empire Center’s December 2010 report, “New York’s Exploding Pension Bomb”:

Parties obligated to pay an amount at some future date need to know the size of that obligation in today’s dollars, which will tell them how much money to set aside. That sum can be smaller than the principal amount due because it can earn interest until the due date. If, for example, you owe $10,000 in ten years, and your savings account offers an interest rate of 3 percent, you would need to set aside only $7,441 today. In this example, you have assessed your future obligations using a 3 percent “discount rate”—the rate at which the principal due is discounted over a given period of time to produce the loan’s net present value.

The discount rate applied to future obligations is a crucial determinant of a pension system’s necessary funding levels: the lower the rate, the larger the contributions required to maintain “fully funded” status, meaning the assets are sufficient to cover all promised pension benefits.

Private pension plans must discount liabilities based on what’s known as a “market” rate—typically, the interest paid on bonds issued by financially solid corporations. This is often much lower than the plans’ projected returns, but it reflects what the money would be earning if invested in lower-risk assets, matching the low risk tolerance of future retirees who are counting on their promised pensions.

Public funds, however, are allowed to discount their long-term liabilities based on the targeted annual rate of return on their assets—i.e., what they hope to earn from investments in a basket of assets dominated by stocks, which offer a chance of higher returns in exchange for higher risk of losses.

Using a private-sector accounting standard, all of New York City’s pension funds were more than 50 percent under-funded as of mid-2009, according to alternative calculations by the city actuary.  While the funds no doubt benefited from stock gains of roughly 20 percent during their current fiscal years, they would still be seriously underfunded if their liabilities were measured using a risk-free market rate of, say, 4 percent — as typically required of private pension plans.

If the city moves to a discount rate of 7 or 7.5 percent, taxpayer contributions would rise faster, while the pension system would be less underfunded. But underfunded it would remain.

About the Author

E.J. McMahon

Edmund J. McMahon is Empire Center's founder and a senior fellow.

Read more by E.J. McMahon

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