New York’s state comptroller reportedly is going to reduce the state pension fund’s discount rate from 8 percent to between 7.5 percent and 7.75 percent, Bloomberg News just reported.  The lower the discount rate, the higher the required tax-funded employer contribution.  So the public pension bill for New York taxpayers is about to grow higher. even higher than already expected given the fund’s performance over the past few years.** [See postscript for caveat, however!]

The comptroller’s move comes as no surprise, given the recent performance of the pension fund’s assets.  The problem is that even a 7.5 percent rate — the lowest used by the fund since 1985 — will significantly understate the true size of the pension fund’s liabilities.

The discount rate applied to future obligations is a crucial determinant of any pension system’s necessary funding levels: the lower the rate, the larger the contributions required to maintain “fully funded” status. Private pension plans must discount their liabilities based on a market rate—typically, a corporate or U.S. government bond rate—which is often much lower than the plans’ projected returns.

Public funds, however, are allowed by government accounting standards to discount their long-term liabilities based on the targeted annual rate of return on their assets—which, for most public funds, is still pegged at an optimistic 8 percent or higher. In other words, the risk premium in the investment target is compounded in the liability estimate.

The typical public pension manager doesn’t just hope to earn 8 percent a year. For all intents and purposes, he or she assures trustees, beneficiaries, and taxpayers that the fund is certain to earn an average, long-run return of 8 percent.  In New York’s case, it appears this target is about to be lowered every so slightly.

But ask yourself: do you know anyone in the world of private investing (anyone not named Madoff, that is), who is willing to guarantee you a 7.5 percent rate of return?  How about 7 percent?  Or even, for that matter, 6 percent?  No junk bonds allowed.  Remember: public pensions are guaranteed by the state Constitution.  The money has got to be there.

While most public pension managers continue to resist the idea, a growing number of independent actuaries and financial economists agree that the net present value of risk-free public pension promises should be calculated on the basis of low-risk interest rates such as the rate on a thirty-year U.S. Treasury bond, most recently dropped below 4 percent.  This is not an argument for actually investing pension funds in T-bills, mind you; it is simply a way to recognize how much it actually costs to guarantee generous such generous pension benefits.

At 8 percent, the state pension fund discount rate is an economic fallacy.   At 7.5 percent, it will still be an economic fallacy.

** PS — For the state government, and for local governments that opt into a pension “amortization” (i.e., borrowing) plan initially proposed by Comptroller Thomas DiNapoli, a change in the discount rate won’t necessarily affect annual pension fund contributions.  Under a gimmick approved as part of the 2010-11 state budget, the annual increase in contributions will now be  capped at a percentage point a year and required payments over that amount in any given year can be spread over a 10-year period.  For participating  employers, a higher discount rate effectively will translate into more borrowing from the pension fund, pushing an even larger (but still underestimated) liability onto the backs of future taxpayers.**

PPS — New York City has separate public pension plans unaffected by the state comptroller’s action.  The city’s pension actuary recently began a customary five-year review of assumptions,  which could easily lead to a similar change, however.