The following essay is part of a twelve-essay series by the Mercatus Center at George Mason University on the effect of low interest rates on the economy. To read other essays in the series, click here.

Municipal finances have been shaped by a historic period of protracted low interest rates—perhaps most significantly for the pension plans offered by states and many local governments.

According to the US Census, state and local governments operate a combined total of 6,299 defined benefit pension plans; states operate 299 of those plans, covering more than 18 million public employees. State plans hold $3.1 trillion in assets and report $4 trillion in liabilities for a total unfunded liability of $948 billion—a funding gap that has generated a lot of concern for many governments. But the story is a bit more complicated than that. Interest rates have a big effect on both the performance of pension asset portfolios and the measurement of plan liabilities.

On the asset side, low interest rates mean weak returns on plans’ fixed-income investments. Before 2008, plans expected annual returns of 8 percent on their assets. Because plans are funded by a combination of employee-employer contributions and investment income, a drop in investment earnings means governments or employees must contribute more to the plan to make up the difference.

The persistent low-interest-rate environment is one reason plans have shifted their portfolio holdings to higher-risk investments. This behavior, called “gambling for redemption,” became especially obvious after the 2008 recession as plans began to chase higher returns. The share of alternative investments in plan portfolios has doubled since 2006, from 11 percent to 23 percent, at the same time that the share of equities fell from 61 percent to 50 percent.

There’s a more subtle reason that plans have been incentivized to dramatically shift their portfolios to riskier holdings as pension funding gaps widened after 2008. Public plans in the United States measure the present value of pension liabilities on the basis of the rate of return the planners expect to earn on those plan assets. On average, post-2008 public plans assume 7.6 percent earnings annually.

The problem with using the return on assets to measure liabilities is that the two are independent in value. Pension liabilities are guaranteed bond-like obligations that many governments statutorily promise to pay out to their employees. Pension plan assets have their own value—the assets are made up of higher-risk investments such as stocks and alternatives. Pension liabilities and assets are indeed fundamentally different in terms of their underlying value.

Figuring out the worth of pension liabilities in present dollar terms means matching them to their equivalent in risk—such as the risk-free return on Treasury bonds. Low interest rates mean a bigger present value for pension liabilities. Applying a notional return on 15-year Treasuries of 3.2 percent increases states’ unfunded pension liabilities to $4.3 trillion. That is how the market would value state pension liabilities given current interest rates.

Using current reporting and accounting conventions, state and local governments don’t recognize the true value of pension liabilities or the risk premium they are assuming. The risk premium is the difference between the assumed rate of return on assets (7.6 percent) and the rate of return on Treasuries (3.2 percent). Not recognizing the risk premium is possibly the biggest risk of all. Undervalued liabilities and poor asset performance are a recipe for funding shortfalls.

An increase in interest rates would help mask the accounting mismatch between assets and liabilities. But it wouldn’t necessarily solve the fundamental valuation problem.

As the return on Treasuries moves closer to 7.6 percent, the rate of return that plans are assuming for the assets, which is the risk premium, would technically be erased. The market value of the liability would shrink, and the funding gap would close.

That is, the $4.3 trillion market value of the unfunded liability would shrink back down to what plans currently recognize in their accounts: a $948 billion liability. So, in effect, the market value of plan liabilities would converge with the actuarial values that plans are currently reporting.

For many years, the market value of pension liabilities did coincide with the actuarial value. When bond yields were higher, plans could use the expected return on their assets to value plan liabilities without creating a funding gap, because the numbers were much closer. The underlying problem for pension accounting isn’t making interest rates on bonds match the return on a portfolio of stocks; it’s what those numbers represent that matters.

Plans expect to earn 7.6 percent annually on a mix of higher-risk investments largely comprising equities and alternatives. With high-risk investments come volatility and uncertainty—and no guarantee of expected returns. The pension valuation mismatch will continue if plans keep looking to the performance of risky assets to value a guaranteed liability.

So, although an increase in interest rates means the market valuation and the actuarial valuation of pension liabilities converge, it’s not for the right reason. Unless accounting guidance changes for public-sector pensions, plans will still be valuing their risk-free liabilities with reference to risky assets.

Photo credit: Tim Evanson, flickr