How Well Does the Risk-Free Rate Predict the Future Rate of Return on Investments? Implications for Public Defined-Benefit Pension Plans

Prior studies have suggested that public pension liabilities should be discounted using a risk-free rate. However, government accounting standards still allow the use of the long-term rate of investment return for valuation of pension liabilities. This paper reexamines the appropriateness of using the risk-free rate in the valuation of public pension portfolios. Based on historical investment return data, the authors simulate two diversified pension investment portfolios and estimate their long-term growth. They find that the risk-free rate produces a significant downward bias in the prediction of the future value of pension assets and argue that using the risk-free rate for valuation would overestimate plan underfunding and create unnecessary funding pressure for state and local governments.