Dear Ask a Scholar,
Why are states allowed to use an 8% discount rate as compared to the private sector that uses a 5% discount rate? This premise is bankrupting cities and states. What is documentation and proof of this idea, when Warren Buffet states the 100 yr. average is 5.33%?
- Fred Starkey
Answered by King Banaian, professor and chairman of the Economics Department of St. Cloud State University. He holds a Ph.D. in economics from the Claremont Graduate School. He has consulted at the central banks of Ukraine, Egypt and Macedonia and the ministries of finance of Indonesia, Macedonia and Armenia. He is author of The Ukrainian Economy Since Independence (Edward Elgar, 1998), co-editor of The Design and Use of Political Economy Indicators (Palgrave, 2008) and more than thirty-five articles and book chapters discussing monetary policy and political economy. He directs the Center for Economic Education at SCSU. He was recently elected to the Minnesota House of Representatives.
This question is very interesting to us in state legislatures right now. There is no standard that applies -- each state can choose its own discount rate. Most states are currently between 7-8.5%. The problem is that if you assume a lower rate, your state will be seen as having a larger unfunded liability, which may trigger either increased contributions by state workers, tax increases or (even more controversial) reductions in benefits to retirees. Most legislatures are thus reluctant to change the assumption. I would note to Fred that these pension plans invest in a wide spectrum of assets from bonds to stocks to private investment vehicles. So they do not necessarily earn just 5%, but they have had trouble making that over the last ten years cumulatively.
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