A discount rate is the interest rate pension plans use to calculate the current value of future retirement benefits. This tells you how much money is needed today to be able to pay future benefits, which in turn is one factor in determining the contribution rates required from employers and employees.
The assumed rate of return is the return that a pension fund plans to receive on its investments and is determined by using a set of assumptions to project future investment returns. The discount rate and assumed rate of return are one in the same which helps to ensure steady contribution rates as well as making sure there is enough investment income to cover future liabilities. The investment income matters, as investment earnings account for a majority of pension funding. A shortfall in long-term expected investment earnings must be made up by higher contributions or a reduction in benefits.
The most important thing to understand about a discount rate and assumed rate of return is that ultimately, the pension fund’s actual return on investment matters much more than the discount rate and the assumed rate of return.
Here is an example. Let’s say a pension fund assumes a low discount rate of 4%. Initially, the contributions required from employers and employees would be high because the fund expects only a 4% return on investments. But over time, the fund’s investment returns exceed a 4% return, and so, the contributions required will decrease because more money than expected is being poured into the fund from investment return.
Now let’s assume a pension fund has a high discount rate of 9%. Initial contributions would be low because the plan is expecting a high return on investments. Over time, however, if the pension fund’s investments do not return 9%, contributions would have to increase in order to pay for the benefits.
The trick with choosing a discount rate is to pick a figure that is realistic so that contributions may remain steady for decades, helping to ensure the taxpayers of today are charged as appropriately as the taxpayers of tomorrow. In other words, the end result should create generational fairness.
LAGERS uses a conservative discount rate of 7.25%. This is based on an asset liability study that incorporates capital market assumptions and liability projections for the future. As of 2015, LAGERS’ 20 year return is 8.70% and its return since inception is 8.92%. These assumptions are formed every five years to ensure the appropriate figures are being used to maintain a financially stable pension fund. LAGERS is very comfortable with its assumptions and the contribution rates charged to employers and members.