Jeremy Gold
WP2001-06
Abstract — Actuaries commonly, and in accordance with professional standards, use expected rates of return (on an anticipated asset mix) to discount the liabilities of defined benefit pension plans and to develop periodic plan expenses and contributions. With risky assets, the symmetry of returns about the expected return is deemed sufficient to develop costs that are unbiased over time. In the public (governmental) plan sector, expenses and contributions are almost always identical and intergenerational equity is a high priority.
This paper uses arbitrage principles to show that the use of expected returns including equity premia is biased in favor of early generations at the expense of later generations, a wealth transfer disguised as risk diversification over time. It is shown that unbiased results can be developed, with no wealth transfers between generations, by assuming risk-free rates of return independently of the actual asset mix.
Because cost computations anticipate equity premia, governments are likely to offer their employees pension benefits and valuable options (Skim funds) at less than their risk-adjusted cost, and to enter into costly strategies such as the issuance of Pension Obligation Bonds (POB’s).