Ethics and discount rates


in Economics, Geek stuff, Politics, Psychology, The environment

The discount rate is a basic tool of accounting and economics: people and institutions often need to deal with costs and benefits which will arise in the future, and it doesn’t usually make sense to simply value them as if they were happening today. A person expecting pension payments of $1,000 per month in thirty years probably shouldn’t value them as though they had the money in hand today, and neither should the organization that will be making the payouts.

To adjust for the time difference, people doing accounting choose an annual discount rate by which to reduce the value of things expected in the future.

Problematically, however, the compounding effects of this across long periods of time can make the specific rate you choose into the most important feature of the calculation. This has an extreme effect in climate change economics.

In the context of pensions, a recent Economist article explained:

The higher the discount rate, the less money has to be put aside now; American public plans tend to use a discount rate of around 7.5%, based on the investment return they expect to achieve…

A promise to pay a stream of pension payments in the future resembles a commitment to make interest payments on a bond. A bond yield is thus the most appropriate discount rate. But given how low bond yields are, pension deficits would look larger (and required contributions would be much higher) if such a discount rate were used. A discount rate of 4%, for example, would mean the average public pension plan would have a funding ratio of only 45%, not 72%, according to the CRR.

That last bit means that American institutions which owe pensions to employees in the future may have only 45% of the money which is necessary for that purpose, rather than the 72% which they currently believe themselves to possess.

While there is an intellectual and even a moral case for discounting the future, it seems clear that it’s a practice with considerable moral risks associated. We are in a situation where simply by making optimistic assumptions we can reduce the burden which we owe to future generations. If we get things wrong, especially in the multi-century case of climate change, they will have no way to hold us to account.

Psychologically, this may also lead to us ‘discounting the future’ in other ways. If people expect corporate and government pension plans to be broke by the time they retire, it may inspire a super-cautious response of independent personal pension saving, or it may lead to people writing off any hope of financial stability in old age and simply ignoring the risk. Such temptations may be even greater for those who see the massively inadequate response the world is undertaking in relation to climate change and ask whether – even if governments, firms, and individuals did set aside adequate retirement savings in the near future – the world will still be intact enough in the second half of the 21st century for those funds to be meaningful.

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. January 2, 2017 at 7:06 pm

So why don’t workers in DC schemes put more money aside? The paper suggests that savers may have been deceived by the robustness of past returns. The authors assume that workers would like to retire on 75% of their final salary and that 30 percentage points of that would come from other sources, including social security. Furthermore, they assume 2% annual real-wage growth during workers’ careers, and that, on retirement, savers buy a 25-year annuity with their pot.

Combine those real returns into a portfolio of 60% American equities and 40% Treasury bonds (a standard asset allocation) and you get an overall return of 3.5% a year. That is two percentage points lower than the 5.5% achieved from the same combination in the past. And it means that a worker would have to save 15% a year, not the current 9%, to reach the target.

Even that approach looks optimistic. With bond yields less than 2%, inflation will have to average under 1% to deliver the 1% real return assumed by the authors. And fund-management charges will eat into returns as well. On a 2.5% real-return assumption, contributions would need to hit 19% of payroll.

So why aren’t workers saving more? They may not be overestimating asset returns. Instead, they may be indulging in “hyperbolic discounting”—valuing the income they earn today far more highly than the income they will earn in old age. After all, employees in DC schemes tend to get lower retirement pay than those in DB plans (because employers are contributing less). Yet there is no evidence that workers in companies with DC plans demand more current pay to compensate.

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