Tuesday, April 19, 2011

What is the Risk-Free Rate?

For years, when looking at an expected rate of return on a pension trust, I have been asked to look at things like real rates of return, risk premiums, and the "risk-free rate." The risk-free rate has always been defined as the yield on US Treasury debt instruments, the safest investment in the world. Yesterday, the fine folks at Standard & Poor's gave a negative outlook on the US. They said that this means that there is at least a 1 in 3 chance that the United States' AAA credit rating will be downgraded within the next two years. S&P gave as its reason the potential inability of the government to get together and find a way to control the spiraling federal debt.

There remain a number of debt instruments, according to S&P, with a solid AAA rating. Interestingly, they all seem to yield more than US Treasuries. Should they become the risk-free rate? What is going on here? What is the risk-free rate?

I spoke with a few friends and acquaintances with more economic training than I. The consensus was that this was simply S&P's way of lighting a fire under Congress' and the President's collective posteriors. Surely, no US-based company can be more credit-worthy than the country in which it is domiciled. If the US economy is that weak, then how can individual companies be that strong?

As I meander back to my more customary topics, I look at the implications for pension plans. Surely, this action by S&P will cause the US borrowing rates to increase. This, in turn, would suggest that the yield on high-quality fixed income investments will increase. But, this will cause discount rates on public and corporate pension plan liabilities to increase which will decrease those liabilities and give the plans that support those liabilities better funded statuses.

What? Does that mean that this is a good thing? Are the collective state and local and pension plans really far less than $3 trillion underfunded?

It seems that this is a quandary worthy of the legendary Scotsman immortalized by the Bard of Avon: "Fair is foul, foul is fair."

In any event, this tells me that its time for the United States to employ some of the strategies that many have been preaching about at corporate levels for the last two decades. Our country is a large enterprise. Is it time for us to practice some sort of enterprise risk management? Should the Department of Homeland Security report up to the Secretary of Risk? Or is the Secretary of Risk just another name for the President?

I don't know, but perhaps it is useful food for thought.

No comments:

Post a Comment