Chapter 10

PRESENT VALUE FOR ORGANIZATIONS AND COMMUNITIES

In chapter 8, we touched on not just how individuals use Present Value but also how organizations do so. In fact, managers at many companies—particularly if they have an MBA—would say that almost all important decisions a company makes utilize Present Value, only they call it the “discounted cash flow method.”³⁹ It’s true that, superficially, the mechanics of the discounted cash flow method and Present Value thinking are quite similar, but in fact there are some subtle—but very important—differences. For one thing, the discounted cash flow method generally focuses on just the “high likelihood” scenarios, while in Present Value thinking we try to imagine all the possibilities, recognizing that low likelihood/high impact possibilities can be very important. Nassim Taleb calls these possibilities “Black Swan” events and suggests that such “impossible to predict” scenarios are the ones that ultimately change our lives in the most important ways.⁴⁰ While I agree with Taleb that these scenarios are impossible to predict, I don’t think they are impossible to imagine. That is why step 2 is so critical to Present Value thinking, a step that is usually given little attention in discounted cash flow analysis.

In addition to the above, discounted cash flow models typically only consider financial/measurable factors, while Present Value takes into account non-financial items. Furthermore, discounted cash flow models take a pure “foregone investment” or “cost of capital” approach to setting a discount rate. We have seen before that for individuals, non-financial factors can be extremely important, and setting a discount rate only based on “foregone investments” ignores the way we as individuals inherently value things today versus the value we place on future consequences. I would argue that both of these factors are relevant for organizations as well, and as a result here, too, Present Value should be used to make important decisions.

Many would say that an organization (company, government, community, etc.) chooses its discount rate on a more “rational” and less psychological basis, but is it really true that organizations themselves utilize a more “rational” model for determining time preference? After all, organizations are made up of human beings, each of whom, as we’ve seen above, does not utilize a consistent or even determinable (as yet) model for how time passes or how important the present is relative to the future.⁴¹ In chapter 8 we discussed how “time horizon” effects might affect the decisions that organizations make regarding present and future events and the implied discount rates in the present values they come up with, but I wonder if there is more to it than that. Perhaps every organization has its own “personal rate of discount.”

Even though their finance departments may pride themselves on incorporating cost of capital and foregone investment rates into their decisions, in practice it may be that organizations make decisions based on the aggregate discount rates of their human participants (or at least its senior managers). How many young high tech companies (run by extremely young CEOs) have we seen making decisions (from what products to develop, to how to compensate their employees, etc.) that imply an extraordinarily high rate of discount? How many public companies do we see focusing solely on near-term financial results at the expense of long-term stability, and how many governments do we see these days taking steps on issues ranging from the environment to retirement policy that imply a disproportionate emphasis on the here and now versus the long-term future? It cannot be that those organizations and their leaders don’t anticipate being around for the long term. Clearly they do—or at least say they do.

I believe that organizations can make better decisions not only by being more thoughtful about the discount rate they use (step 4) but also by being more systematic and adhering more closely to the principles of Present Value, laid out in steps 2 and 3. Organizations need to do a better job imagining the future, then evaluate the relative likelihood of possible scenarios, and utilize a discount rate that reflects the appropriate time horizon and time preferences of their particular entity. The failure to imagine all the possible futures (step 2) was illustrated by the story of the FCC and the telephone companies I related in chapter 7. Many organizations also go astray in step 3 by trying to explicitly predict the future and determine the exact probabilities of what is going to happen, and almost all of them do not think clearly enough about their time horizon and discount rate.

But there is another challenge an organization faces in making a Present Value decision. Almost by necessity, the factors involved are more complex than a decision taken by an individual. The shape of possible future scenarios stemming from the choice that an organization makes may be similar to that facing an individual, but since the effects are felt by more people to varying degrees, determining the “value” of each of those scenarios is more complex, and that value will vary considerably by virtue of the various stakeholders in the decision.

To illustrate that complexity and the distinction between Present Value and “discounted cash flow” analysis for an organization, I want to look at a set of decisions that are being made across the country right now around an issue that is both vitally important to many people’s future and one that I believe is a textbook example of how the failure to utilize Present Value in the right way can lead to disaster.

Specifically, let’s turn our attention to the state of our public employees’ retirement programs, a subject that is very much in the news these days. Much has been written about the plight of retirees in the wake of Detroit’s bankruptcy⁴² and the desperately underfunded condition of the Illinois State Pension Plan,⁴³ but well before those plans got into trouble, there was a state where (in my view) almost all of the principles of good Present Value thinking were violated, creating a financial crisis that almost sank their retirement system and problems that are still having to be dealt with today, twenty years after they emerged.

Promises, Promises, Promises

I was first introduced to the world of public pension plans in the mid-nineties when one of the employers who participated in the Oregon Public Employees Retirement System (OPERS) asked me to take a look at the bill that they had just received for the year’s pension contribution. This was at a time when the stock market was booming and the investment returns that large pension funds were able to obtain were running at 15%–20% per year. OPERS was no exception,⁴⁴ and so my client was puzzled (and not a little dismayed) to find that even with these robust returns, the amount she was being asked to contribute to OPERS each year kept increasing. Theoretically, the benefits of these investment gains should have reduced the plan’s “unfunded liability” and with it, my client’s costs.

It didn’t seem reasonable to me either, but when I looked more closely at the actuarial report and the provisions of Oregon’s Plan, the answer was obvious.

There are two kinds of retirement plans that are typically provided by states, cities, counties, and other governmental entities to their employees. The first is a “defined benefit” plan under which a fixed pension benefit (that might be a function of an employee’s years of service and salary) is provided by the plan and guaranteed for life. One key aspect of these plans is that because the benefit is fixed and guaranteed, the cost of these plans is variable and depending on investment returns (and other demographic variables), the amount an employer has to contribute every year to pay for the plan goes up and down. Historically, this “pension promise” was the predominant type of plan provided not only by public employers but in the private sector as well.

Beginning in the early 1980s, more and more employers began implementing “defined contribution” plans. Unlike defined benefit plans, a defined contribution plan specifies the amount the employer will contribute to a retirement account on behalf of each employee every year, and how much an employee receives in retirement will depend on the investment returns that account enjoys. So, while a defined benefit plan provides guaranteed benefits for the employee and variable costs for the employer, a defined contribution plan provides variable benefits for the employee but guaranteed cost for the employer. Thus, when an organization decides what kind of retirement plan to provide, they have to make a decision as to how much risk (upside and downside) they want to take on and how much they want to pass on to their employees.

Even though my client thought that OPERS was a traditional defined-benefit plan, in fact it was not. In truth, it wasn’t a defined-contribution plan either. It was both. The way OPERS worked was as follows.⁴⁵ The basic benefit was determined under a defined benefit formula (e.g., someone who worked for the state for thirty years and retired at age fifty-eight would receive a lifetime benefit of 50% of their final, average salary, payable until they died). However, operating in tandem with this formula was another defined-contribution arrangement (the “Money Match”) under which an account was set up (though in this case not actually funded) and 12% of pay was allocated to it each year (6% contributed by the employee and another 6% “Money Match” allocation by the employer). That account would then be credited with interest each year based on the investment returns actually experienced by total plan assets (not just amounts that were actually in the account). When the employee chose to retire, the account would be converted into a lifetime annuity. The employee would then get whichever of the two benefits was bigger. Thus employees would get the best of both worlds. If investment returns were poor, they would receive the basic defined-benefit formula benefit, and if investment returns were good, they would receive the “Money Match.” Needless to say, if the employee got the best of both worlds, the employer got the worst of both worlds.

But it was worse than that. The state provided for a minimum guaranteed return on money-match accounts of 8% per year. So in good years, money-match accounts would be credited with the actual return on assets,⁴⁶ but in bad years the accounts would still be credited with 8% interest. Not only was there no risk to the employee on the defined-benefit piece, there was no risk on the defined-contribution piece as well!

In retrospect, the consequences of operating a plan like this were inevitable. The plan was extremely popular with employees and as the stock market boomed throughout the ’80s and early ’90s, benefits soared. Even when the market paused or pulled back, the effect of the 8% guarantee kept benefits on a steady upward trajectory. Eventually, OPERS participants began retiring with guaranteed pension incomes of well over 100% of their earnings while employed.⁴⁷ But, of course, there was a price. Costs for all the employers in the state (including cities, counties, and police and fire districts, as well as municipal utilities like my client) began to increase dramatically and by the time I was called in, the annual cost of some employers’ annual OPERS contribution was exceeding 20% of payroll.⁴⁸ By contrast, the employer cost for a typical retirement plan in the private sector (regardless of whether it is defined benefit or defined contribution) is generally around 5%–10% of pay.⁴⁹

So what went wrong? How did the state get into this mess, and what would it take to get it out?

Believe me, when a multibillion-dollar mishap like this occurs, there is no shortage of “blame analysis” (not to mention litigation) that ensues, and my purpose is not to recount the details of those debates. I spent hundreds of hours helping to untangle the mess and learned a tremendous amount about both the political process and the mechanics about how public employer retirement plans operate. As fascinating as it was, it is not the subject of this book. What I want to do instead is to take a step back and talk about how a clearer understanding and adherence to the principles of Present Value thinking could have avoided much of the disruption and broken promises that ultimately occurred.

One might say that step 1 of the process was not performed well because when the Oregon Legislature implemented the plan’s formula (including the money match), they did so without fully understanding the nature of the choice it faced. Instead of deciding whether to adopt a defined-benefit or a defined-contribution structure, they chose to adopt both types of plans. As flawed as that first step may have been, I think the problem was less with clarifying their choice and more with the Legislature not being clear on the present-value implications of the decision they faced and in particular the way steps 2 and 4 were (not) performed.

I wasn’t present at the time, but I can well believe that a comprehensive discounted cash flow analysis was performed before the decision was made. Furthermore, in doing that analysis, let’s say that the Legislature did enumerate the three options they might have considered: a defined-benefit plan, a defined-contribution plan, or the “combo” plan they ultimately chose. How should they have approached it? Well, as we know, in using Present Value, step 2 is critical, and to my mind, this was the root cause of the problem. In particular, I believe there was a failure of imagination. When the money match was implemented in the mid-seventies, projections of benefits were undoubtedly done (with the cash flow duly discounted), but clearly those projections did not extend far enough into the future, nor did they consider a wide enough range of possibilities.

In 1978, I can well imagine that it must have seemed absurd that interest rates would fall to the low single digits and that that, combined with stock market volatility, would cause money match benefits (and costs) to skyrocket, but using Present Value thinking, the decision makers might have been able to foresee that as a possibility. Furthermore, even if they considered what actually occurred as being “highly unlikely,” it seems that the potential consequences of such a scenario were never fully investigated. Had such an analysis taken place, the money match would likely not have been implemented in the way it was, and the crisis that ultimately ensued could have been avoided.

Given that the promises that OPERS made (and the Oregon Supreme Court has ruled several times on just how ironclad those promises were) extended decades into the future, it was, in my view, essential to consider the impact on employees and the financial health of all the cities, counties, and so forth of what it would take to fulfill those promises in all circumstances. In this case, the results of the failure to execute step 2 were wrenching. When the full extent of the problem became apparent, all the public employers that participated in OPERS were faced with a series of very difficult choices. First they had to “stop the bleeding” and make sure the problem didn’t get worse. This was harder than it might seem since participants understandably felt that they had a contractual right to all the benefits that were part of the plan when they were hired.

But fixing the problem for the future was only half the battle. By the mid-nineties, the outlook for Oregon and its local governments was so grim that if current benefits were not reduced for employees and maybe even retirees, basic services (e.g., fire, police, and schools) of cities, counties, and other public entities might have to be cut back to forestall bankruptcy, and everyone saw the present-value implications of that scenario. It was a classic case of “pay me now or pay me later,” and regardless of the discount rate used, there was no option for deferring payment any longer.

Beyond the obvious importance of being more attentive to low likelihood/high impact events in step 2, there was one other aspect of Present Value that is central to the story of OPERS. I mentioned it at the very beginning of this chapter. Specifically, it is step 4. While I am sure that OPERS and their actuaries did a great deal of thinking about the discount rate to be used to determine the Present Value of benefits that were published in its report each year, I am not as sure that they thought enough about the discount rate and time horizon to use when considering the design decisions that led to the 8% guarantee on money-match accounts. This decision was made by individuals whose time horizon might or might not have extended beyond the next election or the next collective bargaining contract.

In fact, I would state this principle more strongly. As a general rule: Decisions about long-term promises, like pension benefits (as well as many others affecting large groups of people), require a time horizon and a discount rate that reflects the interests of the organization or the community itself and not just the aggregation of the personal rates of discounts of all the parties involved in making the decision.

In the end, all the parties were able to put aside their agendas—and there were many—and craft a solution that spread the financial pain and broken promises as equitably as possible. In developing that solution, the five steps of using Present Value effectively were followed much more faithfully with both the financial and non-financial consequences of system changes considered. Steps 2 and 3 in particular were better addressed with more possibilities and their relative likelihoods analyzed. Finally, unlike in the past, a much longer time horizon and different stakeholders’ discount rates were taken into account.

No one was happy with the final result, but no city or county went broke, and the system survived. Today, except for limited “grandfathering” of longtime employees and retirees, the “new” OPERS is basically a defined-contribution plan,⁵⁰ and Oregon is no longer in the news as one of those states where pensions are at risk.

In my opinion, traditional discounted cash flow analysis is inadequate for use by organizations that are contemplating making a very long-term commitment like a pension plan. For this, the tool of Present Value is essential, but even here that tool needs to be utilized with skill, finesse, and most importantly, a recognition that an organization is more than just the collection of the individuals who make it up.