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State and local US pension plans hold an estimated $3 trillion in assets, with market values regularly disclosed in plan financial statements. By contrast, public defined benefit pension liabilities are routinely reported at actuarial values that may differ substantially from market values. The authors propose that a more accurate way to value plan liabilities measures the present value of accrued benefits discounted at market interest rates for fixed income investments that are (or are nearly) default-free. They illustrate the difference between these measures for a set of public sector pensions using publicly available information.

Pension systems are a central component of the compensation package for workers in virtually every developed nation, and nowhere are they more important than for public sector employees. The growth of public pensions has spurred a hot debate of late, since some private sector employees envy their public sector counterparts the relatively generous benefits negotiated by strong unions that traditionally represent civil servants. Also some politicians had argued that pension and health-care benefits paid to police and firefighters, schoolteachers, and other civil servants have become too expensive for the public purse, especially when benefits have been cut in the private sector And the costs of maintaining public sector pension plans have come under the microscope of late, as municipalities, states, and other governmental units facing difficult financial times and volatile capital markets realize they must cut corners. This volume takes up these and other themes pertinent to the future of public employee retirement systems around the world.

This chapter analyzes the risks and rewards of moving from an unfunded defined benefit pension system to a funded plan for civil servants in Germany, allowing for alternative portfolio mixes using a Monte Carlo framework and a Conditional Value at Risk metric. The authors identify an investment strategy for plan assets that will minimize worst-case pension costs; this turns out to be 22 percent in equities, 47 percent in bonds, and 31 percent in real estate. The authors show that moving toward a funded pension system for German civil servants can be beneficial to both taxpayers and civil servants.

Chapter 3 provides an understanding of how expected liability cash flows and their present values are calculated and series of future payments are distributed. Readers will understand the difference between nominal, inflation-linked, and real cash flows which have so much effect on the liability hedging strategy. This chapter provides key points regarding liability risks, liability valuation methodologies calculated by actuaries and the potential impact on the investment strategy through practical and easy-to-understand charts. This chapter provides the tools to negotiate a more appropriate discount margin with actuaries and, as a result, get an amount of contributions which maximize expectations. This chapter is an important step in understanding the liability driven investment techniques.