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.
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.
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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.
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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.
Typically, when you think about yourself, a region of the brain known as the medial prefrontal cortex, or MPFC, powers up. When you think about other people, it powers down. And if you feel like you don’t have anything in common with the people you’re thinking about? The MPFC activates even less.
More than 100 brain-imaging studies have reported this effect. (Here’s a helpful meta-analysis—while some fMRI studies have been called into question recently for statistical errors and false positives, this particular finding is robust.) But there’s one major exception to this rule: The further out in time you try to imagine your own life, the less activation you show in the MPFC. In other words, your brain acts as if your future self is someone you don’t know very well and, frankly, someone you don’t care about.
This glitchy brain behavior may make it harder for us to take actions that benefit our future selves both as individuals and as a society. Studies show that the more your brain treats your future self like a stranger, the less self-control you exhibit today, and the less likely you are to make pro-social choices, choices that will probably help the world in the long run. You’re less able to resist temptations, you procrastinate more, you exercise less, you put away less money for your retirement, you give up sooner in the face of frustration or temporary pain, and you’re less likely to care about or try to prevent long-term challenges like climate change.
This makes sense. As UCLA researcher Hal Hirschfield put it: “Why would you save money for your future self when, to your brain, it feels like you’re just handing away your money to a complete stranger?”
Our current political climate in the United States reflects this same cognitive bias against the future. Recently, President Trump signed a sweeping executive order undoing a vast array of regulations designed to mitigate long-term climate change in favor of policies that provide much shorter-term economic benefits. And Treasury Secretary Steven Mnuchin recently made headlines when he said publicly that he is “not worried at all” about the possibility automation could eliminate millions or even tens of millions of American jobs in the future. “It’s not even on our radar screen,” he said, adding that it won’t happen for “50 to 100 years or more.” But, as Daniel Gross wrote in Slate, he’s wrong. It probably will not take five decades or more for robots and artificial intelligence to significantly reduce the number of jobs available to Americans. Recent economic research from MIT suggests that 670,000 industrial jobs have already been lost to automation in the U.S.