The way states and local governments account for pensions is about to change – slowly.

The Governmental Accounting Standards Board, a nonprofit based in Norwalk, Conn., will release a draft of changes to pension accounting rules Friday. These changes will first affect government balance sheets in fiscal year 2013.

The most significant change in the proposal will move unfunded pension liabilities out of a footnote and onto government balance sheets.

GASB officials emphasize the new rules won’t change how much states and cities owe – or how much they have to contribute to their plans – but they will increase transparency and uniformity.

“The economic reality is that nothing has changed; it’s the presentation that has changed,” GASB Chairman Robert Attmore told Stateline recently.

“We would encourage GASB to implement this tomorrow,” said Sheila Weinberg, founder and CEO of the Institute for Truth in Accounting. “Right now if you look at the balance sheet, the balance sheet is a bogus number.”

Weinberg said the changes bring “full transparency” to pension liabilities. She said it took her organization, experts on the subject, a year and a half to determine that all 50 states combined have more than $500 billion in unfunded liabilities. After the changes, Weinberg said this information will be more accessible to legislators and the general public.

“You can’t make good decisions if you don’t know the right number,” she said.

Under the current rules, Weinberg said, California had more assets than liabilities on its balance sheet as recently as 2008. “Obviously, that’s totally bogus,” she said.

Mark Zehner, an enforcement officer for the Securities and Exchange Commission’s Public Pension unit, told that the uniformity also will help his agency better regulate the market.

“The multitude of options available generates complexity and the ability to hide a lot of problems,” he said. “In the long term, this (change) is a positive. We’re bringing to the surface what some of these numbers really mean.”

The GASB proposal would also:

  • Allow only one actuarial method for calculating pension costs (entry age normal, level percentage of payroll)
  • Limit the length of time over which governments can spread pension costs related to current employees (a weighted average of employees remaining service period)
  • Force pensions to immediately recognize costs or savings caused by benefit or assumption changes
  • Require governments to report their unfunded liabilities calculated in three different ways: using their chosen discount rate, the discount rate minus 1 percent and the discount rate plus 1 percent
  • Implement a new, blended discount rate for pension plans that expect to run out of assets
  • Include ad hoc cost of living adjustments – or COLAs – in pension liabilities if the COLAs are essentially automatic

GASB first mandated the reporting of pension liabilities in 1997. It more recently required governments to report their retiree health care liabilities, known as other post-employment benefits or OPEB.

Unions and other supporters of public pensions have blamed GASB’s rules for recent efforts to replace public employee pensions with defined-contribution plans, similar to private sector 401(k) plans.

The public will have 90 days to comment on GASB’s proposal, called an exposure draft. The board expects to finalize the changes by June 15, 2012.

John Bury, an actuary who serves private-sector clients and blogs about pensions, said the changes are an attempt to increase the annual required contribution, or ARC, but he doesn’t see the point when many governments don’t contribute the full amount anyway.

“If you give them a number of $5 billion and they put in $2 billion, what are you going to do, give them a number of $6 billion so they can put in $2 billion,” he said.

The Pew Center on the States has reported findings similar to Weinberg’s institute. State pensions around the country, according to Pew, have $2.28 trillion in assets set aside to pay $2.94 trillion in promised benefits, leaving an unfunded liability of $660 billion.

Both Weinberg and Pew collected information reported by state governments to arrive at their numbers. Many financial economists question the assumptions used by states, saying they drastically underreport their liabilities.

Joshua Rauh, an associate professor of finance at the Kellogg School of Management at Northwestern University, estimates the total unfunded liability of all 50 states is actually $2.5 trillion.

The difference between Rauh’s estimate and the numbers reported by state governments is the discount rate. GASB allows states to use their expected rate of return as the discount rate for future payments, while financial economists like Rauh argue those rates are arbitrary and too high.

Jeremy Gold, an actuary with a doctorate in finance, said GASB’s approach may be mathematically accurate, but it doesn’t reflect the economics behind pension liabilities.

Although GASB’s proposal includes some changes to the handling of the discount rate, Rauh is not satisfied.

“I think the entire Governmental Accounting Standards Board system is so off the mark,” Rauh said, “I’m not willing to praise them for incremental changes.”

Gold said GASB’s rules rein in the “most flagrant abuses” but make only minor changes to the “most central measurement errors.”

When a government calculates how much it owes future retirees, it has to put a value on future spending. Under current GASB rules, governments that expect an 8 percent return on their pension investments – the most common number – discount the value of a future dollar by 8 percent per year.

GASB and states base their logic on the expectation that pension funds can earn 8 percent on contributions by investing in the stock market.

The new GASB rules will allow governments to publish their unfunded liability based on their chosen discount rate, but they will have to also calculate their liability based on that discount rate plus 1 percent and minus 1 percent.

At GASB’s June 27 board meeting, the members talked about requiring governments to report their liability using three different discount rates, which they call sensitivity analysis.

“I think the idea of a sensitivity analysis is better than what we have,” said board member Michael Belsky. “You’re doing a favor to the user because the user would try to figure it out anyway.”

“What’s the rationale for 1 percent,” board member Michael Granof asked. “Why not add another column?”

Attmore said users can extrapolate other information from the three numbers provided in the sensitivity analysis.

“I like it better than what we have now,” Granof said.

GASB members discussed how they are setting accounting rules, not changing public policy.

“It might instigate it because it provides information,” said board member Jan Sylvis.

According to Rauh, a 1 percent change in the discount rate is roughly equal to a 15 percent change in liabilities for most pension plans.

The GASB proposal will also require pension funds that expect to run out of assets to use a lower discount rate – equal to a high-quality municipal bond index rate – but only on the liabilities that don’t have underlying assets.

At the June meeting, GASB member James Williams said the blended discount rate was not a dramatic enough response.

“It switches from a pension plan to a Ponzi scheme,” Williams said. “This is a disaster if it ever happens. This is not a business as usual where you switch over to another rate.”

Gold said governments will probably never use the blended rate because they can design their plans to avoid it. He said GASB will need to resolve at least one question with potentially serious consequences: will states don’t follow the plan set out by their actuaries have to use the blended rate?

“New Jersey might have that kind of problem,” Gold said, referring to the state’s decision to fund about one-seventh of its $1 billion pension contribution this year and two-sevenths next year.

Rauh said he also disagrees with GASB’s decision to use a municipal bond index rate because the pension benefits are more protected than the rest of state debts. Since pensions are less risky, he argues, they should have a lower discount rate.

Gold said actuarial calculations are useful for constructing a budget. “It’s sort of an engineering system,” he said. “That doesn’t necessarily lead to a good accounting.”

He said the corporate method for pension accounting, governed by GASB’s sister organization, the Financial Accounting Standards Board, is not perfect but is “immensely better than anything GASB has come up with.”

“GASB continues to follow most of the traditional actuarial assumptions,” Gold said. “They tell you how you’re doing compared to your budget. They don’t tell you whether the budget is adequate.”

Gold said GASB is setting some limits on the types of budgets it allows, but the new rules still “don’t create a budget that would be recognized in the global financial markets as a reliable budget.”

According to Rauh, Gold and others who share their thinking, if a state has to guarantee a pension payment it should use a discount rate it can also guarantee, a rate without any risk.

The risk-free rate is usually equated with U.S. Treasuries which yield considerably less than the stock market.  With a smaller discount rate, governments would need to set aside more money in the present to meet their obligations in the future.

Former Federal Reserve Vice Chairman Donald Kohn, in 2008 while still in that office, told the National Conference on Public Employee Retirement Systems expected rates of return should not be used to discount pension costs.

“While economists are famous for disagreeing with each other on virtually every other conceivable issue, when it comes to this one there is no professional disagreement: The only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate,” Kohn said.

According to Gold, only one government, New York City, publishes its pension liabilities using the risk-free discount rate he supports. He said there is also legislation in Congress, sponsored by Rep. Devin Nunes, R-Calif., that would require all governments that issue tax-free debt to publish their pension liabilities in this way.

“There are a number of things that are happening which are challenging GASB,” Gold said.

By pursuing higher returns, pension funds have to take on risk. In the stock market, Rauh said, “there is a distribution of possible outcomes.”

“The higher the return you target, the greater the chance you’re going to fall short,” he said.

Rauh said it can make sense for people to invest their retirement savings in the stock market, but unlike governments they are able to reduce their spending if their investments don’t meet expectations.

In the case of state pension plans, Rauh said, taxpayers are “providing a tremendous amount of downside insurance.”

Rauh said historically stocks have returned 11 percent and yet no pension fund expects to earn 11 percent. He said if a government proposed investing entirely at stocks and doubling its expected return using leverage “most people would look at that and say it’s too risky.”

He said states can “try to shade” their liabilities with their expected rate of return, but the rate of return doesn’t change the reality of the amount owed.

Gold said using the wrong discount rate makes some of the other improvements proposed by GASB insignificant.

 “After they mismeasure the shortfall, they then in a budgetary way plan to pay for the shortfall,” he said.

Pension liabilities can be analogized to a mortgage, according to Gold.

“The mortgage that they have in place doesn’t even pay the interest on the mortgage,” Gold said. “It’s growing to infinity.”

He said in a mortgage this is called negative amortization.

“The teaser rates that were part of the housing disaster three years ago were based on exactly that,” Gold said.

Bury said there are a number of actuarial problems with public pensions that should be addressed.

  • Healthcare for life makes public employees live longer, making standard mortality tables irrelevant.
  • Actuaries don’t account for pension spiking, the practice of taking a high-paying job or extra overtime to maximize pension benefits.
  • Plans allow employees to buy credits and only the employees who benefit buy them, which increases costs.

According to Bury, actuaries are using techniques to keep contributions down because that is what governments want. “They’re afraid to be independent,” he said.

Public employees are going to get their benefits, Gold said, “the question is who is going to pay for it.”

“Essentially, we, this generation, have consumed the services of police on the beat, but we are asking our children to pay for half of the pension costs,” Gold said.

In a recent paper, Rauh estimates governments would need to raise taxes by $1,398 on every American household to fully fund pensions in within 30 years. Even if all public employees stopped earning pension benefits now, according to Rauh, each family would have to pay $800 to fully fund pensions in 30 years.

“As an older taxpayer, I’m getting the benefits,” Gold said. “Today’s taxpayers are happy because they’re not being charged.”

“The unhappy people should be tomorrow’s taxpayers, but nobody’s standing up for them,” Gold said.