Accounting board votes to change pension rules for state and local governments

    Norwalk, Conn. – State and local governments will need to disclose unfunded pension promises alongside debt on their balance sheets beginning in 2015 after an oversight board voted unanimously Monday to change relevant accounting rules.

    The rule change will not change how much debt governments actually have, just how they are required to report the debt.

    The Governmental Accounting Standards Board, based in Norwalk, Conn., unanimously approved two sets of rule changes, one for pension plans themselves and another for the government employers that sponsor the plans.

    According to GASB, the new requirements for pension accounting will make financial statements more useful, enhance their “value for assessing accountability and interperiod equity” and increase “consistency and transparency.”

    Government pensions have been the source of recent political disputes and a wide range of states and cities have embraced reform, including Rhode Island, Utah, Wisconsin and the California cities of San Diego and San Jose.

    GASB defines generally accepted accounting principles for governments in the U.S. other than the federal government, much like its sister organization, the Financial Accounting Standards Board, defines GAAP accounting for the private sector.

    Both FASB and GASB are part of the Financial Accounting Foundation.

    Currently, governments disclose unfunded pension obligations in footnotes to their financial reports. Under the new rules, these debts will be listed alongside money owed to bondholders and other liabilities.

    “They’ll be reported out in the open instead of being buried in the notes,” said Eileen Norcross, a senior research fellow at the Mercatus Center who has written extensively about pensions. “That brings about more discipline.”

    “It’s not a funding rule,” Norcross said. “It’s a reporting rule.”

    The new rules also:

    • Limit the range of actuarial methods and assumptions available to governments.
    • Standardize the time periods over which governments can spread out changes in liabilities and assets.
    • Mandate accounting for ad hoc cost-of-living increases if they are essentially automatic.
    • Change the way governments discount their liabilities and increase disclosures related to the discount rate.

    The new rules will go into effect for pension plans in fiscal years beginning June 15, 2013, a year ahead of implementation for governments themselves, which starts with fiscal years beginning June 15, 2014.

    The first reports under the new rules will be issued a year later in 2014 for plans and 2015 for government sponsors.

    Under the new rules, actuaries must use a specific method to calculate pension benefits (entry age, level percentage of payroll) at least every two years.

    According to the new standard, actuaries could previously choose “among six methods with additional variations.”

    Under the new rules, costs or savings attributed to changes in benefits will be recognized immediately. Costs or savings from differences between expectations and actual experience will be recognized over the number of years before the average employee retires.

    That calculation will include retired employees as having no time before retirement.

    The effects of changes in assumptions will be spread over the same time period.

    Differences between expected investment returns and actual returns will be spread over a five-year period, a practice known as asset smoothing.

    Norcross said GASB’s embrace of smoothing is disappointing.

    “Over time you don’t gain anything” from the practice, she said.

    GASB will also require governments that consistently provide cost-of-living increases to retired employees to include future increases in the valuation of their pension costs.

    Governments will also have to disclose their assumptions, explain the causes of changes in net pension liability, show how much of their pension liability is covered by pension assets and report how close their actual contributions come to the actuarially-defined contribution,

    “I think I see some technical improvements as they put on the final touches,” said Jeremy Gold, an actuary with a doctorate in finance who has been critical of government pension accounting. “All in all, however, I think they continue to miss the mark in a big way.”

    Gold said it will be unclear under the new rules how much of pension costs for work done yesterday will be “foisted upon future taxpayers.”

    “Interestingly, in the 1980′s, many plans were overfunding, overcharging taxpayers of that period for the benefit of those who came later,” Gold said.

    GASB stated increased interperiod equity – or the assignment of changes in pension finances to the proper reporting period – as one of its goals for the new rules.

    Gold said it will still be difficult to compare pension plans and taxpayers will still have difficulty determining the value of benefits earned in any given year.

    “In other words, what are we taxpayers paying in total compensation to those employees who are providing us with public services today,” he said. “How do such total compensation packages compare to those in the private sector?”

    “This is too little, too late,” said Frank Keegan, editor at State Budget Solutions. “The new regulations leave too many loopholes and can just provide another level of deception.”

    “In fact, these new guidelines will actually encourage the worst public pension plans to take more risk at a time when they should be reducing risk,” Keegan said. “That just sets dedicated municipal and state workers and taxpayers up for a bigger crash in the next market downturn.”

    He said government pensions “are in the hole for at least $4.4 trillion and the hole is getting deeper every minute,” citing an April 2012 report by the Mossavar-Rahmani Center for Business and Government at Harvard’s Kennedy School.

    “GASB members should ask themselves whether they are part of the solution or part of the problem,” Keegan said.

    Although the rules make changes to the way governments discount their liabilities, financial economists critical of GASB’s methods – including Gold and Norcross – are not satisfied.

    Many governments assume rates of return above 7 percent, with some as high as 8.5 percent.

    Norcross said the use of such high discount rates creates a “tendency to underfund” because the liability appears smaller.

    Governments will need to disclose how they calculate the discount rate, but they will still be allowed to use a rate based on the expected rate of return on plan investments.

    Economists object to this connection between asset returns and the value of liabilities as contrary to basic economic principles.

    Nobel-prize-winning economist William Sharpe lampooned this connection in a satirical video. During a morning-show style interview, a state-pension actuary claims his $1 million mortgage with a fixed rate of 4 percent is only a $650,000 liability because his investments will return 8 percent a year.

    “I must admit that this puzzles me,” the interviewer says.

    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.

    Rather than base the value of liabilities on asset returns, economists say they should be valued based on their likelihood of having to be repaid.

    Since pensions are guaranteed – there is no risk they won’t have to be repaid short of bankruptcy – they should be valued using a risk-free rate of return, often equated with Treasuries.

    Billionaire New York City Mayor Michael Bloomberg also criticized the high rates of return assumed by pension funds.

    “The actuary is supposedly going to lower the assumed reinvestment rate from an absolutely hysterical, laughable 8 percent to a totally indefensible 7 or 7.5 percent,” Bloomberg told the New York Times. “If I can give you one piece of financial advice: If somebody offers you a guaranteed 7 percent on your money for the rest of your life, you take it and just make sure the guy’s name is not Madoff.”

    GASB’s rules introduce a new method for calculating the discount rate and increase disclosure of that calculation.

    Under the new method, if a pension plan is projected to run out of assets it will no longer be able to use a discount rate based on its expected rate of return.

    Instead, such a plan would need to calculate its discount rate for the period after it runs out of assets using “a tax-exempt, high-quality municipal bond rate.”

    The resulting discount rate will be a blended mix of the expected rate of return and the municipal bond rate, weighted according to the availability of assets for investment.

    These changes do not address economic concerns and instead reaffirm the relationship between asset returns and the value of liabilities.

    Governments will also need to disclosure the sensitivity of their pension liabilities to the discount rate.

    If, for example, a government uses an 8 percent discount rate, it will need to disclose what its obligations would be if calculated using a 7 and 9 percent discount rate to show how dependent the calculation is on the rate chosen.

    “Even though a number of systems have been lowering the discount rates, most rates are still closer to 8 percent than 7 percent,” Gold said. “In the last year or two rates on Treasury securities have declined more sharply and thus the spread over Treasuries has increased.”

    He said the increased spread “means that GASB’s new rules may be understating liabilities by as much as 50 percent.”

    Norcross said these methods are “masking the true economic value of these plans.”

    “They’re just trying to make reality more palatable to themselves,” she said.

    GASB first mandated the reporting of pension liabilities in 1997. Last year, GASB released a draft of these changes and collected public input on the proposal which led to some revisions.

    In July, GASB will begin a two-year deliberation on retiree health insurance, commonly called other postemployment benefits, which will lead to new accounting rules in the summer of 2014.