The accounting trick that will haunt public pensions

Reuters

A view of a doorway of the City hall building in Scranton, Pennsylvania July 11, 2012. Firefighters, police officers and public works employees in Scranton, Pennsylvania sued the city on Tuesday after the mayor slashed pay for the city's workers to the state's minimum wage of $7.25 an hour. Scranton, a city of about 76,000 in the northeast of the state, is the latest U.S. city in financial turmoil amid sunken revenue collections, lowered state aid and increased pension and other costs.

Article Highlights

  • Public pensions were around 76% funded as of 2010, with unfunded liabilities exceeding $750 billion.

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  • If accrued pension benefits are valued using riskless treasury yields, unfunded liabilities today top $4 trillion.

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  • Once bond markets take notice, state/local government will at last face market pressure to manage pensions responsibly.

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State and local government employee pensions around the country are significantly underfunded. The Governmental Accounting Standards Board (GASB), which is the closest thing that comes to a regulator of public pensions, tells them, through its accounting rules, that the single best thing pensions can do to improve their funding is to take greater investment risk. Economic theory, accounting rules applied to virtually all other pension plans, and plain common sense strongly disagree. GASB rules cause U.S. public pensions both to vastly understate their true liabilities and to take excessive investment risk, putting in danger both government budgets and the economy as a whole. With pension liabilities breathing down the necks of state and local governments around the nation, it is time for bond rating agencies to expose what GASB rules sweep under the rug.

Under GASB's current accounting standards, state and local pensions "discount" their future benefit liabilities using the assumed rate of return on pension's assets, typically 8 percent. Discounting calculates the present value of a future payment by subtracting interest each year, something like compound interest in reverse. Under GASB's current standards, public pensions were around 76 percent funded as of fiscal year 2010, with unfunded liabilities exceeding $750 billion. 

"If accrued pension benefits are valued using riskless Treasury yields, unfunded liabilities today top $4 trillion, an amount that makes most current pension plans financially unfeasible." -Andrew G. BiggsBad as this may seem, the reality is worse. In economic theory, financial markets and the rest of the pension world, riskless liabilities like public pensions are valued using low discount rates to reflect the fact that public employee benefits are guaranteed, by law, legal precedents and often constitutional amendments. If accrued pension benefits are valued using riskless Treasury yields, unfunded liabilities today top $4 trillion, an amount that makes most current pension plans financially unfeasible.

In response to criticism, GASB in June proposed amended rules. Under the new standards, the current 8 percent discount rate could be applied to benefits only through the years in which the plan's assets are expected to last. Liabilities occurring in years after plan assets would be exhausted must be valued using a lower municipal bond rate. 
Any step toward reality would seemingly be welcome. But GASB's new approach would reduce pension funding ratios by only around 10 percentage points. As the State Budget Crisis Taskforce report recently stated, even the new GASB rules "fall far short of what finance experts argue is appropriate and reported unfunded liabilities will not increase anywhere near as much as they would under a pure finance approach." 

But the dangers of GASB's discounting rules are far from merely theoretical. Like the current rules, the new regulations tell pensions that boosting investment risk automatically makes them better funded, before a dime of higher returns have been realized. Since riskier investments have higher expected returns, shifting to a riskier portfolio allows public pensions to use a higher discount rate, instantly improving their funding status.

And these misaligned incentives have real effects. In a recent study, economists Aleksandar Andonov and Rob Bauer of Maastricht University and Martijn Cremers of Notre Dame show that public sector pensions in the U.S. take greater investment risk than either U.S. corporate pensions or public plans abroad, which cannot discount liabilities using high expected asset returns. "In the past two decades," the authors state, "U.S. public funds uniquely increased their allocation to riskier investment strategies in order to maintain high discount rates and present lower liabilities..." Accounting-driven choices for U.S. public sector pensions, the authors say, "have large economic effects and could have potentially severe future consequences."

Despite GASB's intransigence, there is hope on the horizon. The bond ratings agency Moody's, buttressed by a number of academic studies and government agency reports, announced in early July that it will no longer accept state and local governments' pension liability figures at face value. Instead, Moody's will value pension liabilities using yields from high quality corporate bonds, similar to the standards applied to private pensions. While corporate bond yields are almost surely too high- public pension benefits remain safer than corporate pensions and thus should be discounted at lower rates - even this change would nearly triple unfunded pension liabilities to $2.2 trillion nationally. Once bond markets take notice, state and local governments will at last face market pressure to manage their pensions responsibly. 

Andrew G. Biggs is a resident scholar at the American Enterprise Institute.

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