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GASB Public Employee Pension Disclosures Aren't Merely Insufficient, They're Part Of The Problem.

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My recent article, “Puerto Rico Illustrates Need For New Public Employee Pension Disclosures,” argued that any rescue Puerto Rico rescue bill passed by Congress needs to include the provisions of Rep. Devin Nunes's Public Employee Pension Transparency Act (PEPTA), which would require that state and local governments accurately disclose their public employee pension liabilities. This so-called “fair market valuation” would be accomplished by “discounting” future pension liabilities, which are guaranteed by law, using the interest rate on guaranteed U.S. Treasury securities. The PEPTA approach would show two things that GASB disclosures don’t: that state and local pension plans are on average very poorly funded and that taking more investment risk won’t solve that problem.

Following that article, some have asked why existing public employee pension accounting requirements from the Governmental Accounting Standards Board (or GASB) aren’t sufficient. Didn’t GASB recently revise its accounting standards for state and local retirement systems? The answer is that GASB’s revisions don’t fix the key faults that GASB’s standards have had all along, which is that they lowball a public pensions’ liabilities and encourage that pension to take excessive risk in funding those liabilities.

Under the GASB rules that were in place through 2013, known as Statements 25 and 27, a public employee pension plan valued its future benefit liabilities by “discounting” them at the rate of return the plan assumed for its investments. So, as a simple illustration, if a plan owed a lump sum of $1 million in benefits 10 years from now and it assumed an investment return of 8 percent, the present discounted value of that benefit payment would be 1,000,000/1.0810, or $463,193.

This approach is simple, but it has a crucial flaw: the benefits offered by a state/local pension plan are guaranteed, meaning that they must be paid under almost any imaginable situation. Illinois, Oregon and other states found that out the hard way after legislation to reduce benefits was overturned by their Supreme Courts. But the 8 percent return used to discount those benefits is based on a risky portfolio consisting mostly of stocks and alternative investments, such as private equity, hedge funds and real estate. Economists are almost unanimous in believing the GASB approach to be wrong. As Jeffrey Brown, Dean of the University of Illinois College of Business, and David Wilcox, Director of the Federal Reserve’s Division of Research and Statistics put it, “Finance theory is unambiguous that the discount rate used to value future pension obligations should reflect the riskiness of the liabilities.”

If we considered public pension benefits to be as guaranteed as U.S. Treasury bonds, currently yielding around 2 percent, then the true liability value of that $1 million payment in 10 years’ time is $820,348, 77 percent larger. When pension liabilities are valued appropriately, the true funding status of state and local pension plans -- which is currently a not-so-great 75 percent -- falls to about 50 percent and unfunded liabilities in some calculations top $3 trillion. By any accounting standard other than their own – by which I mean the accounting standards applied to U.S. corporate pensions, the accounting standards that public employee plans in other countries use, or the standards employed in financial markets worldwide to value an enormous range of liabilities – U.S. state and local pension plans are in bad financial shape and pose a meaningful threat to state and local government finances and, potentially, even to the federal government’s budget.

But GASB reformed their pension standards. They fixed this problem, right? Wrong.  Beginning in 2014, GASB began implementing Statements 67/68, which revised the calculation of public pension liabilities. But these revisions were minor. In my view, GASB 67/68 were enacted under pressure to appear to be doing something about pension accounting rules, but without making the majors changes that so many independent analysts were calling for.

Under GASB 67/68, a pension plan can discount its liabilities using the assumed return on risky assets – the 8 percent value I referred to earlier – so long as the plan expects its assets to be sufficient to cover those liabilities. If the plan expects its fund to run out at some point, then any liabilities occurring after that run-out point would be discounted using a lower return derived from the yield on municipal bonds. As I argued in the Financial Analysts Journal in 2011, this approach makes no sense analytically: funded liabilities are presumably more likely to be paid, so they should be discounted using a lower interest rate, while unfunded liabilities are presumably riskier and should be discounted using a higher rate. In other words, GASB’s new method has things exactly wrong.

But the more important point is that GASB’s new rules don’t change much. For some plans that are in truly dire shape and in danger of running out of money soon, GASB 67/68 has an impact. Say, Detroit’s main pension plan is forced to use a bond yield to value at least some of it liabilities. But for most plans, insolvency isn’t imminent, which means that plans can continue to use a high 8 percent or so discount rate, which lets them understate their liabilities and shortchange their contributions. As a result, GASB 67/68 won’t change much on the unfunded liabilities that most plans report – despite literally 98 percent of economists agreeing that those reported values significantly understate plans’ true liabilities.

But there’s something worse: under GASB 67/68, as under the previous Statements 25/27, there are huge incentives for state and local pensions to take excessive investment risk. And there is clear evidence that public employee pensions have reacted to these incentives by taking on more risk.

Under GASB 67/68, a pension plan that takes additional investment risk can assume a higher rate of return for their plan. A higher assumed rate of return, under GASB rules, implies a higher discount rate for liabilities. A higher discount rate for liabilities means a lower present value of liabilities. And a lower present value of liabilities means lower contributions to fund those liabilities.

And we know that state and local governments are already feeling the pinch over pension contributions. Even using GASB’s very forgiving accounting standards, nearly 60 percent of state and local governments didn’t make their full pension payments in fiscal year 2013, the last year for which full data are available.

Have pensions responded by taking on additional investment risk? They sure have. Data from the Public Plans Database show that in 2001, state and local pensions held 64 percent of their investments in risky assets. That share has steadily risen, reaching 72 percent in 2013. Public plans blame their poor financial state on the market downturns stemming from the bursting of the dot-com and housing bubbles, but since those downturns they’ve taken non more investment risk, not less. The Society of Actuaries, one of the governing bodies for the actuarial profession, noted with worry that “public sector plans in the U.S. are unique in that they have taken additional risk as the plans have become more mature, compared to private sector plans in the U.S. and private and public sector plans in Canada, UK and the Netherlands, which have taken less risk as plans have matured.”

The reason is simple: under GASB’s rules, a plan that takes more risk immediately reduces its (measured) liabilities and can contribute less. Under the more market-oriented rules governing U.S. corporate pensions or pensions in Canada, the U.K. or the Netherlands, the discount rate is fixed and taking more risk doesn’t let plan sponsors lower contributions. So those plans don’t have incentives to take excessive investment risk. GASB’s rules, even the supposedly reformed Statements 67 and 68, facilitated what amounts to gambling by public sector pensions by effectively crediting plans with higher investment earnings before any of those earnings have actually taken plan. And we’re not talking small amounts here. Public pension investments today are close to $3.5 trillion, according to Federal Reserve data.

Under GASB accounting rules, a public employee pension that takes greater investment risk instantly becomes “better funded” and can reduce its contributions. That isn’t just wrong. It’s dangerous. To protect taxpayers Congress needs to include new and accurate pension disclosure requirements in any Puerto Rico legislation. Existing GASB pension accounting regulations aren’t just insufficient. They’re part of the problem.