Civic Report
No. 63 February 2011
UNMASKING HIDDEN COSTS:
Best Practices For Public Pension Transparency
Josh Barro, Walter B. Wriston Fellow, Manhattan Institute for Policy Research
Executive Summary
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SUMMARY The underfunding of public pensions, and the threat this poses to the fiscal solvency of cities and states, has emerged as an urgent policy concern. But pension accounting rules are so convoluted that many lawmakers are themselves in the dark about the true costs of the unsustainable pension promises they've made. This report recommends five steps that public pension plans could take that would disclose their finances more fully. This would clarify the magnitude of states' total accrued liabilities and their annual impact on budgets. Making this information available is the first step in helping states adopt policies that would save taxpayers money in the long run.
In 2010, the pension plans of state and local governments came under increased scrutiny in response to their generally weak financial positions and mounting costs to taxpayers. By some measures, these funds are as much as $3 trillion short of the assets they would need to cover the promises they have made to government workers and retirees. However, several shortcomings in these funds' financial disclosures have made it difficult for even lawmakers and policy experts to accurately evaluate pensions' actual financial condition.
There are several steps, over and above what the Government Accounting Standards Board already requires, that funds could take that would disclose their finances more fully. The recommendations lie in five areas: Discounting a. In calculating their pension liabilities and funded status, pension funds should use a market-value discount rate. b. The disclosure of the sum this method produces would accompany the existing disclosure, which rests on a discount rate based on expected returns on assets. Smoothing a. Funds should use a standardized "smoothing" period of five years to calculate asset values. b. Funds should also report funded status on the basis of a market value of assets with no smoothing. Accrual method a. Funds should continue to use Entry Age Normal as a standard accrual method for calculating funded status when applying the standards stated above. Projections a. Funds should issue annual five-year projections of contribution rates required of participating governments. Normal cost a. Funds should calculate and report the normal cost of pension benefits using the market-value discount rate they use to calculate pension liabilities and funded status.
These steps would make it easier to answer such questions as: How well funded is a given state's pension plan? How much does a public employee's pension in a given state cost? And what effects are pension costs likely to have on the next few years' budgets?
The report also discusses which entities should be responsible for implementing these changes in disclosure policy. It argues that states should voluntarily adopt them, and that they should require municipalities to do so. The federal government should also take steps to encourage states to make the recommended disclosures. A bill currently before Congress, the Public Employee Pension Transparency Act, would give states financial incentives to make some of the disclosures that this report recommends.
This report does not recommend substantive changes to state and local governments' retirement benefit policies. A government could comply with all of the recommendations in this report and still leave payout amounts, retirement ages, and all other aspects of benefit packages unchanged. However, a clearer understanding of the extent of governments' liabilities, which these recommendations, if implemented, would afford, might lead governments to make substantive and meaningful reforms.
About the Author
Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute, focusing on state and local fiscal issues. He is the co-author of the Empire Center for New York State Policy's "Blueprint for a Better Budget." His recent work has included studies on public employee pensions and on property-tax reform.
Barro is a frequent television, radio, and print commentator on fiscal and economic issues. He writes bi-weekly on fiscal issues for RealClearMarkets.com, is a regular contributor on National Review Online and has also written for publications including the New York Post, the New York Daily News, the Washington Examiner, National Review, and City Journal. Prior to joining the Manhattan Institute, Barro served as a staff economist at the Tax Foundation and worked as a commercial real estate finance analyst for Wells Fargo Bank. Barro holds a B.A. from Harvard College.
Introduction
In the last year, the scope of state and local governments' obligations to their current and future retirees began to register as a matter of serious public concern. Governments' obligations to retired workers are similar in many ways to bond debt but are not necessarily reflected in conventional measures of government indebtedness. When these obligations are not fully offset by assets held in trust, they are said to be unfunded and to place a debt-like burden on future taxpayers.
The Pew Center on the States last winter released "The Trillion Dollar Gap,"[1] a report that estimated the total unfunded retiree benefit liability at $1 trillion by adding up figures on the financial statements of state retirement systems. This figure is a large addition to the $1 trillion of states' explicit outstanding long-term bond debt as of 2009.
The true size of the unfunded liability for retiree benefits is far larger. This is because governments use excessively optimistic assumptions when estimating the size of their pension liabilities. If less rosy accounting is used, with the (smaller) liabilities of local governments included, unfunded pension obligations total more than $3 trillion. If the costs of health care for retirees (also called "Other Post Employment Benefits," or OPEB) are included, unfunded obligations amount to more than $4 trillion.[2],[3]
Anyone following press accounts of the issue should be forgiven for being confused about the total size of the unfunded liability. Several factors make it challenging to size up pension and OPEB liabilities on an apples-to-apples basis, but the root cause is accounting rules that allow governments to report incomplete and overly optimistic information.
On an installment of CBS's 60 Minutes airing on December 19, 2010, securities analyst Meredith Whitney characterized the opacity of state and local governments' recent financial statements as "the worst I've ever seen."[4] This is the same Meredith Whitney who spent the middle of the decade raising the alarm about hidden risk on bank balance sheets and foretelling the bursting of the mortgage bubble.
Bad accounting rules do more than just deceive taxpayers and bondholders. Pension accounting is so convoluted that it also deceives lawmakers themselves, many of whom make unsustainable pension promises simply because their true costs are hidden from them.
In this report, I make several recommendations for improving the transparency of financial information related to governments' pension and OPEB obligations. These recommendations do not have direct, substantive policy implications: a government could follow all recommendations in this report and still maintain its current pension and OPEB plans unchanged. Rather, adopting these standards would clarify the magnitude of states' total accrued liabilities and their annual impact on budgets. The availability of this information might lead states to adopt policies that would save taxpayers money in the long run.[5] Briefly, the recommendations address five areas of pension accounting:
1. Discount Rates. Retirement plans use a "discount rate" to convert pension or OPEB liabilities due far in the future into a present value. Government Accounting Standards Board (GASB) guidance leads plans to use discount rates that are unreasonably high. Such rates allow them to understate their true liabilities and claim to be better funded than they really are. Plans should additionally report their liabilities discounted at a lower rate that corresponds to the low risk borne by pensioners that they won't be paid. Doing this would result in plans' reporting a higher (and more accurate) present-value liability and a lower ratio of assets to liabilities (the "funding ratio").
2. Smoothing. Most retirement plans do not recognize unusual gains or losses on assets immediately. Instead, they recognize them over a period of yearsâ??most often, five. Unfortunately, some plans have been changing their smoothing periods opportunistically: shortening them to recognize sharp gains quickly, or lengthening them to delay recognition of losses. Doing this allows funds to overstate the value of the assets they hold and thus make their unfunded liabilities seem smaller than they actually are. Plans should instead use a standardized smoothing period of no more and no less than five years at all times. They should also continue to separately report the market value of their assets as of particular dates and disclose the funding ratio on both a smoothed and an un-smoothed basis.
3. Accrual Methods. There are several ways to estimate the dollar value of the benefits that a mid-career employee has accrued to date. Each method will generate a different estimate. Wisely, GASB requires plans to present certain data using a standardized accrual method called "Entry Age Normal." This accrual method is designed to spread the recognition of costs associated with an employee's pension benefits across his or her career in proportion to the wages and salaries paid to that employee. This standard should be maintained.
4. Projections. When a pension plan's financial position deteriorates, actuaries direct the plan's sponsors (i.e., state and local governments) to contribute more money. But because of asset smoothing, it takes several years before a protracted decline in stock prices is fully recognized, forcing sponsors to deal with the shortfall by increasing their contribution rates. Pension fund managers know that stock-market losses, especially the steep ones of recent memory, are very likely to drive required employer contributions higher in the coming years, as past losses are gradually recognized. However, because most plans do not issue public projections of contribution rates, legislators do not necessarily have fair warning of these impending increases. Therefore, pension plans should annually issue five-year projections of employer contribution rates, so that lawmakers can plan to accommodate rising pension costs in future budgetsâ??or enact pension reforms to lower costs.
5. Normal Cost. The factors that obscure the aggregate cost of pension plans also obscure the cost per employee. Employer contributions are the basis for current measures (such as those published by the U.S. Bureau of Labor Statistics) of these costs, but they do not represent the full cost, which is the present value of the pension credit that employees receive for providing service in the current year. Public pension plans should report the market value of this ongoing cost, as private firms already do. This figure is the true "cost" of offering pension benefits, whether it is met with cash in the current year or by incurring a liability that will be covered in the future.
Finally, this report will discuss who should be responsible for implementing these recommendations. We think that states should voluntarily adopt these standards, and then require municipalities to adopt them.
The question of federal involvement is trickier. A bill currently before Congress, the Public Pension Transparency Act, would give states strong financial incentives to use market-based discount rates to calculate their funding ratios and to provide twenty years' of future cost projections. (It should be noted that this bill, if enacted, would not obligate the states actually to make pension contributions derived from market-based discount rates; nor does this paper argue that they should be obligated.)
In general, the federal government should give leeway to states to manage their own finances. However, there are several good reasons for the federal government to use its fiscal powers to impel states to adopt all the disclosure recommendations made in this paper.
1. Discount Rates[6]
The liability side of a pension plan's balance sheet consists of a stream of promised payments to beneficiaries. Some of these payments are due retired workers in as little as one month, and others will not come due for decades. In order to arrive at a present cost of that entire stream of liabilities, pension plans "discount" the cost of benefits to be paid in the future, as though the principal to cover the cost were already in the plan's possession. Because invested capital grows over time, the growth of any sums set aside reduces the size of the contributions that the plan is obligated to make.
If, for example, $10,000 is due in ten years, and a savings account or some other safe investment vehicle offers an interest rate of 3 percent, only $7,441 would have to be set aside today. In this example, a 3 percent "discount rate"â??the rate at which the principal due is discounted over a given period of time to produce the loan's net present valueâ??has been used to assess future obligations.
When discounting future obligations, pension funds follow the guidance of the Government Accounting Standards Board (GASB), an organization that establishes financial standards for state and local governments. According to the U.S. Government Accountability Office, GASB operates independently and lacks the authority to enforce its standards, but many state laws require local governments to follow them, and rating agencies will take into account whether GASB standards are followed.[7]
In its Statement 25, "Financial Reporting for Defined Benefit Pension Plans and Note Disclosure for Defined Contribution Plans," GASB advises that a discount rate "be based on an estimated long-term investment yield for the plan, with consideration given to the nature and mix of current and expected plan investments." (This language clearly contemplates a portfolio that includes investments with fluctuating yields.) In other words, pension funds should choose discount rates that equal the expected return on assets. So long as average returns are sufficient to cover a plan's benefits, it is deemed fully funded, according to GASB standards, even if the riskiness of its investment choices creates a greater than 99 percent chance of a funding shortfall at some point, which taxpayers would be responsible for repairing.
Plans mostly invested in stocks and other equities use the stock market's higher returns over long periods of time as their rationale for using discount rates of about 8 percent. As University of Chicago economists Robert Novy-Marx and Joshua Rauh point out, GASB permits underfunded pension plans to increase their liability discount rates and thus reduce or eliminate their funding gap, simply by increasing the risk profile of their asset portfolio. For example, a plan with a 10 percent funding shortfall and expected asset returns of 7 percent would move into "surplus" if it contributed no additional funds and simply adjusted its asset mix to produce an expected 9 percent return. To Novy-Marx and Rauh, GASB's policy makes no more sense than allowing households to "write down the value of their mortgages by simply reallocating their savings from a money market account to an investment in the stock market."[8]
Unfortunately, a plan may fail to meet its return target for an extended period, or even experience a significant drop in asset values, as all pension funds of substantial size did in 2008â??09. If such a period should persist long enough, pension reserves can drop to the point where states are forced to close the gap by drastically increasing pension contributions; indeed, contribution rates in most states are already climbing and can be expected to go much higher in the next several years. Governments' own indefinite existences do not give them the luxury of waiting indefinitely for the market to recover.
The pro-cyclical tendencies of capital markets make the manipulation of discount rates particularly costly for taxpayers. Even if an aggressively invested pool of assets turns out to be large enough on average to cover pension liabilities, taxpayers will be least able to pay the extra taxes to cover funding gaps when returns fall short, because shortfalls are most likely to occur during recessions.
Although windfalls, too, are possible, they come during economic boom times, when they are least needed, and don't necessarily accrue to taxpayers' advantage: many states, including New York, New Jersey, and California, have used the over-performance of pension investments to increase the generosity of pension benefits rather than to tide over their plans' shortfalls. Effectively, taxpayers are providing insurance to pension funds by converting a risky investment return into a risk-free return. Current pension accounting treats this insurance as though it were costless.
For these reasons, financial economists object to the use of expected asset returns to discount liabilities. Their thinking is that public pension plans provide a benefit that is essentially guaranteed. But the gains and income on which pension plans rely to provide that benefit are not guaranteed and are thus potentially highly variable. To eliminate this mismatch, "discount rates should be derived from securities that have as little risk as the liabilities themselves,"[9] the "risk" of these liabilities being that a pension plan could somehow escape its obligations to beneficiaries, an exceedingly unlikely eventuality. The theory underlying this approach is commonly known as the "market value of liability" (MVL).
Just as GASB oversees public plans, the Financial Accounting Standards Board (FASB) oversees private plans. FASB guidance calls for private plans to discount their liabilities roughly in accordance with MVL. FASB's directive rests on the recognition that firms cannot pass on to plan participants the risk associated with higher returns. Paragraph 44A of FASB Statement 87 reads:
Under IRS guidance, private plans generally choose a discount rate based on a blended average of corporate bonds in the Moody's Aa rating range, pegged by Mercer Consulting, as of February 2011, as paying 4.99 percent over seven years or 5.88 percent over nineteen years; most public pension plans would use a discount rate in this range, depending on the demographic makeup of their participants. This yield reflects the degree of risk associated with high-quality corporate bonds; nearly risk-free assets such as U.S. Treasury bonds pay considerably less.
How Should Public-Employee Retirement Plans Select a Discount Rate?
For the reasons laid out above, the discount rates used by public-employee pension plans are far too high and are leading those plans to understate their true liabilitiesâ??and therefore to overstate their funding levels. Congress can improve pension transparency by requiring pension plans to use a lower, standardized discount rate when reporting their liabilities, in addition to whatever reporting method they use today.
But how should that rate be chosen? My preference is to require discounting on the same basis on which private plans set their discount rates per FASBâ??the yields of Aa-rated corporate bonds. Doing this would have the advantage of being simple and in accordance with standard accounting practice. However, it is not exactly in accordance with MVL, as the risk associated with public-employee retiree benefits is not the same as the risk associated with a high-quality corporate bond.[10]
An alternative approach would be to discount pension benefits using Treasury bond yields. Treasury yields are lower than the yields of Aa-rated corporate bonds because Treasury bonds pose almost no risk, while high-quality corporate bonds pose some risk, though a low one. This approach assumes that there is nearly zero risk that retirees will not be paid their pension benefits and produces a very conservative (i.e., large) estimate of liabilities. According to the estimates of the American Enterprise Instituteâ??s Andrew Biggs, pension funding shortfalls as of mid-2008 under this approach exceeded $3 trillion,[11] a figure that does not fully reflect even the stock-market crash of 2008â??09.
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