PENSION ACCOUNTING

We know that public pensions are significantly underfunded, but answering the question of "just how underfunded?" is harder than you might think. This is because pension plans can make accounting choices that change their reported funding gaps without any change in the amount of assets they hold or the liabilities they owe. Sometimes, these choices hide the true extent of pension underfunding, leading lawmakers and taxpayers to underestimate the true cost of promises to public employees.

This primer covers two key accounting concepts that are used and misused to determine a pension plan’s funding gap. One, selection of the "discount rate," regards the amount of money that must be set aside in the present to cover a liability due far in the future. The other, "asset smoothing," refers to the way pension plans recognize unusually strong or weak asset returns, such as those we have seen since the second half of 2008.

Discount rates

Let’s say you owe a payment of $1,000,000 in thirty years. If you can reliably expect to earn 8 percent per year on your investment, you only need to hold $100,000 today. But if your return rate is 5 percent, a much higher amount—$230,000—is needed upfront. The rate pension plans use to estimate how much cash they need now to make payments later is called the "discount rate": if you use a discount rate of 8 percent, you would need $100,000 today for that million-dollar liability in thirty years. The lower the discount rate, the higher the present liability.

The key word in the paragraph above is "reliably." Most pension plans set a target of earning asset returns of about 8 percent and then use that asset return target as a discount rate. It is entirely feasible for a pension plan to achieve an 8 percent average return with a diversified portfolio of equity and fixed income investments. The trouble is, an 8 percent return is not reliable or guaranteed—sometimes the return will exceed 8 percent, but because of the skewed distribution of stock market outcomes, it will actually achieve less than an 8 percent return more than half the time.

And when a pension fund misses its investment target, it’s not pensioners who bear that burden—it’s taxpayers, who must pay extra contributions to the pension fund to cover the shortfall in returns.

You might assume this all comes out in the wash. After all, sometimes funds will overperform and taxpayers will be able to pay less for pensions. But it does not wash, for two reasons. One is that excess returns often go to finance sweetened benefits. The other is that funding shortfalls will tend to arise in recessions, when taxpayers can least afford to cover them. By bearing the burden of covering funding gaps when the economy performs poorly, taxpayers provide valuable insurance to public employees, but that’s not reflected on pension balance sheets.

In recognition of the risks associated with equity investments, private sector pension plans estimate the present cost of their future liabilities based on the risk associated with those liabilities—which is to say, a low risk, since pension benefits are guaranteed. The allocation of pension investments is irrelevant for determining the size of the current pension liability.

This makes sense: imagine that you have a stock portfolio, and you plan to use income produced by it to pay your mortgage. You reallocate your portfolio into riskier investments and now anticipate a 10 percent annual return instead of 8 percent. You wouldn’t say that you now owe less on your mortgage because you changed your investments. But public pension accounting standards would allow you to say that, by reallocating your stocks, you have reduced your mortgage balance.

Adopting standards similar to those in the private sector would currently require lowering discount rates to 5 percent or lower, depending on what is assumed about the riskiness of pension liabilities—whether public pension benefits are merely low-risk, like private sector benefits that can be abrogated only in bankruptcy, or close to a no-risk instrument like a Treasury bond. But state governments have resisted such a shift, because it would expose the true cost of pension liabilities and require governments to start putting up cash to fund pension benefits sooner. And while pension actuaries defend the use of high discount rates, there is a clear consensus among financial economists that lower rates should be used.

The effect of discount rate selection on unfunded liability calculations is enormous. Taking pension plans’ financial statements at face value, state and local government pensions are short by roughly half a trillion dollars. Apply a market value discount rate, and that gap soars to $3 trillion. (A similar issue exists with Other Post Employment Benefits, with a funding gap likely in the range of $1 trillion to $1.5 trillion.)

Asset smoothing

While discount rate selection is the most important factor distorting the accuracy of pension fund financial statements, it is not the only one. "Asset smoothing" can significantly change a pension plan’s reported funding status, especially in times when equity returns differ sharply from the historical average.

Most pension plans do not immediately recognize changes in their asset values. Instead, they recognize asset returns as though they had performed as expected—typically, that means about an 8 percent return. Then, over a period of several years, they recognize any deviation from that expected return. Smoothing periods vary, but four or five years is typical.

As a result, when the stock market has recently declined sharply, pension plans will tend to overstate their asset values and funding ratios. This is another reason that pensions are in worse financial condition than their financial statements indicate.

Like discounting, smoothing can be an appropriate practice when performed in a reasonable manner. Because states and localities must balance their budgets each year, sharp swings in required pension contributions are undesirable; smoothing helps ensure that pension contribution rates rise and fall gradually.

Trouble arises when pension plans use smoothing periods that are too long (in the wake of the 2008 financial crisis, some states have adopted smoothing periods of up to ten years) or when they opportunistically change their smoothing practices to avoid making required contributions.

The most notorious case of this led, in 2010, to the SEC’s first ever action against a municipal bond issuer. The SEC sued New Jersey for misleading bond investors by changing its smoothing methodology in 2001—the state temporarily abandoned smoothing and revalued its assets based on market value at June 30, 1999, near the peak of the tech bubble. It then used the increase in measured asset value to justify a 9 percent across-the-board benefit increase.

The SEC’s complaint was not so much that New Jersey had done this, but that it had failed to adequately explain this action to bondholders, who might have been misled into believing the state’s pension systems were better funded than they actually were. And New Jersey is not alone in fiddling with its smoothing techniques—Arizona, South Carolina, and the city of Los Angeles all recently lengthened pension smoothing periods in order to hide the negative effects of the economic crisis on their pensions’ funding status.

Implications

These accounting issues aren’t purely academic. By misusing both smoothing and discounting, states and localities are able to hide the true cost of the pension promises that they are making, and put taxpayers on the hook for benefits that nobody would have agreed to with more transparent accounting. Achieving true transparency on retirement benefits will require standardized and reasonable practices for pension accounting that accurately reflect true costs to taxpayers in the year that pension benefits are accrued.