Why Better Reporting Won't Lead to Healthier Pensions

a | A

By Josh Barro

The Governmental Accounting Standards Board approved new rules yesterday that will change the way states and municipalities report their unfunded pension liabilities. Many governments will report much larger funding gaps, but the actual effects on bond markets and public policy are likely to be small.

The biggest effect of the change is that many pension funds, particularly those with the lowest funding ratios, will have to use lower discount rates to value their liabilities. Think of a discount rate as the inverse of an interest rate -- the lower the discount rate, the more money you must have on hand now to cover a liability that won’t be paid until later.

Along with other pension policy experts, I’ve been critical of the discount rates used by government pension funds. The funds use discount rates of 7.5 percent or 8 percent, set to match their expected rates of return on assets. A discount rate should match the risk associated with the item being discounted. Since a pension looks more like a bond than a stock, with fixed and guaranteed payments, the discount rate for a pension liability should be similar to a bond interest rate: about 5 percent.

This sounds like an arcane accounting matter. But the discount rate is one of the most important components of a pension fund’s financials. Typically, adopting a 5 percent discount rate would increase a pension fund’s reported liabilities by 30 percent to 40 percent. Universal adoption of a 5 percent pension liability discount rate would add about $2 trillion to the liabilities of state and local pension funds in the United States.

The new GASB rules will force funds with significant underfunding to use “market value” discount rates, close to 5 percent, to value the portion of their liabilities that are not covered by assets. That means reported funding gaps will rise, and they will especially rise at the funds that were already reporting big gaps. Under the new rules, the Illinois Teachers’ Pension System, one of the country’s worst funded, would have shown just an 18 percent funding ratio as of July 2010.

I was once very enthusiastic about the cleansing power of better pension reporting. State and local governments took on pension liabilities whose size they did not understand. Making clear the size of these liabilities, I thought, would get taxpayers and bondholders to enforce discipline on pension policy.

Since 2009, intervening events have caused me to change my views. Better financial reporting is still a good thing, but it’s not likely to spur governments to reform their pension systems.

A similar accounting change required governments, over the last few years, to start reporting very large unfunded liabilities for retiree health benefits. But while governments have started reporting these liabilities, few have been aggressive about funding them -- and the bond markets have reacted to that inaction with a collective shrug.

Bondholders have good reason to be blasé: They expect to be repaid even when a government has pension obligations it hasn’t funded and can’t service. Six states have passed laws in the last three years that retroactively cut pension benefits earned by government workers, but none has so much as breathed the thought of a general obligation bond default. Several states, including Rhode Island and California, have laws that explicitly place bondholders ahead of pensioners in repayment priority.

Bond investors don’t need governments to perform on all their obligations. They just need them to meet their bond obligations. And with this evidence that bondholders will come first, they don’t spend a lot of time sweating the size of pension debts.

Taxpayers and pensioners do have an interest in pension underfunding, but in practice the reporting of larger numbers (“You thought you owed $6 billion but really you owe $16 billion”) tends to cause their eyes to glaze over. What really moves taxpayers and pensioners to demand reform is when changes in liabilities translate to changes in cash flows: Either governments must start putting lots more money into a pension fund, driving taxes up or spending down; or the pension fund’s ability to send actual checks is called into question.

But higher reported liabilities only sometimes translate into current-year cash flow pressures. Some states and cities have legal or constitutional requirements that force them to fund pensions on a specific schedule, or have long traditions of funding their pensions as scheduled. In these jurisdictions (such as San Jose and Rhode Island), sharply rising liabilities have translated into sharply rising current-year pension costs, and therefore into political support for big reforms.

In other places, such as New Jersey and Illinois, lawmakers deal with unaffordable and unfunded pension costs by shirking their obligations to fund pension systems. New Jersey Governor Chris Christie has patted himself on the back for proposing that the state deposit $1.1 billion into its state pension fund this year, the largest payment in the state’s history. Unfortunately, that falls far short of the actuarially recommended payment of $3.74 billion.

The ability to put off payments to a more convenient time -- or possibly never -- has allowed politicians in New Jersey and Illinois to avoid implementing reforms that would sufficiently contain the growth of pension debts. Both of these states enacted some sort of pension reform in the last few years, but reforms were much more timid and less effective than reform in Rhode Island. Less flexibility on when to make payments likely would have meant more impetus for reform.

And that’s where the new GASB rules fall short: They deal only with stated liabilities, not with required cash flows. Even though governments will have to admit their liabilities are bigger than they had claimed, coughing up the extra cash to meet the projected shortfall will be optional.

This isn’t GASB’s fault -- it only makes recommendations. We need a set of rules that relates to funding, not just to reporting of liabilities. Bigger numbers in financial statements are apparently insufficient to force taxpayers and lawmakers to pay attention. The federal government can, and should, use its powers to force states to adequately fund their pension systems. If higher pension liabilities caused more tax dollars to be diverted into pension funds, then maybe taxpayers and lawmakers would pay more attention to their solvency.

(Josh Barro is lead writer for the Ticker. Follow him on Twitter.)


-0- Jun/26/2012 19:50 GMT