The public pension funding crisis has led to a vigorous debate over how those pension liabilities are valued and how large they are. The debate is long overdue. For state and local governments across the nation to get their finances in order, they first need to define the problem they need to tackle — and it appears to be worse than previously thought, as The Washington Post reports:
The latest rules come on line from the bond-rating firm Moody’s at the end of this month. They are projected to triple the gap between what states and municipalities report they have in their funds and what they have promised to pay out to retirees. That hole would stand at $2.2 trillion.
For the worst-off cities, the new pension debt calculations could mean bond rating downgrades and increased borrowing costs when localities try to raise money for new projects, Moody’s has warned.
The accounting changes themselves will not force policymakers to alter how they fund pensions. But finance experts say that by simply highlighting greater funding gaps, the rules will intensify pressure on state and local governments to allocate more of taxpayers’ dollars to their pension funds. More likely, public workers may have to contribute more to their retirements or see promised benefits curtailed, measures that have already been implemented in more than 40 states
Nationwide public pension liabilities being greater than expected is nothing to cheer about. However, the Moody’s accounting rule change is welcome, because it presents a clearer picture, a necessary first step toward addressing the public pension crisis.
The lower estimates of public pension liabilities, such as that of the Pew Center on the States ($757 billion for pension promises and $627 billion for retiree health care), are large enough to cause serious worry. Yet Pew’s estimate is based on state’s own overly optimistic projections, many of which are based on discount rates that assume average annual investment returns of 7 to 8 percent. While some investments might achieve such returns, those returns are not guaranteed. Pension liabilities, on the other hand, grow without interruption. Therefore, a downturn can push a pension plan’s funding ratio down substantially.
Moreover, using a discount rate based on high investment returns incentivizes pension fund managers to seek those higher returns through riskier investments — which can exacerbate underfunding when they go bust.
This kind of high-return discounting was allowed for years under reporting standards issued by the Governmental Accounting Standards Board (GASB). Critics of the GASB standards, including economists Robert Novy-Marx and Joshua Rauh, argue that they fail to account for the risk inherent in the plans’ liabilities. They note in a recent study:
Government accounting procedures in this area contrast with the financial dictum that cash flows should be discounted at discount rates that reflect their risk. Under guidelines established by the Government Accounting Standards Board (GASB) state and local governments discount their pension liabilities at expected returns on their plan assets. Plans’ actuarially recognized liabilities are consequently mechanically decreasing in the riskiness of the plans’ investments. Plan actuaries typically assume that the expected return on their portfolios will be about 8 percent, and then measure the adequacy of assets to meet liabilities based on that expected return. This accounting standard sets up a false equivalence between relatively certain pension payments and the much less certain outcome of a risky investment portfolio …
The report by the State Budget Task Force, also known as the Ravitch-Volcker report (after Task Force founders, former New York Lieutenant Governor Richard Ravitch and former Federal Reserve Chairman Paul Volcker), released on July 17, 2012, summarizes a lot of the critiques of the GASB standards:
Under standard actuarial practice and accounting guidance from GASB, actuaries use a discount rate based on the expected return on assets held in the pension fund. That is, the rate they use to discount liabilities is by definition the same as their investment earnings assumption, even though in concept they need not be the same. The vast majority of pension plans currently assume they will earn 8 percent. Economists and others have noted that the size of the liability has nothing to do with how much the funds will earn. As researchers Jeffrey Brown and David Wilcox noted, “This practice contrasts sharply with finance theory, which is unambiguous that the appropriate discount rate is one that reflects the riskiness of the liabilities, not the assets.” The economics profession is virtually unanimous in this view.
There is no unanimity on what discount rate (or rates) would reflect the riskiness of pension liabilities, but given strong legal protections most researchers believe the risk of nonpayment is low, and some even believe benefits should be treated as risk free. This means that in current market conditions the discount rate would be far lower than 8 percent. The Center for Retirement Research at Boston College frequently uses 5 percent in its analyses. Other researchers have used lower rates, which lead to even higher estimates of liabilities. There is no definitive answer, and discount rates will vary with market conditions. There have been periods, particularly during the early 1980s, when risk-free or low-risk interests rates actually were higher than pension fund earnings assumptions.
Using a higher-than-appropriate discount rate can have at least three effects. First, pension plans will appear healthier than they otherwise would, potentially creating incentives to reduce contributions to plans or to enhance benefits. Second, it can create pressures for pension systems to invest in risky assets in an effort to achieve higher investment returns.
Recently, those critiques have led to some concrete changes. In June, GASB issued new rules, under which pension plans with less than 80 percent of assets needed to pay their obligations would have to use a discount rate based on more realistic investment return projections of 3 to 4 percent. However, the new GASB rules, by allowing pension funds with a funding ratio above 80 percent to continue to use a discount rate based on higher investment returns, leave the door open to some gaming of the numbers, as The Wall Street Journal pointed out. And, as Andrew Biggs of the American Enterprise Institute in a July 2012 study, published by State Budget Solutions, “the new regulations cement in place the flawed notion that boosting investment risk makes a pension better funded, before a dime of higher returns have been realized.”
However, the new GASB rules did encourage others — including Moody’s — to reconsider how public pension liabilities are valued. Biggs, in the same 2012 study, explains the virtue of the new Moody’s approach:
In a July 2 draft, Moody’s has proposed discounting pension liabilities using yields on Citibank’s Pension Discount Curve, which is derived from high quality corporate bonds as used by private sector defined benefit pensions to value their own liabilities. For years 2010 and 2011, to which Moody’s will apply this revised discount rate, the yield average 5.5%. As of June 30, 2012, the average yield on bonds with the duration of 15 years was 3.9 percent while for over 20 years the average yield was 4.1 percent. Thus, Moody’s would use a discount rate around 0.6 percentage points higher than the U.S. Treasury yields used above.
Under Moody’s revised approach, unfunded pension liabilities as of 2010 would rise from around $770 billion to around $2.2 trillion. While not as high as a pure market based approach, Moody’s comes far closer to the truth than do either current accounting rules or GASB’s proposed revisions. Moreover, Moody’s new approach could have significant beneficial effects. First, because Moody’s would not discount pension liabilities using the expected return on pensions investments, this would eliminate incentives for public employee pensions to take on excessive investment risk. Second, Moody’s new disclosures would be aimed at investors in debt issued by state and local governments, with the goal of providing these investors with better information regarding the true debt obligations of governments issuing municipal bonds.
Hopefully, the new Moody’s methodology is the start of a trend. Some state officials are likely to resist changes in reporting, but they will are bound to find overly rosy funding projections harder to sustain.
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