CBO Endorses GOP’s Methods for Pension Projections

A new report gives credence to a plan that state and local government officials say will overstate the challenges facing pensions.
by | May 9, 2011

A new report from the non-partisan Congressional Budget Office seems to endorse an accounting method for public pensions that is being championed by House Republicans to the chagrin of state and local leaders.
 
As public pension shortfalls have continued to grow, so has the divide between two camps that maintain vastly different views on how, exactly, pension plans should project their asset growth.
 
The current method, favored by state and local government financial officials, assumes that their investments will have about 8 percent growth. They say historically, over the long-term, that’s representative of the growth of plans' assets.
 
But many conservatives say that’s an overly optimistic projection used to downplay the severity of the shortfalls. House Republicans are lining up behind a plan by Rep. Devin Nunes that would essentially require pension plans to use the “fair-value approach” – a more conservative projection of interest rates, tied to Treasury yields, which would be closer to 4 percent. The proposed standards are similar to those used by corporate pension funds.
 
The new report from the CBO – viewed as Washington’s referee on financial matters – suggests the method preferred by Republicans is a more accurate measure.
 
“By accounting for the different risks associated with investment returns and benefit payments, the fair-value approach provides a more complete and transparent measure of the costs of pension obligations,” the CBO wrote in the report.
 
That statement is significant and will provide a serious boost for the Republicans' cause. It should also help defend them against claims by advocates for the status quo, who often say the Nunes proposal isn’t an attempt at real transparency. The endorsement from CBO would help Republicans, who insist their plan in based on sound financial principals – not politics.
 
CBO also criticized the existing standard, writing that it essentially assumes those investment returns are virtually assured in the long-run. “However, even over very long periods, higher returns on risky investments are not a sure thing,” the report says.
 
Officials from rating's agency Moody's also say the Nunes legislation would help increase access to pension data and make it easier to compare plans.
 
Andrew Biggs, a resident scholar at the conservative American Enterprise Institute who has been one of the leading advocates for the fair-value approach, says he isn’t surprised by the report’s findings.
 
“I think this CBO report is a very positive thing,” Biggs told Governing. “It doesn’t say anything that any financial economist wouldn’t tell you, but it gives the stamp of approval that this isn’t some weird economic thing or some political thing.”
 
Biggs says supporters of the current method have tried to paint the concept as the work of conservative academics and right-wing politicians. But the report shows “this is the point of view of the economics profession and financial markets,” Biggs said. 
 
Even those who support the current methods admit that while they don’t agree with the CBO report, it does apparently endorse the methods favored by House Republicans.
 
The CBO report comes on the heels of a recent report from the Pew Center on the States, which found a $660 billion gap between pension assets and liabilities. The CBO’s report portrayed a slightly worse gap at $700 billion. Those figures are based on the accounting methods chosen by the pension plans themselves. It was based on a survey of 126 state and local pension plans that represent about 85 percent of public pension assets in the country. 
 
Assuming a lower rate of return such as 4 percent – approximately what the Nunes bill calls for – the gap is a much wider $2.9 trillion. The figure underscores the stakes of the debate. A slight adjustment to the expected return makes make the pension funding gap seem 400 percent worse.
 
Diane Oakley, executive director of the National Institute on Retirement Security, says using the lower rate could cause public confusion and spook the markets unnecessarily, especially because the Nunes plan permits more volatility in the projections.
 
But advocates for reform say transparency is paramount. Nunes says in addition to requiring a lower project for investment returns, his bill has the advantage of requiring all plans to use the same rate. That would allow government workers to more easily compare their benefit packages to those offered by other jurisdictions.
 
Under Nunes' legislation, pensions would report two sets of numbers – one based on their own standards, and one based on the new one -- that would be posted online. States and localities wouldn’t necessarily have to use the conservative projections when deciding their level of contributions, but they would need to release the figures for reporting purposes.
 
Each method carries risk. The lower rate could prompt states to contribute more to the pensions than necessary – since investment returns might be much higher in reality. As a result, taxpayers could be forced to deny funding from other areas unnecessarily in order to fund a surplus. But the higher rate, if not realized, would leave states scrambling to fund the pensions if returns aren’t as great as expected. 
 
Biggs says the risks of each method aren't equal. Returns on investments tend to follow the general state of the economy. When returns are low, that’s when the rest of the economy will be slow – and that’s when states would have to close the gaps, which would be difficult. Essentially, if the higher projects aren't right,  future taxpayers would have to bail out the pension funds at a when they’re least able to do so. 
 
“Overestimating a pension system’s expected return is essentially gambling with the financial welfare of the next generation of Americans,” testified Colorado Treasurer Walker Stapleton at the subcommittee hearing.
 
Advocates for the status quo would argue that there is typically a long time frame to address those types of shortfalls, and historically, the pensions have had strong returns.
 
Groups representing state and local governments -- including the National Association of Counties, the United States Conference of Mayors, National League of Cities and the International City/County Management Association, among others – have opposed the Nunes plan, largely because the numbers it would produce could undermine investor confidence in the municipal bond market. 
 
Democrats also say the Nunes plan is part of an attempt to overstate pension funding gaps and create an air of crisis that will make it easier to push workers from defined benefit to defined contribution plans. Rep. John Lewis, ranking member of a House Ways & Means subcommittee that held a hearing on pensions on last week, characterized the bill as part of a GOP effort “to widen the gap between the rich and the poor.”
 
The CBO report also said that state and local governments whose pension gaps become out of control may seek a federal bailout -- also raising the ire of state and local officials.
 
“If the financial condition of state and local pension plans worsened, the federal government might be asked to assist in the funding of such plans,” the CBO wrote. “If granted, such assistance would raise the federal deficit and debt, unless offset by higher taxes or lower spending in other areas.”
 
Republicans endorsing the conservative calculations have made the very same point, and the CBO report seems to lend credibility to their fears. The Nunes bill contains a statement indicating the federal government won’t bail out busted pension plans. State and local governments have portrayed a bailout request as a completely unrealistic threat that lacks historical precedent.
 
Overall, the report downplayed the threat that underfunded pensions play to state governments, saying they have sufficient assets, earnings and contributions to pay what they owe for several years. 
 
Despite its endorsement of the fair-value approach, the CBO does acknowledge the challenges posed by that path. In addition to potentially putting an unnecessary strain on government budgets, it could make the budgeting process itself difficult. A fair-value approach would increase the volatility of reported underfunding, causing fluctuating balances that would be difficult to manage.
 
The existing standards allows plans to average the value of their assets over several years to minimize the impact of swings from a single year.
 
But even that’s not entirely a black mark against the fair-value approach. By not smoothing the asset values, fair-value provides a clearer view of fluctuations that can occur and "may discourage risk taking on the part of fund managers,” the CBO wrote.
 
The report did acknowledge that a pension plan could adopt a hybrid system, since there doesn’t need to be a connection between the standards used for reporting and the standards used to calculate contribution levels.
 
The Nunes bill does not technically require plans to adopt the new standard. Instead, it would revoke the ability of state and local governments to issue tax-exempt bonds if they refuse to report using the new methods. However, that would severely increase the cost of borrowing for municipalities to the point that non-compliance would probably not be an option.

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