Why Honest Numbers Are Good for Public Pensions

The new pension-accounting standards for governments were bitterly opposed by unions and many pension administrators, but they are good for governments, their employees and their taxpayers.
by | July 9, 2012

The last week of June was a big one for state and local government finances. Most of the attention was on the Supreme Court's decision on the Affordable Care Act, which will have a huge impact — at this point a somewhat murky one — on health-care costs. But another decision, the Governmental Accounting Standards Board's vote completely rewriting the rules for pension accounting and reporting, will have a profound impact as well.

I receive benefits from two government pension funds, one as a result of my service as city auditor of Kansas City and the other resulting from my term as the city's mayor, so I view the GASB decision with a certain amount of naked self-interest. I also view the decision from the point of view of one with decades of experience in public finance, both as a practitioner and an academic. From both points of view, however, I can tell you that the GASB decision is a good one. It meets the basic test that the purpose of accounting standards is to have financial statements better reflect the actual fiscal circumstances of the government for which they have been prepared.

The GASB pension rulings, codified as "Financial Reporting for Pensions" and "Accounting and Financial Reporting for Pensions," are complex and comprehensive and will not be available in final form until the end of July or early August. But here are three provisions that I think are most significant:

• First, net pension obligations must now be included as a liability on the balance sheet. GASB has formally acknowledged that pension obligations are essentially debt and that debt must be displayed prominently in the financial statements and not buried in the financial statements' notes. The result is that the statements' bottom-line number — "total net assets" — is going to be impacted, in some cases substantially, by the net pension liability of the government in question. In essence, what GASB has said is that when elected officials vote to increase pension benefits, they are voting to take on debt. Now policymakers, citizens, investors, bond holders and government workers are going to be able to see in a clear, cumulative way how much debt has been incurred and the extent to which it is being paid for.

• Second, GASB has made a reasonable compromise on the contentious issue of the "discount rate" — the rate used to discount projected benefit payments to their present value. Using a high rate of return makes the future obligation smaller; using a low rate makes it larger. On the one hand, there are pension funds that have been using discount rates as high as 8 percent, which seemed completely unreasonable, especially when you realized that in some cases, when a pension plan was severely underfunded, there were no assets to earn those returns. On the other hand, there are financial economists who've seized on the issue and demanded that GASB set the discount rate much lower, at what is called the "risk-free rate of return." While it's not exactly clear how that number would be defined, the result probably would be a discount rate of 3 percent or lower. GASB essentially ruled that as long as the plan's net position is projected to be sufficient to pay current employees and retirees, the discount rate should reflect the real rate of return of the fund — typically about 5 percent. To the extent that the plan does not meet the condition of funding current employees and retirees, it must use the index rate on tax-exempt bonds of AA or higher rating — currently about 3.65 percent.

• And third, GASB ruled that governments participating in a cost-sharing multiple-employer pension plan must "record a liability and expense equal to their proportionate share of the collective net pension liability and expense for the cost-sharing plan." Many local governments are part of these plans, which are often statewide, as is the case in Ohio and Wisconsin, for example. Previously, these governments thought they could make the annual contributions required and they would be held harmless. GASB's ruling recognizes that the nature of such plans is that these governments have a share of the responsibility assumed by the plan. This will be an awakening for many.

GASB's ruling has been five years in the making. It has been bitterly opposed by public-employee unions, and many non-union government employees also are rightly worried that the increased prominence of governments' net pension liability will fuel more vitriol toward public workers. Many pension administrators also opposed the change and worried that including the pension liability on the balance sheet would result in a total-net-assets number that was negative — that, after including net pension liabilities, a government's total liabilities would exceed its total assets.

The fact is, however, that the purpose of the financial statements is to reflect economic reality, and over the long run no one benefits from obscuring that reality. Like every other government employee, I believe I earned, and thus am owed, the pension benefits I receive. Pension benefits are, in fact, a debt just like any other debt incurred by governments, and if they had been reflected that way in the financial statements, maybe we could have avoided the drastic cuts in benefits now occurring in many communities. Trust in government begins with honest numbers. In the last week of June, GASB made a huge step in that direction.

Mark Funkhouser  |  Director, GOVERNING Institute
mfunkhouser@governing.com

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