The Governmental Accounting Standards Board (GASB) has officially filed for a divorce from pension funds' and employer's funding policies. The July 8 exposure draft of proposed financial reporting standards will almost certainly work its way into formal rules next year. Unfortunately, the vast majority of pension funds will most likely adopt the accounting rules, but then go their own way with their funding policies because most employers cannot afford to pay the full actuarially calculated costs of the GASB standards. The resulting void will invite mischief and must be addressed by the public pension and public finance communities.

For those who don't follow GASB closely, the accountants have decided that:

  • Unfunded pension liabilities should be presented on the balance sheets of the employers.
  • The full cost of retirement benefits should be "expensed" as costs on the employer's financial statements, regardless of what the employer actually contributes to the retirement plan each year
  • The calculation of the pension liabilities should be refined to use (1) a different discounting rate to value liabilities that cannot be funded by assets already held in trust or contributed regularly, and (2) shorter amortization periods that would generally ensure that money is put away to pay for benefits before employees retire -- and not paid by the next generation who would get no benefits for bills presented to them after workers have left the payroll.

The proposed standards have many other features of keen interest to pension fund insiders and governmental accountants, but they bear less importance to the actual funding of these plans. The key issues that matter most to budgeters are the discount rate and the amortization period.

The new math. Historically, public pension funds have used a discount rate based on the trustees' expected rate of investment return. Until recently, that number averaged 8 percent, reflecting an expected return of approximately 10 percent annually for stocks and 5 percent for bonds, using an asset allocation that was roughly 60 percent stocks and 40 percent bonds. Lately, that number has been shaved by many pension plans and is now averaging somewhere in the upper 7 percent range. Smaller plans typically use a lower rate than the jumbo statewide plans that have access to more-sophisticated "alternative" investment opportunities like hedge funds and private equity, where expected returns are higher.

GASB has left this concept intact, with one important exception: When assets in the pension portfolio plus their expected investment income and current contributions are insufficient to pay for liabilities already incurred, the actuaries will now need to discount the remaining liabilities with a blended rate that instead takes into account the employer's cost of capital -- a tax exempt municipal bond yield. The result will likely be a reduction of as much as 70 basis points (0.70 percent) on the average discount rate for an average plan if it does not fund fully. Because the discount rate is an exponential factor in the denominator, the lower discount rate results in a higher liability -- and thus a higher annual contribution to pay off the future pensions.

The second decision -- to amortize unfunded liabilities over shorter periods of time -- will also increase actuarially calculated costs. It's like refinancing a 30-year mortgage into a 15-year note. Payments go up.

Volatility. What CFOs and budget officers won't like is the volatility of annual pension contributions that the new accounting standards would bring on -- if they are adopted as the funding policy. Stock markets gyrate and don't go up in a straight line. The number of times that they have returned 10 percent in the past 50 years is just a handful. As the legendary Peter Lynch of Fidelity Magellan fame used to say, the stock market is more likely to return either 20 percent or minus 10 percent, than its historical average. Statistically, there is a 32 percent "tail risk" that stock portfolio returns will deviate by at least 15 percentage points from their average in any given year. That translates into a 10 percent unexpected fluctuation of pension portfolio values every three years. For a plan that is 80 percent funded, the resulting change in its net position would require a 40 percent change in the unfunded liabilities to be amortized annually, which could easily wipe out that year's revenue increases. So with the pension assets marked to market each year, the annual pension expense will jump around and be very unpredictable. To base budgets on numbers that fluctuate this much would require unstable tax rates or payroll adjustments that are simply not feasible for many public employers. In many cases, taxpayers and the general public would ultimately suffer from this budget volatility, especially if public managers start squirreling away tax dollars for budget reserves to ride out the bumps.

The GASB's new accounting and financial reporting measures are great stuff, and I applaud the board and staff for their big-picture thinking. (If only these rules had been effective in 1998, before many pension trustees and public employers gave away the store with unaffordable benefits!) The new standards are not likely to be followed any time soon, however, in the actual funding and contribution policies of pension plans. On the contrary, I expect to see pension trustees take this all very seriously, adopt the accounting standards for financial reporting purposes, and then tip-toe into incremental adjustments in their funding policies. Over time, many will whittle down their amortization period to something like the average remaining service period of their current employees, but not right away. They will also probably shave their discount rates a little every year or two until they come closer to the GASB's formula. But they won't present bills in 2013 for an additional 25 to 50 percent cost increase to public employers that are already suffering from the actuarial cost of paying off the stock market losses of 2008-09 through higher contributions under current rules. That's a shame, because many will keep kicking the can down the road to the next generation as today's baby boomers retire in droves before their employers have properly funded their benefits.

What's next? With the implementation of these accounting standards still a year or two away, the divorce isn't imminent. But forward-looking finance officials and budget-makers must begin to think about how this will impact their employer's financial management as well as their bond investors' perceptions of their actual financial position. In a future column, I'll provide a punch-list of action items for pro-active public officials to start implementing.

Finally, it's time for professional associations in the public sector to start thinking about who will fill the void in providing normative guidance to public employers and pension plans for their funding policies. If we don't use GASB's standards to determine annual contribution levels and plan our budgets, what should we be using? Leaving these decisions to individual pension boards and public employers is the wrong answer: There are too many opportunities for mischief and naïve decisions. If the actuarial profession had "hard" standards to guide their clients, this issue might go away, but the "principles-based" approach of the actuarial societies leaves so much latitude that there will be wide variations in actual practices. That leaves the entire public pension community vulnerable to continued complaints from critics who are convinced that deep problems are being swept under the rug. Failure to self-discipline will only annoy those in the U.S. Congress who have called for uniform national disclosure. Even worse, it could lead to a public pension bill that injects the federal government into state and local affairs. We'll all be better off if state and local governments move toward the GASB standards as aggressively as they can bear, as the economy begins to slowly expand, despite their continued fiscal stress. And that applies to their OPEB retiree medical plans as well, since most employers are still paying nothing into a trust fund while they run up expenses that are buried now in their footnotes.