As reported here last month, the Governmental Accounting Standards Board (GASB) has issued an exposure draft of proposed changes in pension accounting rules that will repaint the landscape in municipal finance. Once the rules become final as expected, pension liabilities will be displayed on the balance sheet, and the "true cost" of pension benefits must be reported in the operating statement — even if the employer fails to make the necessary annual contributions. That true cost will be higher than most employers now pay. Although implementation is still a year or two away depending on the size and nature of the system, it's time now to begin preparing for the implications of some important changes.
- Debt managers must prepare to explain to investors and bond rating agencies how their balance sheet will look after these liabilities (which total about $1 trillion nationally) become reportable, and why.
- Labor negotiators will finally have a better way to show the impact of promised benefits and the fiscal consequences of future proposed benefits increases.
- The amortization of unfunded liabilities will be accelerated, which will result in higher actuarially calculated employer contributions. The old game of deferring pension costs for 30 years and rolling over the debt forever, like a credit card, will end next year.
- Pension trustees and administrators need to figure out whether they will require employers to contribute on the basis of generally accepted accounting principles (GAAP) or on some other formula. In many cases, the GAAP requirements will present "sticker shock" and the pension plans will find it necessary to tip-toe in GASB's direction rather than plunge in immediately.
- Budget officers need to prepare for whatever this means in their 2013-14 fiscal year budgets, and some states and large municipalities with $1 billion pension plans must address these as early as next summer.
- Although these accounting rules apply only to pensions, the GASB has begun a parallel study project for other post-employment benefits (OPEB) such as retiree medical plans that will inevitably need to follow the same or similar standards. When we add those numbers, the total balance-sheet liabilities for an average employer with both pension and OPEB benefits at average levels will exceed $150,000 per state and local government employee.
Some of the GASB proposals are still "wet cement" in the sense that stakeholder and professional comments received between now and October's scheduled public hearings could encourage the board to modify some of its proposals. However, the sense I get from close observers is that the fundamental points described above are set in "pretty firm cement" now and won't likely change.
There may be some tweaking of how they calculate some technical aspects, such as the discount rate for valuing future liabilities on today's books and how employers amortize certain expenses. But there is little doubt that employer's financial statements are going to change, with greater emphasis on visibility. Footnote disclosures will also be far more comprehensive and transparent, including historical information on funding ratios, key actuarial assumptions, and the investment return assumptions all the way down to each asset class such as stocks, bonds, real estate, etc.
Public sector managers who bury their heads in the sand while this pension accounting tremor approaches will find themselves shaken when the earth moves beneath them. That's why I'm encouraging forward-thinking financial officers, top-level managers and elected officials to start their planning now. Here's a punch-list of actions to consider and initiate where appropriate:
1. Obtain and read a copy of the bond lawyers' disclosure guidelines discussed in my previous column. They are proposing a 10-year forward projection of future pension costs and the funding status of the plan. Investors will be looking for this information regardless of how GASB says it should be reported on the books. So the bond community is already raising the bar for increased transparency and forward-looking information for investors.
2. Going one logical step beyond the bond lawyers, have your actuaries prepare 15-year projections of your future contributions under the proposed GASB guidelines versus your current contribution policies, along with the resultant funding ratios. Because the average employee will retire in 12 to 15 years from now in most public pension systems (half of 25 or 30 year career spans), a 10-year projection will fail to show whether your amortization policy is "kicking the can" to future taxpayers, or whether you'll pay off the bills before the average worker today will retire. Thus, you probably need 15 years of projections to get a clear picture. My prior column on pension Ponzi schemes explains the issue. Be sure to have the actuaries run the numbers with an amortization schedule that matches the average remaining service lives of your current employees.
If you belong to a statewide system, you will need to work together with other participating employers to get these numbers, because the plan administrators will not be happy about providing individualized employer projections while the GASB is still deliberating. But that should not dissuade you from requesting the data, which is essential to your planning.
3. Begin working now to cut the costs of retiree benefits through the various mitigation techniques described in this column and elsewhere. That includes raising employee contributions for pensions, requiring employee contributions for OPEB plans, changing benefits formulas for future service for future employees at the least and for current employees where legally permitted. My previous columns have provided roadmaps for these strategies, which are now even more important as the crushing costs of retirement benefits become more visible to the public.
4. Start discussing these data with labor unions now, especially if negotiations are underway. It makes absolutely no sense to enter into long-term labor contracts knowing that the GASB rules will show a deeper hole than the unions will now admit. Employers who now settle for the status quo before the numbers hit the front pages of their financial reports are going to look pretty stupid. Get the true cost data and put it on the table. Some union negotiators are now anxious to cut a deal before the truth gets out. The national labor leaders know that GASB's truth squad is on the horizon. Let the unions know that you need to fund as close to GAAP as possible and taxpayers won't tolerate any more games with the numbers. That's why you must obtain the projections listed in #1 and #2 above, before you walk into that room.
5. Plan your approach to the investment community. Before your next bond issue, you will want to have a clear and concise explanation for the rating agencies of how the numbers will show on your books and what this will do to their standard financial ratios. More importantly, the investment analysts want to know what you're doing to manage costs over the long run. Some of them will even ask about your labor strategy in #4 above. You may need professional help to develop a plan and tell your story, or you may be able to handle this internally, but every public manager and debt administrator needs to have a credible explanation and strategy.
6. Meet with your pension officials and begin candid discussions of what you will be able to afford to contribute toward their plan in the future. Pension officials and their plan-centric actuaries typically understand the concept of "sustainability" from a very narrow perspective. They don't see the insides of the employer's financial capacity. They just send the bills and expect them to be paid. A complete sustainability analysis requires evaluation of the benefits, the full cost of those benefits over the remaining service lives of today's workers, and then a multi-year financial forecast of the employer's total revenues and expenditures to see if the benefits can really be supported. OPEB costs at true levels must be included in that analysis, which most pension officials tend to ignore unless they are running that plan as well (which most do not). Only the CFOs and budget directors of the employer are capable of pulling all this information together — so they must take the lead on this work, cooperating and collaborating with their retirement plan administrators. Once the pension folks know what's feasible, they will be better prepared to set reasonable and sustainable contribution levels. Waiting around for the other shoe to drop will be a failing strategy.