Tag Archives: Alicia Munnell

GASB’s new guidance and the well-funded plan

As of June 2012, GASB has put forth two new accounting guidelines to help value public sector pension plans. These are GASB 67 and GASB 68. These rules help government actuaries to calculate the value of plan assets and plan liabilities. The new rules are a replacement of GASB 25 and GASB 27. The former guidance – GASB 25 –  has been roundly critiqued by economists for conflating assets and liabilities for the purposes of valuation – a violation of several established principles of economics and finance. The main critique of GASB 25 has been covered many times. The old guidance allowed public sector pension plans to chose a discount rate to value pension plans liabilities based on the expected returns of plan assets – roughly 8 percent annually. The critique of economists is basically this. The value of the liability is independent from the value of the assets. How the liability is financed is independent from how it is valued. The discount rate that should be used to value the liability should be based on the characteristics of the liability. Public plans should be valued according to their relative safety (or risk) as government-guranteed payments to workers. Economists suggest the rate on Treasury bonds is a good choice. Using the expected return on assets is logically misguided and leads to all kinds of trouble – plan underfunding, diminished contributions, more risk taking on the investment side. Will GASB 67 and GASB 68 fix this? No. According to the new standards (which are only for reporting purposes), plans will apply two different discount rates to calculate plan liabilities. To the funded portion (the portion backed by assets)  the assumed rate of return on plan assets will be used. For the unfunded portion plans will use the yield on municipal bonds. Andrew Biggs notes in a recent paper, “the logic is precisely backwards.”And further, the new standards,

…. cement in place the flawed notion that boosting investment risk makes a pension better funded, before a dime of higher returns have been realized. Under the current rules, a pension that shifts to riskier investments can discount its liabilities using a higher interest rate. Under the new rules, a plan that takes greater investment risk can assume its trust funds will last longer and therefore fewer years of benefits would be discounted using lower municipal bond rates. The incentives to take greater investment risk, particularly at a time when state and local governments would be hard-­‐pressed to increase pension funding, are obvious.

How will the new GASB standards affect plans individually? Alicia Munnell and her co-authors at the Center for Retirement Research at Boston College have calculated that. Well-funded plans look pretty good. Consider Delaware. Under GASB 25 Delaware’s main pension plan is 94 percent funded with an unfunded liability of $456 million. Using GASB’s new guidance – the blended rate of 8% – the state employees’ plan is 83 percent funded. And here is my rough estimate of the same plan using market valuation. Using a discount rate of 3.6 percent (the yield on 10 and 20 year Treasury bonds in 2011 when the valuation was performed) Delaware’s State Employees’ Plan is 51 percent funded and it has an unfunded liability of $6.9 billion. That also means the normal cost for the employer to fund employee benefits rises from 9.74 percent of payroll or $125 million a year to 12 percent of payroll or $216 million per year On the asset side Delaware is a leader in shifting its investment portfolio to riskier investments. Between 2002 and 2011 Delaware increased its exposure to alternatives from 9 percent to 24 percent. This puts Delaware in fifth place (in 2009) for the percentage of pension assets invested in alternatives. But with higher returns comes more risk, and that is something the new accounting guidance still does not adequately account for.

 

Pension accounting narratives

The controversy over just how expensive public pension plans are, and are likely to be, is growing more contentious. The reason is that some defenders of the current system cavalierly dispense with insights of financial economics in favor of a story that unravels on closer inspection.

Here is one current narrative. State budgets only require 3.8 percent of total spending to pay for pension obligations. This is taken from a report by the Center for Retirement Research at Boston College by Alicia Munnell, Jean-Pierre Aubry, and Laura Quinby.

Read the report more closely. This claim is based on what states contributed on average in 2008. First, it is an aggregate number. Second it is based on an 8 percent discount rate. That is, this is what states contributed, on average, based on the flawed notion that it is possible to lower the size of your debts by assuming high returns on your assets. Yes, they weren’t contributing very much. Their accounting is set up to ensure they underfund their pensions.

Secondly, some states have made a habit of deferring payments. So, what states contributed in 2008 tells us nothing about what they will need to contribute to make up for the shortfall. The next thing to keep in mind is that while some states are moderately funded, other states like Illinois and New Jersey are very badly underfunded. The aggregate “hides substantial variation” as the authors admit. The authors go on to calculate under more realistic discount-rate scenarios (Alicia Munnell adds one percentage point to the Treasury rate to get to 5 percent), Illinois and New Jersey will need to start contributing 12 to 13 percent of their budget. Now also consider a new report by Willshire Associates indicating no state will be able to meet its assumed investment returns over the next ten years.

The second claim being made by a few opinion makers is so deeply contradictory, I am not sure how it can be reconciled.

It is this. And, I quote two articles in full:

Nor are state and local government pension funds broke. They’re underfunded, in large measure because — like the investments held in 401(k) plans by American private-sector employees — they sunk along with the entire stock market during the Great Recession of 2007-2009. And like 401(k) plans, the investments made by public-sector pension plans are increasingly on firmer footing as the rising tide on Wall Street lifts all boats.

And, from today’s Washington Post:

“Public-employee unions say that although the occasional stories of workers who game the system make for good headlines, the real problem was reckless behavior on Wall Street, which caused the value of pension-fund assets to plummet. To force state and local employees to accept what now passes for retirement security in the private sector would amount to a race to the bottom for all workers, they contend.

AFSCME Secretary-Treasurer Lee A. Saunders said: “401(k)s have been around for a generation and the result is tens of millions of workers who lack retirement security. We need to figure out ways to expand effective retirement programs to more Americans. We gain nothing by destroying the defined benefit plans that public employees agreed to and funded over the course of their careers.”

Now, consider the primary critique of public sector defined benefit accounting. Current public sector pension accounting claims it’s possible to measure pension obligations according to what the assets are expected to return when invested in the market.  This has led plans to apply an 8 percent discount rate to value their liabilities. This in turn has led them to invest increasingly in higher-risk vehicles like hedge funds and real estate. The reason: they need to get 8 percent or better on average in order to have enough assets set aside to pay their obligations, which are already underestimated, because of this circular logic.

Economists have been stating consistently that  public plans should be valued using the yield on Treasury bonds (currently 4 percent) to reflect the safety and security of a government pension. What follows from this? An accurate calculation of the size of what is owed; and a more conservative investment strategy.

But defenders want to cling to the math that has led plans to embrace risk and underfund promises.  Remarkably, and without any sense of contradiction, the same defenders express dismay when the market doesn’t return what they anticipated.

What is so scary about 401(k)s? Investment risk must be borne by the individual worker and it cannot be made to disappear with actuarial alchemy.

Perhaps defenders of the accounting mess really think the numbers don’t matter and underfunding is nothing concerned about. After all, the government has a sure hedge against this risk: the taxpayer.