Economics, Entitlements

SEC commissioner endorses fair value accounting for public pensions

Image Credit: Shutterstock

Image Credit: Shutterstock

I have written ad nauseum about how public employee pension accounting standards allow the plans to minimize their liabilities and overstate their funding health. On paper, these plans report underfunding of around $1 trillion. In reality, they are underfunded by $4 trillion or more. More recently, I served as the co-vice chair of the Society of Actuaries Blue Ribbon Panel on pension underfunding. And so I am happy to report that, in a May 29 speech, Securities and Exchange Commission member Daniel M. Gallagher endorsed both the logic behind our ideas and specifically referenced two reforms we suggested.

In light of Detroit’s recent bankruptcy, Commissioner Gallagher said, it “is imperative that bondholders know with precision the size of the potential pension liabilities of the entities in which they are investing. And yet, they do not. This is because, for years, state and local governments have used lax governmental accounting standards to hide the yawning chasm in their balance sheets.”

How does this happen? Here I’ll simply quote Gallagher at length:

“To calculate future inflows, a sponsor must assume the fund’s future rate of investment return. Here, state and local pension plans have generally been over-optimistic: many assume a 7.5 to 8% return, when a rate in the mid-6% range would be more realistic. Striving to meet this artificial and inflated goal may cause funds to reach for yield, exposing them to increased investment risk and potentially exacerbating the problem.”

“Even worse, pension plans also have valued their expected outflows based on this same expected return on assets, discounting their future liability to a present value using that 7.5–8% number. This is contrary to fundamental tenets of financial economics: liabilities should be valued at a rate that reflects their risk, not the risk of the assets that are expected to cover the liabilities.”

“The riskiness of a pension obligation depends on state law. If pension obligations have the same preference as general obligation debt, then the municipality’s own municipal bond yield (generally around 5%) would be the proper discount rate. Or, if as we’ve seen from Detroit, pensions will be saved before all else, then we should use a default-free measure to discount the liability: specifically, the Treasury zero-coupon yield curve. This would result in a discount rate in the low 3% range.”

“Obviously, the higher the discount rate, the lower the present value of the liability. The difference between a discount rate in the range of 7% and one in the range of 3% is in large part responsible for the hidden $3 trillion in unfunded liabilities that are currently going unreported.”

“This lack of transparency can amount to a fraud on municipal bond investors, and it does a disservice to state and local government workers and retirees by saving elected officials from making the hard choices either to fully fund the pension promises that were made to public employees, or not to make the promises in the first place.”

To address these issues, Gallagher turns to two proposals from the SOA Blue Ribbon Panel that I sat upon:

“First, entities should value and disclose their liability using a risk-free discount rate, for example, the treasury yield curve, applied to all benefit liabilities.” The Panel argued that by comparing these values to those calculated using the standard “expected return” approach, analysts can determine how much of a plan’s funding health delivered upon the assets it holds and how much upon the expectation of receiving a risk premium on those assets going forward.

“Second, entities should calculate and disclose a baseline plan contribution—the amount actuarially necessary to fully fund the plan—based on those conservative liability assumptions, along with a conservative estimate of return on investment. Investors would then be able to readily compare financials calculated using GASB standards and disclosures about the current level of plan funding against this common baseline. Entities would be free to explain to investors why the differences exist.”

Gallagher concludes thusly:

In the private sector, the SEC would quickly bring fraud charges against any corporate issuer and its officers for playing such numbers games. And, we would also pursue and punish the so-called fiduciaries who recklessly seek yield to meet unrealistic accounting assumptions. We should not treat municipalities any differently.

Let the wailing and gnashing of teeth from the public pension community begin…

Follow AEIdeas on Twitter at @AEIdeas.

2 thoughts on “SEC commissioner endorses fair value accounting for public pensions

  1. Let’s see. A bunch of union workers thought they bought some politicians. Turns out they invested their retirement plan in a ponzi scheme. Tough, better luck in your next life.

  2. Egads. Imagine fair reporting on VA benefits. We are talking about $2 trillion in outlays in the next 10 years. Yes, $2 trillion. Maybe more if the avowed socialist Bernie Sanders has his way.

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