The Accounting Trick that Will Haunt Public Pensions

September 13, 2012

State and local government employee pensions around the country are significantly underfunded. The Governmental Accounting Standards Board (GASB), which is the closest thing to a regulatory body for public pensions, may steer the fate of public pensions to an even worse place than it is now, says Andrew G. Biggs, a resident scholar at the American Enterprise Institute.

GASB, in contradiction to basic economic theory and accounting rules that apply to almost all other pension plans, advises that the pensions should take greater investment risks to improve their funding. That is because GASB rules cause public pensions to understate their liabilities, which provide an incentive to take greater investment risks.

  • State and local pensions discount their future benefit liabilities using an assumed rate of return, typically 8 percent.
  • In 2010, public pensions were around 76 percent funded.
  • However, unfunded liabilities exceeded $750 billion.
  • Using riskless Treasury yields, unfunded liabilities are around $4 trillion, making pension plans unfeasible in the status quo.

In response to criticism, GASB proposed new rules in June that allowed 8 percent discount rates only through years in which the plan's assets are expected to last. Otherwise, they must be valued using a lower municipal bond rate. Moreover, GASB would reduce funding rations by 10 percent.

However, these new regulations will do little to alleviate the problem public pensions are facing.

  • These new regulations give pensions the incentive to take bigger risks.
  • In addition, riskier investments have higher expected returns, which allow for a higher discount rate.

There is still hope that public pensions will become sustainable. Moody's announced recently that it would no longer accept state and local governments' pension liability figures at face value. Moody's said that it would value pension liabilities like it does private pensions: by using yields from high quality corporate bonds. Biggs hopes this will create pressure on governments to correctly manage their pensions.

Source: Andrew G. Biggs, "The Accounting Trick that Will Haunt Public Pensions," Real Clear Policy, September 5, 2012.

 

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