Will More Transparency Help With Public Pension Plan Financing?

NJ State House

That’s the premise behind a bill introduced in Congress to require state and local government pension plans to be more candid, but whether it turns out to be true will depend on what accounting standard is used to determine plan liabilities, a public sector actuary and an economist told Bloomberg BNA.

The Public Employee Pension Transparency Act, or PEPTA, introduced March 21 by Rep. Devin Nunes (R-Calif.), “would require state and local government pension plans to disclose their liabilities in a uniform and transparent manner based on widely accepted accounting principles,” Nunes said in a news release.

“State and local pension systems may seem fiscally secure, but that is often a façade created by assuming unrealistic rates of return on investments and by using other accounting tricks,” Nunes said.

A forthcoming report from Stanford University Professor of Finance Joshua Rauh puts a $3.4 trillion price tag on estimated unfunded liabilities, Nunes said.

The bill would ensure public access to the disclosures through a searchable website made available by the Secretary of Treasury. The bill would also eliminate the federal tax-exempt bonding authority of those governments that fail to make these disclosures.

Deciding what accounting principles should be used to measure public pension plan costs is a subject for debate between public plan actuaries and economists.

Accounting Alternatives

The introduction of PEPTA fits into a decade-old campaign by economists and their actuary allies who believe that all pension plans should be evaluated on a “market liability basis,” Paul Angelo, a senior vice president and actuary for Segal Consulting in San Francisco, told Bloomberg BNA.

The market liability basis calculates a plan’s liability according to the discount rate that the plan would get if it were to go into the market and settle its pension obligations by purchasing an annuity or portfolio of low risk bonds, he said.

The market discount rate does not reflect the long-term expected investment return on the plan’s investment portfolio, which is currently in the range of 7 percent to 8 percent but is trending downward as many plans adjust their expectations, Angelo said.

In contrast, public plan actuaries employ the concept of “level-cost modeling” that uses an assumed expected return discount rate and most often-level cost actuarial cost methods, he said.

“There is a fair discussion to be had about what is the appropriate long term expected return to be used as the discount rate using level-cost modeling as distinguished from market pricing modeling,” Angelo said.

Market liability pricing is also unsuitable for government pension plans because, unlike private corporations, governments never go out of business, said Cathie Eitelberg, head of Segal Consulting’s public sector market at its Washington, D.C. office.

“For companies going out of business, their retirement liability is a negotiated number” and may factor into a calculation of their settlement liability if the Pension Benefit Guaranty Corporation takes over the pension liability, she told Bloomberg BNA.

On the other hand, “it is extraordinarily rare for public pension plans to go to settlement,” she said.

For example, when Orange County, Calif., went bankrupt in the 1990s, it had no impact on pension plan contributions, Eitelberg said.

Economists’ View

In response to the arguments presented by the Segal actuaries, Andrew G. Biggs, resident scholar at the American Enterprise Institute, advocated for the economists’ point of view that the market discount rate is the proper accounting measurement for government pension plans.

“Public actuaries just don’t have a good explanation for why U.S. state and local pensions—uniquely in the pension or financial world—should use different accounting methods that low-ball the costs of their plans and encourage pensions to take excessive investment risk,” Biggs told Bloomberg BNA.

State and local pension plans took their actuaries’ advice and assumed more investment risk, believing the plan would be immediately better funded and plan sponsors could cut their contributions. However, the expected cost method says nothing about “how with riskier investments, the sponsor’s contributions are going to vary significantly from one year to the next,” Biggs said.

Public plan actuaries “operate from an outmoded accounting system which failed to adapt as pensions shifted from investment in bonds to investments in stocks and alternatives,” he said.  “Using an expected cost method back when pensions held mostly bonds was theoretically wrong, but not a problem because both bonds and pension benefits are very, very safe. But using an expected cost method when benefits are guaranteed but investments consist of 70 percent stock and alternatives is just plain wrong.”

The problem is not just in a theoretical sense, Biggs said.

“As pension plans take more investment risk, the volatility filters through into government contributions that go up and down a lot from year to year,” he said. “For example, the average actuarially required contribution tripled from before the recession to today, and as a result many governments can’t afford to pay them.”

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