Friday, December 15, 2017

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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.