Public Sector Pension Plans to Face Tighter Scrutiny

By Steve Metz

Steve Metz
Steve Metz

Government pension plans have been in the news a great deal the past few years and it hasn’t been pretty – due in large part to poor investment performance these public plan costs have skyrocketed along with their unfunded liabilities.  Governments all over the country have been hit hard with huge increases in legally required pension contributions that are devastating their budgets.  New accounting rules coming soon will bring even more attention to these issues.

Before we go too much further, it is important to note that determining the value of pension plan unfunded liabilities is an inexact science. For example, the magnitude of the liabilities is extremely sensitive to certain assumptions such as future investment returns, salary increases and employee turner and retirement rates.

The Governmental Accounting Standards Board (GASB) issued a pension accounting standard this year that will affect how public sector plans report pension costs and liabilities beginning in 2014.  The reason for the new GASB standard is to improve transparency, consistency and comparability in pension reporting.  The new rules affect pension accounting in a number of ways, however there are three areas that seem likely to be the most dramatic:

Determination of the Discount Rate and Funded Status:

Pension liabilities are calculated by projecting future cash flows and then discounting them back to determine the present value – the higher the discount rate, the lower the present value of the liabilities.  Currently, pension liabilities are discounted using an expected rate of return on plan investments, typically 7-to-8 percent per year (the Georgia plan uses 7.5 percent.)

Under new rules, plans will use a combination of the discount rate and a municipal bond index return which will typically be much lower – currently about 4.5 percent.  The mix of the two rates will depend on how well funded the pension plan is – the lower a plan’s funded status, the less it can use the expected rate of return and the more it will have to rely on the bond index.

As a result, poorly funded plans will have to use a much lower discount rate that will increase their underfunded status compared to current rules.  This “double-whammy” effect will provide more incentive for governments to get their plans properly funded and keep them there.

The State of Georgia’s pension plan is 73 percent funded using the current GASB rules (based on the June 30, 2011 valuation report and discounting the liabilities at 7.5 percent.)  Under the new GASB rules Georgia’s funded percentage might drop further starting in 2014.  To put this in perspective, this past Summer the Pew Center on the States rated Georgia as a “solid performer” regarding the funding of its pension and retiree medical benefits.

Costs Associated with Benefit Increases:

Currently, government employers report pension costs under a method that allows them to spread the cost of benefit increases over many years.  The new rules will significantly accelerate recognition of these costs.  Currently costs associated with a change in benefits are spread over a period as long as 30 years (depending on the particular plan’s circumstances).

Starting in 2014 costs will be recognized 100 percent in the year they are adopted.  Here is the real world impact of that change:  Under current rules a cost-of-living adjustment (COLA) that increases plan liabilities by $10 million might only result in an annual charge of $800,000 per year.  Under the new rules all $10 million will be charged in the year it is adopted.  This will make it much harder for public sector plans to approve retroactive benefit increases.

“Substantively automatic” Benefit Changes:

New rules require that pension plan liabilities should include the cost of any benefit change that is “substantively automatic” based on criteria such as the historical pattern of granting them and the consistency in the amount.  For example, under current rules if an employer provided a 2 percent COLA during each of 15 previous years but these increases were not “automatic” the plan liabilities would be determined as if no future COLAs were anticipated.

Under new GASB rules liabilities would presumably reflect future 2 percent COLAs – which could increase the liabilities by 15-to-20 percent.  There are probably few if any public sector employers with a pattern this clear, but many fall into a very large “gray area” with frequent or regular benefit changes.

This rule change could lead to some very challenging discussions for auditors and their clients.  It will also presumably lead public sector pension boards and governments to give more consideration to what expectations they are setting with repeated “one-time” benefit increases.

The 2014 year GASB accounting rule changes have predictably received mixed reviews from stakeholders in the public pension arena and it is unfortunately true that with any significant change there will be added costs and complexity in an area that is already complicated.

However, given the magnitude of public sector plan liabilities and the impact pension plans have had on governmental budgets any change that improves transparency and consistency is welcome.

(Steve Metz is a retired pension actuary.  During his career he consulted with large and small employers in the public and private sectors in a variety of industries.  Prior to retiring he was a Partner at PwC, an Associate of the Society of Actuaries and an Enrolled Actuary.  This article was written for the Georgia Public Policy Foundation.)

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