CBO: Change Public Pension Accounting to Fair-Value Method

(May 8, 2011) – A recently released Congressional Budget Office (CBO) brief suggests that American public pensions should alter the way they calculate plan liabilities, asset values, and funding ratios.

According to The Underfunding of State and Local Pension Plans, public pensions should use a fair-value method that incorporates a discount rate used on future cash flows to discern their liabilities to future workers, as opposed to the current GASB guidelines.

“For assets, the fair value is what an investor would be willing to pay for them—that is, the current market value (or an estimate when market values are unavailable); it is not the averaged, or smoothed, market values that are reported under GASB guidelines,” according to the brief. For pension liabilities, the fair value can be thought of as what a private insurance company operating in a competitive market would charge to assume responsibility for those obligations.”

Their reasoning is one often cited by those in the pension plan space. “In the case of state and local pension plans, the discount rate for future benefit payments using the fair-value approach is lower—and, therefore, the estimated present value of those payments is higher—than under the GASB approach,” the brief says, explaining why it is suggesting a change to accounting and valuation methods. “Under the fair-value approach, future cash flows are discounted at a rate that reflects their risk characteristics. Hence, for pension liabilities, the discount rate reflects the fact that the cash flows associated with accrued liabilities are fixed and carry little risk; it is very unlikely that the liabilities will not be honored.”

Any move toward changing pension accounting would have a material impact on the overall funding levels of the public pension system, of course. “It’s widely reported to be a $1 trillion problem, but if you dig into the numbers, it’s a $2 to $3 trillion problem,” David Kelly, an actuary at Mercer Investment Consulting’s Financial Strategy Group, told aiCIO in April. “The reported liabilities are understated by using an optimistically high discount rate,” the result being a misstatement of what the plans actually owe. Kelly’s assessment is supported by another prominent pension actuary. According to Steve Alpert, Chair of the American Academy of Actuaries Pension Accounting Committee, fair-value accounting methods increase the deficit so substantially because “a general rule of thumb regarding pension accounting is that when a rate-of-return assumption drops 1% it can cause a 10% to 15% change in liabilities.”

To see aiCIO’s profile of the New York City pension system – and how pension accounting is creating a hidden liability nation-wide – click here.