How the GASB's New Pension Standards Could Make Things Worse

The underfunding of state and local public pensions in the U.S. is around $4 trillion. That amounts to the largest local fiscal crisis facing our nation. The cost ultimately will dwarf that of TARP, the Fannie Mae/Freddie Mac bailout, the S&L bailout, or any other recent American financial crisis.

The agency responsible for public pension accounting, the Government Accounting Standards Board, or "GASB," allows state and local governments to report far greater fiscal health by comparison and collective underfunding of only about $1 trillion. For more than six years, GASB considered changes to address this discrepancy. Very recently, it approved new standards to "substantially improve the accounting and financial reporting of public employee pensions." Astonishingly, their changes could make things worse. True, GASB reforms could reveal several hundred billion more dollars in underfunding. But that small progress is overshadowed by the key reforms GASB omitted.

Currently, public pension funds make their own assumptions about their future investment returns without GASB interference. If public pensions increase the riskiness of their investments, they assume a higher rate of return. Simultaneously, pension funds use that high rate to "discount" their long-term liabilities, which artificially reduces today's sticker price for the future costs of retiree benefits. This practice has no basis in finance or economics and encourages public pensions to make risky investments and then underestimate the amount they owe. It is the principal reason economists think they are hiding trillions of dollars in liabilities. GASB's new standards do little to change this.

Instead, new rules effect soft changes, like requiring funds to explain their discount rates, though many already do. In 2010 the chief New York State actuary explained theirs while avoiding any meaningful financial evaluations. He might at least have heeded Warren Buffet: "I think it's very hard to come up with a persuasive case that equities will over the next 17 years perform anything like ... they've performed in the past 17. If I had to pick the most probable return ... that investors in aggregate ... would earn ... it would be 6%." Alas, New York State chose 7.5 percent.

More troubling, GASB implies it is implementing a "blended," more responsible discount rate for plans that expect to run out of assets before they can pay all the benefits owed to workers. Some call this a "compromise." But GASB has made sure its compromise will have little practical application.

The trick is in how GASB now allows states and cities to calculate solvency: GASB concocted a new, convoluted calculation, where state and local governments can add whatever future investment returns and employer contributions they decide to expect. Their bait and switch gives all of America's public pensions enough discretion to appear 100-percent solvent for the purposes of their discount rate calculations. Therefore, none of the country's pension plans would ever need the new "compromise" rate. This is just like the mortgage applicant who lists his hoped-for earnings in the stock market under his current assets and his expected raises at work as his current salary. We all know how that story ends.

Except GASB; they are still all for that. Indeed, this is precisely what happens when pension plans can inflate their solvency using both fanciful investment returns and hoped-for future employer contributions: They can assume future events will fix any current shortfalls. Ironically, these reforms were supposed to eliminate this kind of chicanery. Instead, GASB has embedded such tricks deeper inside its convoluted new solvency formula.

As a final travesty, GASB will no longer require public pensions to disclose the annual employer payments required to bring their funds back to solvency. In recent years many states have borrowed money from bondholders (Illinois) or the pension fund itself (New York) to make this annual payment, while others didn't pay it at all (New Jersey). Now states won't even have to disclose when they shortchange their annual tabs.

One can only speculate why GASB chose to preserve wide discretion for states and cities to choose discount rates while requiring less disclosure around funding. Perhaps they think these problems are inevitable, so it's better to duck than take action. This means when our pension time bomb explodes, those in charge of our safety will be in their bunker, local governments can claim that they followed their accounting rules, taxpayers will be stuck with a trillion-dollar bailout, and there will be blood.