Fair-Value Measure Truer Picture of Public Pension Costs

May 5, 2011 (PLANSPONSOR.com) – An Issue Brief from the Congressional Budget Office suggests that the fair-value approach for measuring public pension assets and liabilities provides a truer picture of public pension costs.

However, the agency says it may still be a good idea to use the Government Accounting Standards Board’s (GASB) measure to determine how to fund plans.  

According to the report, the GASB and fair-value approaches differ in what they tell a plan’s managers, its participants, and the public about the costs of a pension system, including the cost of the risk to taxpayers that the rate of return on risky pension assets may not meet expectations. By using the expected rate of return on assets as the discount rate for converting future benefit payments into today’s dollars, the GASB approach essentially assumes that those returns are as certain as benefit payments, at least in the long run.  

By contrast, the fair-value approach views the returns on assets as more uncertain than the benefit payments, even in the long run; under that approach, the rate of return on assets is not suitable for discounting pension benefits. By accounting for the different risks associated with investment returns and benefit payments, the fair-value approach provides a more complete and transparent measure of the costs of pension obligations, the CBO says.  

In addition, the agency contends that by not smoothing asset values over time, the fair-value approach provides a clearer view of the fluctuations that can occur in long-term funding needs when risky assets are used to finance fixed pension obligations. By making the mismatch in risk between assets and liabilities more transparent, the fair-value approach also may discourage risk taking on the part of fund managers.  

On the other hand, by indicating a larger amount of underfunding, adopting a fair-value approach in reporting pension plans’ finances could indicate a need for a significant increase in funding, which would further strain government budgets—despite the fact that, on average, a much smaller increase in funding might turn out to be sufficient to cover pension plans’ liabilities. Moving to a fair-value approach could also increase the volatility in reported underfunding and, therefore, in funding requirements, making budgeting for the required contributions more difficult.  

However, the CBO says there is no necessary connection between the information provided by the fair-value approach and the determination of a sponsor’s annual contributions to the plan, which could be calculated on a different basis. To take into account the higher expected returns on riskier portfolios, annual contributions could continue to be based on the GASB guidelines for measuring liabilities, and volatility in annual contributions could be reduced by basing contributions on shortfalls averaged over several years, the agency suggests.   

If adequately funded, such a strategy would offer a significant likelihood that a plan’s assets would be sufficient to cover its liabilities, though the strategy would be accompanied by the risk of a significant shortfall that could burden future taxpayers. The CBO proposes that in some cases it may be appropriate for future taxpayers to finance pension costs. The services provided by school teachers, for example, might be justifiably financed, at least in part, by future taxes on people who are now students.

Two Approaches for Measuring Underfunding  

The CBO Issue Brief explains that the two leading approaches to measuring pension costs - guidelines issued by the Government Accounting Standards Board (GASB), which is the organization that specifies the accounting practices generally followed by states and localities, and the fair-value method, which generates estimates of funding that are more comparable to those reported by the corporate sector - often give very different pictures of funding status, primarily because they use different discount rates.  

The GASB and fair-value approaches also differ in their treatment of assets, but that difference does not have a systematic effect on estimates of underfunding, the report says.  

Under the guidelines provided by GASB, actuaries compute liabilities by discounting future benefit payments using a discount rate based on the expected rate of return on the plans’ assets. (Currently, the median of pension plans’ assumptions for future returns on state and local pension assets is about 8%, or 4.5% after removing the effect of the median assumed rate of inflation.) That approach provides a measure of the amount that must be invested in assets earning the expected rate of return, on average, in order to cover future payments.  

The guidelines also allow the reported value of assets to be an average of the market value of assets over several years, so as to blunt the impact of a large swing in the value of equity holdings in a single year.  

Under the fair-value approach, 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. 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.  

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. Under the fair-value approach, future cash flows are discounted at a rate that reflects their risk characteristics.  

So, 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. (By contrast, under the GASB approach, the discount rate used for liabilities reflects the greater risk associated with pension funds’ assets.) Under the fair-value approach, one way to approximate the discount rate applied to future benefit payments is by using the interest rate on municipal securities (adjusted to remove the effect of tax deductibility): In 2010, the discount rate would have been about half as large as the median discount rate of 8% under the GASB guidelines.  

According to the CBO, a study published last year that examined the sensitivity of estimates of underfunding to discount rates for pension plans in the Public Fund Survey illustrates the large difference between the GASB and fair-value approaches. Unfunded liabilities in 2009 amount to about $0.7 trillion when liabilities are discounted at 8%, but total $2.2 trillion when liabilities are discounted at 5% and $2.9 trillion when they are discounted at 4%. Those unfunded liabilities, as calculated on a fair-value basis, indicate funded ratios of roughly 55% and less than 50%, respectively.  

The Issue Brief, “The Underfunding of State and Local Pension Plans,” can be downloaded from http://www.cbo.gov.