Reporting for State and Local Government Pension Plans

Overview

State and local governments are in financial trouble; some are on the verge of collapse due to excessive spending, aggravated by the severe recession. Investment losses stemming from the recession along with falling tax revenues have been key factors underlying this crisis. The agencies have long borrowed to pay operating costs, and their less-than-transparent financial accountability is catching up with them. Their defined benefit pension funds are underfunded by trillions of dollars. This situation poses a threat to our entire economy.

The Pew Center on the States ¹ estimates a $1.38 trillion gap between the assets and liabilities of the states for public sector retirement benefits, which includes $757 billion for pensions and $627 billion for retiree health care. Almost all the states have acted to decrease such benefits or increase employee contributions in the last few years, but the changes to date will not close the gaps.

While private pension plans are insured by the Pension Benefit Guaranty Corporation, an independent federal agency, government pension plans are guaranteed only by the agencies that sponsor them, subject to the laws of that government. Those plans are far more generous in terms of the calculation of highest average earnings, the credit for overtime in the calculation of benefits and unused annual leave. Such plans also allow for generous early retirement benefits and frequently provide for cost-of-living adjustments.

By 2013, we could see a new “financial crisis”—with states and municipalities defaulting on their bonds. New Jersey, Arizona and especially California and Illinois are among the hardest-hit states. Unions will have to make concessions for public employees. Accounting disclosures will have to improve significantly. The situation is expected to come to a head now that the federal stimulus funds have run out. Municipal bonds or “munis,” which provide tax-exempt interest to holders, have traditionally been considered a safe investment but that may change.

Analysis

Defined benefit plans guarantee or promise pensioners a particular monthly stipend that is independent of the funds available or the investment returns on the fund. That is in contrast to defined contribution plans in which no such promises are made and the accrued funds and investment decisions are the responsibility of the employee. For corporations, the Employee Retirement Income Security Act of 1974 (ERISA) guarantees payment of promised benefits if a corporate defined benefit plan is terminated, with the payments through the federal Pension Benefit Guaranty Corporation. ERISA sets minimum standards for participation, funding, vesting and accrual in business enterprises. There is no ERISA or federal guarantee, however, for government-sponsored defined benefit plans; hardly any of these plans are insured.

State and local governments today do not generally offer full-fledged defined benefit plans to new hires since such pension benefits are protected by law from subsequent retrospective reduction.^2-6 Similarly, few companies today offer defined benefit plans because they are very costly and risky over the long run, since investment returns have proven to be so volatile.

Under Governmental Accounting Standards Board (GASB) Statement No. 27, ⁷ the following items are required to be reported in financial statements:

Government pension disclosures are extensive, if not more so than their corporate counterparts, including historical trends in funding and contributions. That is contrary to what appears in corporate financial reports.

Accounting Standards Codification (ASC) 715-30 sets forth the reporting for company defined benefit pension plans as follows ⁸ : (1) Where the actuarial benefit obligation exceeds the fair value of the plan assets for all the defined benefit plans, the employer is to reflect a net liability on the balance sheet. (2) If the fair value of plan assets exceeds the actuarial benefit obligation, the employer reflects a net asset on the balance sheet. (3) The asset or liability reported may well generate deferred tax accounts due to a temporary difference between book and income tax reporting. The deferred tax effects should be reflected in income tax expense. (4) If the employer provides special termination benefits, a liability and a loss are to be reflected assuming the employees agree to this arrangement and the amount can reasonably be estimated. In the event the employer offers contractual termination benefits, a liability and loss are required if it is probable the employees have earned these benefits and the amounts can be reasonably estimated. (5) The net periodic pension costs (pension expense) consisting of: (a) the service cost—an actuarial present value of benefits to employees for services rendered to date, (b) the interest on the beginning-of-year actuarial benefit obligation, (c) a reduction to reflect the expected return on plan assets, (d) amortization of any prior service cost, (e) amortization of gains/losses on plan assets and (f) the actuarial benefit obligation. ⁹

The following disclosures are required: (1) a reconciliation of the beginning and ending balances of the actuarial benefit obligation; (2) the funded status of the plans, separating the assets from liabilities; (3) benefits expected to be paid in each of the next 5 years and the total for the 5 subsequent years; (4) the employer’s expected contributions in the next year, in terms of the legally required amount, along with discretionary contributions and (5) the net benefit cost or expense (decomposed into service cost, interest cost, expected return on plan assets, amortization of gains and losses, prior service cost amortization, the gain or loss recognized from settlements or curtailments and amounts in accumulated other comprehensive income not yet recognized.)

The Financial Accounting Standards Board and its international counterpart have been working on a revised retirement benefits standard that would eliminate the “income smoothing” element in their current standards. Accordingly, the two boards would plan to replace the expected return element in pension expense with the actual return and to reflect gains and losses on plan assets and benefit obligations as they occur instead of amortizing them over the long run.

The governmental board, GASB, is currently deciding whether to modify defined benefit pensions under its jurisdiction. In GASB (25), “Financial Reporting for Defined Benefit Pension Plans and Note Disclosure for Deferred Contribution Plans,” the board requires that the discount rate be based on “an estimated long-term investment yield for the plan . . .” If the average return can cover the obligations of the plan, the plan can be viewed as funded. Six percent appears to be the rate currently used in most corporate defined benefit plans. The rates used by government plans are generally higher, between 7.25% and 7.50%, which serves to reduce the attention to plans that are not adequately funded. Corporations tend to use Moody’s “A” ratings for high-quality corporate bonds in forecasting expected returns on plan assets.

Under a 2011 exposure draft of an amendment to GASB 25, ¹⁰ the fundamental financial statements would essentially remain the same. The major changes pertain to measurement for which the employer, not the plan, is ultimately responsible. This exposure draft calls for the presentation of two financial statements, significant notes to those statements and required supplementary information pertaining to defined benefit pension plans administered through qualified trusts. The two proposed financial statements are a statement of plan net position and a statement of changes in plan net position. The plan net position statement would include assets, deferred inflows and outflows of resources and liabilities, including benefit payments. The changes in net plan position statement would include contributions from employers, investment income, benefit payments, and administrative expenses. The foregoing items would be required by Statement 25 as amended.

Also under the 2011 exposure draft, the notes to the financial statements would include the same information required under Statement 25: that is, the nature of benefits provided, the classes of plan members covered, how fair value is measured, investment concentrations, along with new information—the composition of the plan’s board as well as investment policies and the time-and-money-weighted rates of return on plan investments.

Single-employer and cost-sharing or multiple-employer plans (the latter relating to multiple employers sharing obligations to pay pension benefits) would also have to disclose at the end of the plan’s reporting period, also as under Statement 25: significant assumptions underlying the total pension liability, including salary increases, inflation, mortality and cost-of-living adjustments; along with new information, including the total pension liability of the employers, the plan net position, net pension liability, ratio of net position to total liability and assumptions used in computing the discount rate.

Single-employer and cost-sharing plans would also present the following new information: schedules for the past 10 years of changes in the net pension liability and information about the components of the net pension liability of employers, including the pension liability, plan net position, net pension liability and the ratio of plan net position to total pension liability and a schedule of employer contributions if they are actuarially determined.

Although some states and municipalities that are short on cash have delayed funding their pension plans, that is the exception rather than the rule; most are making the annual required contribution on time. In fact, some states, especially those with multiple-employer plans, have laws specifying the amounts to be contributed. Nevertheless, the likely remedies for funding shortfalls include, but are not limited to, putting new employees on presumably less costly defined contribution plans or on less generous defined benefit plans with a delayed retirement age and/or increasing employee contributions to such plans.

A different option would be putting new employees in cash balance plans. With these plans, employees and employers both make contributions, with the state guaranteeing the return on the contributions (similar to a savings account). Benefits are based on the funds accumulated over an employee’s years with the employer, rather than on the past 2 or 3 years as in many government defined benefit plans. Legally these are defined benefit plans although they work much like a defined contribution plan.

In contrast to defined benefit plans, defined contribution plans are not insured, so the investment results, for which the employee is responsible, and thus the value of an employee’s accumulated fund is subject to stock market variations. Actually, most government pension plans are uninsured; in the event of bankruptcy, if a government jurisdiction were not bailed out by another government agency, the pensioners would lose out. However, few government organizations have ever gone bankrupt, and few government pension plans have been nullified.

A problem with all proposals to modify state and local pension plans and convert them into 401k plans (or 403b plans in the case of teachers) is that many plans, particularly those covering police and teachers, have no Social Security tie-in. Stated differently, the retirees under these plans may not have paid Federal Insurance Contributions Act taxes, and therefore are not eligible for the “security” that Social Security payments provide.

The most extreme option is reducing pension contributions by the government agency as Detroit is doing. ¹¹ Unions in several cities have agreed to similar cuts.

Government pension plans presumably cannot assume unrealistic returns since actuaries and auditors are expected to prevent that from happening by examining the basis for those returns. Furthermore, prior to 2008 government pension funding was often 80%, and in some cases 100%. The decline in funding since that time has been largely due to investment losses. Nevertheless, the very significant underfunding in a few states, especially Illinois and Rhode Island, can be considered an outlier rather than the norm.

Financial economists Novy-Marx and Rauh have been critical of the basis used for the pension discount rate.^12,13 In their judgment, pension liabilities are risk-free, and thus should be discounted with a risk-free rate of return. Currently, but not necessarily historically, this rate of return is significantly below the long-term expected returns used by government agencies.

Conclusion

The recent reforms by most states include the following: (1) new requirements for employees to contribute larger sums toward their retirement benefits, (2) increasing the retirement age and service years, (3) reducing cost-of-living adjustments, (4) modifying the pension benefit formula and (5) reducing overtime pay in the calculation of final earnings. ¹⁴

While local governments have defaulted on their debt, and municipal bankruptcy is available to local governments and established in federal bankruptcy law, the Congressional Budget Office (CBO) reports that historically these events have been rare. From 1970 to 2009, only 54 of 18,400 municipal bond issuers rated by Moody’s Investor Services defaulted, and in the majority of cases most or all of the debt was repaid. The CBO reports an increase in defaults during the past few years, with 2010 defaults exceeding $4 billion. Over the period 1940-2010, the CBO reports approximately 600 local government Chapter 9 bankruptcy filings.

State and local governments would like to be able to amend their pension plans, but that may not be possible from a legal standpoint, unless the government agency goes bankrupt or is otherwise restructured (as was the case with New York City during the late 1970s). Although no bill has yet been introduced in Congress addressing the issue of state bankruptcy, there is apparently a discussion of its possibility. ¹⁵ At this juncture, it is not clear what would happen in the event of a government agency going bankrupt without receiving a lifeline from another government agency.

On June 25, 2012, the GASB voted to finalize its exposure draft into a new standard effective in 2014 on financial reporting for defined benefit pensions and other retirement benefits. GASB will emphasize the reporting of plan assets at fair market value and the reporting of the benefit obligation. As a result, there is likely to be increased focus on cutting costs of these plans.