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Public pension accounting methods may overvalue fund assets, says analyst

Public pension accounting methods may overvalue fund assets, says analyst

Idaho Freedom Foundation staff
June 28, 2012

As state-based public pensions throughout the country face record funding gaps, the Public Retirement System of Idaho (PERSI) is doing comparatively well, with officials reporting a 90.2 percent funded level in 2011, up significantly from the 79 percent level it faced after the financial collapse in 2008. Still, some experts insist that public-sector accounting practices set by the Governmental Accounting Standard Board (GASB) inflate the actual level of funding, thereby misrepresenting the true solvency of public pensions.

Existing liabilities in public retirement funds may be underreported because state accounting practices regularly make assumptions about expected investment returns and demographic factors like life expectancy of beneficiaries that would be considered unrealistic in private-sector accounting, according to Andrew Biggs, resident scholar at the American Enterprise Institute in Washington, D.C. He also suggests that concealing these details may put future investments in greater jeopardy.

"While public-sector pensions publish lengthy reports on many aspects of their administration and financing, most financial disclosures omit important details regarding the amount of risk inherent in plan investments and how that risk affects the plan's ability to meet future obligations," Biggs wrote. "Current accounting methods not only underestimate funding shortfalls, they offer a seemingly painless way to solve them: invest in riskier assets."

Given that public pensions are obligated to pay benefits no matter their level of funding, Biggs points out that underperforming pension assets may leave taxpayers on the hook for the balance—and this risk is actuarially absent from PERSI valuation. Because payments to beneficiaries are guaranteed, the risk of fund investments failing to grow as expected means that GASB valuation is systematically overstated.

"If you fund a guaranteed benefit using risky assets, there’s a chance (which actually is greater than 50 percent) that you’ll come up short," Biggs wrote in an email to IdahoReporter.com. "However, the taxpayer has to make up the difference since the benefits are guaranteed. So even ‘full funding’ under current GASB rules ignores the value of that contingent liability being placed on taxpayers. Using a risk-adjusted discount rate catches and so reveals the full ‘economic cost’ of the pension. PERSI is valuing their plan as if they were running a 401(k), where getting less than the expected return imposes no cost on the employer. But with a defined benefit plan it does impose a cost, and financial markets are very adept at quantifying it. Using a riskless interest rate to value riskless benefits is the way to do that."

The Pew Center for the States reported an Idaho public pension liability of $772 million in 2008, but Biggs estimated that if PERSI had used fair market valuation for its program assets, that unfunded amount would have amounted to more than $10 billion. Also, despite the 90.2 percent funded figure reported by PERSI last year using GASB-compliant assumptions, Biggs estimates that using fair market valuation for PERSI's 2011 investments, the system would have a $12 billion unfunded liability—leaving PERSI only 44 percent funded.

PERSI's executive director, Don Drum, said in an email to IdahoReporter.com that Idaho's public pension system takes pains to ensure taxpayers are protected.

"I contend that you can achieve sustainability in pension systems without jeopardizing taxpayers," Drum said. "Idaho has always used caution when addressing public pension issues. As a result the PERSI system is considered one of the nation’s best." Drum also characterized Biggs' analysis as suggesting "that any investment besides Treasuries is 'too risky' and should not be assumed, and that the true current value of our liabilities should use that assumption. The actuaries disagree. PERSI disagrees, too. In fact, if one is assuming investments over a 20-30 year period, nominal Treasuries is the riskiest investment for a long term fund whose liabilities are tied to inflation."

Biggs, however, reiterated in his email that his analysis makes no claims about the types of investments that pension funds should make, only that those funds should correctly incorporate actuarial risk based on the possibility of investment failure and the mandate to pay benefits regardless of investment performance.

"The point is this: If I want to guarantee a payment of, say, $1,000 in 10 or 20 years' time, the rate at which to judge the cost of doing that is the Treasury rate," Biggs said. "If I don’t care about guaranteeing it then I can pay less and invest the money in stocks and simply have an expectation (50 percent +) of being able to pay. But that’s not how public pensions work. You have to pay the liability 100 percent of the time, so investing in stocks and simply having an expectation of being able to pay isn’t sufficient."

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