Time to Tighten Rules on U.S. Pensions

Last year was tough for U.S. pension plans—both private and public. But while it looked like private plans were hardest hit, this is merely a matter of appearances. Public plans are in much worse shape, though lenient accounting rules allow them to paint a misleadingly rosy picture of their funding status.

Private pension plans of S&P 500 companies saw their funding gap nearly double in 2011, from $250bn at the start of the year to $450bn at the end of the year, according to a report from Credit Suisse. This shortfall is much higher than the $274bn shortfall from the peak of the financial crisis.

This jump in the shortfall largely results from historically low interest rates. For corporate pension plans, the Financial Accounting Standards Board (FASB) requires that the discount rate must generally equal the rate on the 10-year Treasury – which has recently hovered near 2 per cent. (A lower discount rate leads to a higher present value of long-term plan liabilities.)

Yet the stock returns on corporate pension plans have not been sufficient to offset this lower discount rate; in 2011, the S&P 500 was virtually flat. The contributions required to cover the resulting shortfall will create downward pressure on corporate earnings for 2012.

Unfortunately, the challenges facing private pension funds are minor relative to those faced by public pension funds of state and local governments in the U.S. Official estimates of public pension fund shortfalls are typically in the range of $500bn to $1tn, depending on the timing of the calculation and the actuarial methods used.

However, these estimates drastically understate the true size of the shortfall. This is because public pension plans can choose an “expected rate of return” as their discount rate. Most public pension plans use an overly optimistic rate near 8 per cent, which leads to a significant understatement of their long-term liabilities.

Professors Robert Novy-Marx of the University of Chicago and Joshua Rauh of Northwestern examined the magnitude of these understatements. They found that the liabilities of state pension plans would be more than 70 per cent higher if they were required to use a lower, risk-free rate as their discount rate. This difference means that total liabilities for state pension plans are understated by $2tn. Thus, state pension plans are underfunded by at least $2.5tn.

To reflect more accurately the funding of public pensions, the Governmental Accounting Standards Board (GASB) has proposed a new rule for setting the discount rate for these plans. Specifically, the portion of liabilities that are funded by current assets can continue to be discounted at the expected rate of return. But any “unfunded” portion of the liabilities must be discounted at a lower rate—based on the actual yield of high-quality bands of the relevant government entity.

More accurate accounting would help voters understand the true challenges facing public pension plans. Unfortunately, the public discourse regarding pension reform is toxic.

For instance, New York governor Andrew Cuomo recently proposed a modest reduction in the scheduled benefits of future employees when they retire. Unfortunately, the president of the Uniformed Firefighters Association responded to this proposal by stating that “widows and children of firefighters would be tossed under the bus” by Mr Cuomo’s reforms. There is little hope for reform when such hyperbole substitutes for informed debate.

Stricter accounting rules would also encourage managers to reduce their risk exposure. Currently, managers feel obliged to invest heavily in hedge funds and private equity to support their high expected returns. As explained by Reynold Williams at South Carolina’s pension fund: “There [would be] almost zero chance over the next seven years that we could hit our assumed rate of return” without these riskier alternative investments.

While hedge funds and private equity offer the promise of higher return, they also increase the risk borne by taxpayers. Because governments are contractually obligated to pay accrued benefits, taxpayers will be on the hook if a risky pension investment turns sour.

In short, although the funding gaps for corporate and public pension plans appear at first glance to be roughly similar, the accounting rules for public plans are overly generous. GASB’s proposal to reduce the discount rate on some pension liabilities is a good first step toward a clearer understanding of the actual status of public plans. Hopefully, this increased accuracy will spur a more constructive discussion of meaningful pension reform.