A federal board will soon propose that U.S. states disclose more about their pension funding as worries grow whether states and municipalities can pay for their employees' pensions.
Of the longer-term problems in states' budgets, none loom larger than underfunded pensions. Recent budget crises forced states to cut contributions to their retirement systems and the financial crisis lowered pension funds' investment returns.
Estimates of unfunded liabilities ranging from $700 billion to $3 trillion have led bond buyers, employees and political leaders to demand the most accurate estimates.
David Bean, director of research and technical activities at the federal Governmental Accounting Standards Board, told a municipal analysts' meeting on Friday the board will soon propose increased disclosure of states' pension funding.
The board, which sets accounting standards, will release an exposure draft on the possible requirements in June.
Governments would have to make more thorough annual Cost of Living Adjustments calculations along with presenting employees' projected salary increases, Bean said.
"Where the fistfights occur is with the discount rate," Bean said about returns on pension funds' investments, which affect how well a government can cover those liabilities.
The board would require governments to disclose their long-term expected rate of return on plan investments as determined by actuaries, Bean said.
"This is the actual expected rate of return as recommended by the actuaries," he said. "We're going to make very clear this is not a number that is pulled out of the air. This is based on solid science."
Last year, pension expert Joshua Rauh, a professor at Northwestern University, suggested that pensions forecast their investment returns at too high a rate. By lowering the rate, which is typically about 7 percent, Rauh determined pension funds are short $3 trillion.
The federal standards board wants to "draw back the curtain" and provide more information about how return rates are derived, Bean said.
Republican members of the House of Representatives would like public pensions to forecast a lower rate of return, around 4 percent, which they consider "riskless." Some have introduced legislation that would bar a state from selling tax-exempt bonds if they did not lower the return to what is considered a riskless forecast.
Over the last five years, 21 states have failed to make their full contributions to their pensions, said Eileen Norcross, a senior research fellow specializing in pensions at the Mercatus Center at George Mason University.
Years of strong investment gains balance out years of low returns, Elizabeth McNichol, senior research fellow at the think tank Center on Budget and Policy Priorities, told the conference. Her group has found that public pension investments have earned over 8 percent annually over the past 20 years.
"The riskless rate goes farther than necessary," she said.
The three major rating agencies also are ratcheting up their scrutiny of public pensions. Laura Porter, managing director at Fitch Ratings, told the conference the enhancements the agency made to its pension analyses last month have so far not generated many negative rating actions.
The debate over pension funding will continue. I just wrote about CalSTRS's $56 billion pension shortfall yesterday. I've also written a few comments on CalPERS holding their assumed rate of return at 7.75%. There is sharp disagreement on the appropriate discount rate. Should it be closer to 4% or should it closer to 8%? Why not settle for something in between like 6%? (Of course, some will argue that even 6% over the long-run is unrealistic!)
States should disclose more about their pension funding. They should be as transparent as possible on their funded status, why they use a certain discount rate, explicitly stating the assumptions they use to derive their assumed rate of return, and what will happen if they miss it by 1% or more on rolling-four or six-year basis.
Finally, plan sponsors and policymakers should carefully read a 2010 study from Boston College's Center for Retirement Research written by two Dutch pension experts on how the Dutch should address their funding gap following the 2008-2009 financial crisis. I quote the following:
When a pension fund falls below the 105-percent threshold, the Dutch supervisor requires it to close the gap within five years. In response to underfunding, most Dutch pension funds will automatically suspend indexation, which will help Dutch plans on their path to recovery. In addition, the excess return earned above the nominal rate of interest used to discount liabilities will contribute to improved funding. However, given the severity of the problem, these stabilizing forces may not be enough – additional measures may be necessary to speed the recovery.
A number of policy options could help restore funding more quickly than just waiting for financial markets to recover. Table 1 lists three possible approaches; each would have different effects on intergenerational redistribution. Under Option1, the fund takes no additional actions beyond the automatic suspension of benefit indexation. Option 2 would take the additional step of increasing contribution rates by 2.5 percent. Option 3 would keep contribution rates the same but would, if necessary, cut nominal benefits of current retirees.
When it comes to funding policies, the Dutch pension system isn't perfect, but it's way ahead of other countries that have no funding policies or regulations whatsoever.