Are Pension Liabilities Set to Explode?

Gina Chon of the WSJ reports, Gurus Urge Bigger Pension Cushion:

Government-pension problems, widely considered bad, may actually be even worse.

That is the assessment of some experts who maintain that the current rules of number crunching for state and local governments make retirement-benefit obligations seem lower than they really are.

Soon, their view may prevail. The accounting board for governments is likely to move toward changes that would increase the pension liability that local governments display on balance sheets by tens of billions of dollars.

If the modifications are approved, many already cash-strapped states and municipalities would likely have to increase the amount they are supposed to pay annually to their pension funds to help cover the shortfall.

The General Accounting Standards Board, or GASB, Norwalk, Conn., indicated the direction it was heading in board meetings in January and February.

Since then, public pension funds have been abuzz about the potential change. People familiar with the matter say it is likely those tentative decisions will be adopted. Initial recommendations will be out in June and a final decision is expected next year.

Even without GASB changes, underfunded pension systems already represent a financial problem for many states, thanks mostly to market declines, a lack of funding by governments and benefit increases.

According to a recent study by Wilshire Consulting, the average funding level of state public pension plans was at 65% in 2009, compared with 85% in 2008. Experts recommend that public pension funds maintain at least an 80% level of funding to be healthy.

The accounting changes generally focus on the entire amount of underfunding, rather than the status of a typically smaller annual contribution, and move away from using a fund's expected investment return to calculate pension liabilities.

Twenty-seven state treasurers and 61 representatives of pension systems wrote letters to GASB opposing any changes. The opponents include some of the largest pension funds in the country, including those in California, New York State and Texas.

"This volatility and uncertainty would promote not only inconsistency in the measurement and disclosure of pension information, but also would disrupt public sector budget processes," said the pension systems' letter on the possible changes.

Proponents of the modifications, which include some government bond buyers, civic groups and others who use the financial information presented by local governments, say the current standards mask problems facing pension systems, and therefore, the fiscal predicaments of local governments.

"The current pension deficit disclosure standards have been professionally gamed for a long time," said Diann Shipione, a former trustee of the pension fund for the city of San Diego who has long pushed for tougher standards in pension-fund accounting. "The GASB is now fighting to create the environment where greater clarity is the result."

One thing GASB is looking at is how pension liabilities should be calculated. Governments normally don't display their unfunded pension obligation as a liability on the balance sheet.

Instead, they list only the shortfall in the annual required pension contribution. As a result, states and municipalities that pay the annual contribution report zero pension liabilities. The total unfunded liability is reported in the notes section of the balance sheet.

Under tentative decisions by GASB's board, the displayed number would be changed to the total unfunded pension liability, typically larger than the annual obligation.

For example, New Jersey hasn't paid its annual contribution of $2.5 billion for the current fiscal year, but its underfunded pension liability currently stands at $46 billion.

Another issue: how to calculate the unfunded pension obligation. Currently, the total projected benefits obligation is lowered based on how much the fund is expected to reap in investments, commonly 8%.

Critics argue that rate, which for accounting purposes is known as the discount rate, is inappropriately high. GASB has looked at several alternatives that are currently lower than 8%.

The drop of one percentage point in the discount rate means a 10% to 20% increase in the total pension obligation, according to James Rizzo, senior consultant and actuary at Gabriel, Roeder, Smith & Co., a consulting firm for the public sector. For example, a pension system with a total liability of $100 billion would have an obligation of as much as $120 billion after a decline of one percentage point in the discount rate.

The displayed amount of the unfunded pension liability could be increased even further if GASB lowers the so-called amortization period for unfunded liabilities, or the number of years funds can stretch the liability over. The longer the period, the smaller it looks.

Currently the figure used is a maximum of 30 years. The GASB's tentative decision is that pension liabilities should be amortized over the remaining employment years of the worker, which can be closer to 15 to 20 years for some employees.

Changes to how pensions calculate their liabilities will hit every major public pension plan. Kris Hundley of the St-Petersburg Times recently reported on Florida's pension fund running a deficit for first time since 1997:

On March 1, the state agency that invests public pension money issued a news release bragging about a 16.3 percent rebound in its portfolio in the second half of 2009.

Two days later, the State Board of Administration sat down with its advisory council and revealed the rest of the story:

Even with those gains, Florida's public pension fund slipped into the red in 2009 for the first time in a dozen years. And the fund's shortfall is projected to be even bigger this year. That news has not been as widely publicized.

While past surpluses in the pension fund kept a lid on local contributions during boom times, now the bill is coming due. And plugging the multibillion-dollar deficit will require about a 40 percent hike in contributions from local governments stretched by declining revenues.

Though checks will still be in the mail for Florida's public retirees, by July the fund is expected to have just 87 cents for every dollar in pension promises made. Like a tiny leak, this unfunded liability can grow into a gusher if not addressed quickly. But none of the fixes will be too palatable with either the nearly 1 million public employees and retirees covered by the plan or taxpayers who foot the bill.

The options include:

• Raising more money from local governments.

• Trimming benefits for retirees.

• Making public employees, who now pay nothing toward their pensions, chip in.

Variations on these themes are already bubbling through the Legislature, with limited success. Under one proposal, the state's pension plan would be closed to new employees; another would make new hires pay 1 percent toward their pensions. A less-ambitious proposal by Republican Sen. Mike Bennett of Bradenton, which would affect benefits of employees with less than 10 years' service, was watered down in committee Tuesday. It's the first pension reform proposal to get a hearing this year.

Miami Republican Rep. Juan Zapata has put forth the most far-reaching changes, including limiting payouts to higher-paid "special-risk" employees like firefighters.

Zapata, who is not running for re-election, knows tinkering with benefits is unpopular.

"I took it upon myself to kind of take one for the team to, at the very least, have a conversation about it," he said. "Because nobody's talking about it, and it's an incumbent problem."

State law requires government contributions be set at a rate that covers a year's benefits, but the state doesn't have to fully eliminate the long-term deficit. Last week, a House committee proposed taking this route, which still translates into a $460.8 million bump in local contributions.

But, barring a meteoric rise in investment returns, ignoring the pension deficit means watching it grow. To adequately address the gap, the fund's actuary said, governments will have to pony up even more money — more than doubling the contribution for some elected positions.

The House is proposing to postpone the full increase until after the fall elections.

• • •

While lawmakers tinker with the funding side of the equation, the SBA is exploring ways to increase investment returns on the $116 billion fund. The strategy? Put more money into higher-risk but potentially higher reward alternatives like hedge funds, private real estate and even timber land.

Dennis MacKee, SBA spokesman, denies that the move into riskier investments is anything new. "We started looking into hedge funds when we were well overfunded," he said.

And he says that by diversifying its portfolio, the SBA is actually decreasing risk.

But even if the SBA upped its risk profile considerably, the payoff is debatable. The board's consultants said earlier this month that by sticking with its current asset mix of mostly stocks and bonds, there's only about a 50-50 chance the fund is going to reach its assumed rate of return of 7.75 percent.

Jack up the risk? Probability of making that return ticks up slightly, to 55.4 percent.

"It's a joke," said Leo Kolivakis, a former senior investment analyst at two of Canada's largest pension funds and publisher of the blog, Pension Pulse. "They're deluding themselves if they think they can get that kind of return. And they're taking big risks with pensioners' money."

But the alternative is even less attractive. Lower the projected rate of return to a more conservative number and the state's pension gap grows, triggering even harsher demands on the funding side.

"Pension funds that are experiencing downturns are turning to a 'Hail Mary' pass to save them," said former SEC attorney and South Florida accountant Edward Siedle about the move to riskier investments. "But they'd better have a really good arm, because it's a stretch."

Nor are the SBA's trustees — Gov. Charlie Crist, Attorney General Bill McCollum and Chief Financial Officer Alex Sink — particularly eager to tackle the unfunded liability issue. As beneficiaries of the plan, they're not anxious to talk about paring back benefits. As politicians, all running for higher office, they see no upside in demanding more money from taxpayers or telling them they'll lose services because the dollars are going to government retirees. Voters will be mad enough to find out their library is closing. Tell them the money is going to the retired librarian and they'll be even madder.

Andrew Biggs, former principal deputy commissioner of the Social Security Administration, has strongly criticized public pensions for using what he calls "bogus accounting" and believes the unfunded liability in all states, including Florida, is worse than projected.

"There's no incentive for anybody to be honest about this stuff because the taxpayers are going to be upset," said Biggs, now resident scholar at American Enterprise Institute. "That produces lower contribution rates today but passes off the risk to future taxpayers."

• • •

When experts talk about the recently opened gash in Florida's pension fund, they quickly add this caveat: We're in a whole lot better shape than most states.

Florida was one of only four state pension funds to go into the current recession fully funded. And based on its performance in fiscal 2008 — before the market meltdown — Florida was touted as a nationwide model in a report on public pension funds by the Pew Center on the States.

Kil Huh, director of research at Pew, said it's not surprising that Florida's pension fund should slip into a deficit, given market conditions.

"You're going to see a drop in assets, as well as an increase in unfunded liabilities until the actuarially required contributions catch up," he said. "But that's provided states fully fund these things, which is a big 'if' in this fiscal environment."

States that procrastinate find the tab quickly snowballs. New Jersey was fully funded in 2002 when it began to shortchange its contributions. By 2008 the New Jersey plan was one of the worst in the nation, about 73 percent funded. Catching up now would cost an estimated $3 billion; the state's new governor has recommended simply skipping this year's payment.

Richard Keevey, a professor at Princeton University and consultant on a Pew pension report in 2007, has watched the New Jersey debacle unfold in his back yard.

"When economic times are bad, legislatures are torn by priorities and underfund the pension a little bit till things get better, but they never do," he said. "Florida shouldn't go down that path."

Eric Johnson, assistant county administrator in Hillsborough County, knows exactly what it would take for his municipality to fulfill its pension obligations to about 5,000 public employees this year: $44.5 million, an increase of 18 percent.

To meet that obligation during a year when tax revenues continue to plummet, Johnson said the county was considering cutting benefits or replacing workers with private contractors.

While he's relieved to hear the Legislature is proposing a somewhat smaller increase in contributions, Johnson is troubled by what that means long term. He worries that Hillsborough's triple A credit rating, which translates into lower borrowing costs, could be jeopardized by the move.

"If you have a pension plan, it ought to be fully funded," Johnson said. "Part of the creditworthiness of a government is based on its unfunded liabilities. And the challenge is, when you punt one time, how confident should anyone be that you won't punt a second time?''

If the new accounting standards are implemented, many states risk seeing their creditworthiness slip a few notches. As if that isn't bad enough, the WSJ also reported that federal criminal investigators are looking into possible wrongdoing involving investment transactions of public pension funds including Calpers, the nation's biggest public pension fund by assets.

Accounting woes and criminal investigations are going to rock US public pension funds. It's about time regulators start taking pensions seriously. My only concern is that it's too little, too late.