The Downside of Downplaying Pension Costs

The challenge is that the accounting rules states use to value pension obligations and estimate funding shortfalls can make it difficult to accurately assess pension costs. As a result, states are understating what it costs to provide pensions, making it appear that employees’ pensions are less expensive than they actually are. This can have significant and long-term effects on state budgets.

Kellogg School of Management professor James Naughton argues that public-sector accounting rules allow states to report pension costs that deviate from economic reality. The assistant professor of accounting information and management led a recent study with coauthors Reining Petacchi and Joseph Weber, both at MIT, that shows how states manipulate their estimates of pension-funding gaps, which is enabled by the current accounting standards.

“Accounting for public pensions is not accurate from an economic standpoint,” Naughton says. “The way in which they do their accounting deviates from economic reality.”

Naughton’s team found that states are underestimating pension-funding gaps by a factor of three on average, and that the actual pension-funding gap is over $3,000 per state resident (including those who are not part of the state’s pension plan). Moreover, states are more likely to underestimate this gap when their budgets are already stressed. The low-balling means states can reduce the funds paid into their pensions. This has the unintended consequence of making employees appear less expensive, which means that states believe they can afford a larger workforce. The team estimates that an average state spends an extra $125 million annually in payroll due to this problem. Moreover, the additional employees mean greater future pension obligations, which compounds the issue.

Pensions Remain Relevant

Academic literature and the media are rife with discussions of the chronic underfunding of government pensions.

“Pensions are a major component of most states’ budgets,” Naughton says. “And they are the biggest single liability that most states have.”

Though the majority of large corporations no longer offer pensions to new employees, they remain relevant in the private sector as well because they represent a large component of major companies’ balance sheets. Naughton highlights the example of General Motors: “Even though no new employees get pensions, GM still has tens of billions of dollars in obligations to past employees.”

How and Why States Undervalue Pension-Funding Gaps

Naughton’s research used government pension-related data from all 50 states from 1990 through 2009. The team found that states were more likely to underreport their pension-funding gap (PFG) in years when their budgets were stressed.

The accounting rules that states follow are set by the Governmental Accounting Standards Board (GASB), an independent organization recognized by governments as the official source of accounting rules for state and local governments. The GASB rules enable the underreporting of the PFG in several ways. For example, states are granted significant leeway in “accounting discretion,” including when they choose the discount rate used to determine the present value of the future pension payments.

Not surprisingly, in fiscally difficult times, states tend to use a higher discount rate, which lowers the present value of the projected benefit payments. The upshot: the state can pay less into the pension, which immediately reduces budgetary stress. Thus, use of the higher discount rate acts as a means to the state’s end of reducing immediate financial stress by paying less into its pension fund. This strategy has the added bonus for office-holders of allowing them to avoid unpopular moves such as raising taxes or cutting spending.

On the other hand, states with economic surpluses did not manipulate their pension liabilities at all. States also did not understate pension liabilities when they were issuing long-term debt, though they tended to do so when issuing short-term debt. This is because states typically issue short-term debt only when they face sudden budget shortfalls—another form of fiscal stress.

GASB rules also allow states to underreport pension funding by manipulating amortization schedules for investment losses; but Naughton’s team found this was rare, with manipulation of the discount rate as the favored tool.

It Is a Sanctioned Problem

None of this is to say that states are acting fraudulently. The use of accounting discretion does not violate GASB rules. In fact, Naughton examined the degree to which a state’s pension-funding gap could be explained by its distortion of the discount rate versus the GASB rules’ design. Figuring this out involved comparing state-reported PFGs to those that would have resulted if the states had used the FASB accounting rules that corporations follow, which should generate more “honest” figures.

“The main difference between the GASB and FASB rules is that the GASB are designed to calculate a minimum cash contribution, which allows the use of assumptions which don’t incorporate the investment risk associated with the future cash flows. As a result, the minimum cash contribution is less than the true economic cost,” Naughton says. “But on the FASB side, the investment risk is incorporated because the FASB rules are designed to determine the settlement cost, and that’s really a more accurate reflection of the underlying economic cost.”

Using this approach, Naughton’s team found the average annual total PFG reported by states was $915 per capita, based on the GASB rules. But using the FASB rules to measure the pension liability increased this figure by $3,224 per capita, meaning states are undervaluing PFGs by at least a factor of three, on average. The researchers also found that the average reported understatement of the pension liability due to the use of discretion was $1,246 per capita; and the average understatement of the pension liability due to the design of the GASB rules was $1,978 per capita. The numbers paint a clear picture of the degree to which the GASB rules contribute to the underreporting of PFGs.

It Is a Costly, Compounding Problem

These distortions have costly and far-reaching implications because states use their estimates to make important financial decisions. “In the corporate world, most companies have financial statements they communicate to investors, but then they have internal budgets as well. States seem to rely on just one set of books,” Naughton says.

Consider employee hiring. The states’ manipulated budgets make the cost of each worker appear lower, translating into an assumption that states could hire more employees. For example, if a state has $200,000 budgeted for hiring and it plans to pay each employee $40,000 in wages, with fringe benefits including pension liabilities estimated at $10,000 (so $50,000 total per employee per year), that would translate into the ability to hire four employees. But, if the true annual cost of the employees’ fringe benefits is closer to $15,000, the state would face additional future shortfalls if it hired four people.

“It’s not that they are underreporting just one number,” Naughton says. “It’s that they are making a poor decision regarding how many employees they can hire because of that number.”

Naughton’s analysis found short- and long-term implications of the pension problem. His team found that when states used a greater degree of accounting discretion when implementing GASB rules, they tended to hire more employees the following year.

Again it is mainly the GASB rules that are to blame, according to Naughton. The compounding nature of the pension problem makes it quite costly: Naughton calculated that an average state is likely spending around $125 million extra in payroll annually simply due to the GASB rules. And don’t forget that each additional worker hired means an additional pension obligation for the future and a greater possibility of underfunded retirement benefits.

The Danger of Inaction

Since Naughton’s team began its research, some of the GASB rules have been revised to address these issues. But he says these early revisions do not go nearly far enough. Naughton also described the challenge a move toward more realistic pension-funding-gap estimates raises for state governments: “The concern in state government with most of these changes is that if we move too far toward what it really costs, it could overwhelm municipal budgets, or potentially bankrupt municipalities that cannot make significantly higher contributions.”

Naughton’s research is likely of great interest to the people who write the GASB rules, most of whom are state-government employees, as well as to state budget makers. Although it is easy to understand why these people might avoid remedying the pension problem fully—to prevent bankrupting state governments—Naughton cautions against doing nothing.

“Inaction will create a worse situation in the future because now you have more employees and additional underfunded pension benefits,” he says. “All you are doing is kicking the can down the road.”