Apr 6, 2015

The Down­side of Down­play­ing Pen­sion Costs

Cur­rent account­ing stan­dards ham­per accu­rate report­ing of states’ pen­sion oblig­a­tions and exac­er­bate fis­cal problems.

Yevgenia Nayberg

Based on the research of

James Naughton

Reining Petacchi

Joseph Weber

The word pen­sion” evokes a Mad Men” – era ben­e­fit unlike­ly to be enjoyed by many enter­ing the pri­vate work­force today. While it is true that cor­po­rate pen­sions have large­ly gone the way of the two-mar­ti­ni lunch, pen­sions are alive and well in the pub­lic sec­tor, espe­cial­ly in state government.

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.

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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.”

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

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.”

Featured Faculty

James Naughton

Assistant Professor of Accounting Information & Management

About the Writer

T. DeLene Beeland is a science writer based in Asheville, NC.

About the Research

Naughton, James, Reining Petacchi, and Joseph Weber. “Public Pension Accounting Rules and Economic Outcomes.” Journal of Accounting and Economics. Accepted for publication.

Read the original

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