Las Cruces, NM (MercadAnalytic). In the past few years pension accounting has taken a much more visible role in governmental accounting as state and local governments begin to take notice of potential insolvency concerns of their pension funds. At the extreme, in cities such as Scranton, PA ., and Stockton, CA . which recently filed for Chapter 9 bankruptcy, pension insolvency is now a reality. The conundrum for many state and local governments regarding their pension accounts is determining proper allocation and funding levels to ensure financial sustainability and solvency.
One of the most important aspects regarding pension fund accounting is that they fall under the special fund accounts called fiduciary accounts . A pension fund is a trust fund and receives certain statutory and regulatory protection.
There are essentially two different types of pension plans that state and local governments participate in: 1) defined contribution plans and 2) defined benefits plan. Currently, the latter type of pension plan is much more common, but is quickly losing its popularity due to the increasing risk and liability that many state and local governments are experiencing. According to the GAO (2012), approximately 78 percent of all state and local governments participated in defined benefit plans and only 18 percent of private sector companies offered this type of pension plan to their employees (p. 5).
Perhaps the most distinctive feature between these two plans is how and by whom risk is assumed. In a defined benefit plan the employer assumes all the investment risk while in a defined contribution plan the employee assumes the risk. Table 1 provides a comparison between these two pension plans.
Defined benefit pension plans are sometimes referred to as formula plans. States and local government use different calculations to determine benefits. For example, in a nutshell, in a top of the line defined benefit pension plan “the Cadillac plan”, a typical formula is 2 percent times years of service times the average salary for the best five years of service.
Since most state and local governments use defined benefits plans, the focus of this report is to gain an appreciation on the complexities, deficiencies of past and new reporting requirements.
Background
In 1986 the Financial Accounting Standards Board (FASB) (as cited in GAO-08-223, 2008), required state and local governments to their unfunded pension liabilities according to the Financial accounting standard 87 (FAS 87), Employers’ Accounting for Pensions.
Before the economic downturn of 2008, pension accounting was not as commonly discussed as it is today. The economic downturn of 2008 served as a wake-up call, a more importantly a call-for-action, by many state and local government accountants, managers, and politicians that quickly began to realize how the impact of external market forces can affect the financial solvency of their pension funds. The standard-setters also began to seriously look into the reliability of the reporting requirements for pension plans. At its core, according to the FASB (as cited in James, 2009), the “main purpose of financial accounting and reporting is to provide information that is useful to decision makers”. Furthermore, this information is considered useful, “if it is reliable, relevant, consistent, and comparable”. The crux of this report is to provide an assessment of the reliability of the current reporting requirements and standards.
The Stakeholders
Directly or indirectly pension accounting impacts every American. According to Biggs (2012, July 18), pension plans affect government workers, elected officials, and taxpayers. Interestingly, as long as the U.S. economy is performing well, Americans pay little attention to pension accounting or on their own personal pension funds. However, after the economic downturn of 2008, when many American workers lost up to 40% of the value of their pension value, it became a major concern.
Another reason there is an increased level of interest in pension accounting, is because of the impressive amounts of money that are tied in these funds. Figure 1 shows the breakdown between state government at 41% and local governments at 59% or $35.5 billion and $56.6 billion respectively.
Pension Fund Evaluation
According to the GAO (as cited in Wilson, Reck, Kattelus, 2010), there are three key indicators used to evaluate the status of pension plans:
1) unfunded AAL ;
2) funded ratio ; and,
3) the difference between the annual required contribution and the amount actually contributed.
Perhaps the most common key comparisons used to show pension fund performance level funded ratio which is determined – unfunded/funded. According to a GAO report (2008), a funding ratio of 80 percent is considered a healthy level and implies that “80 percent of the pension plan has enough assets to pay for 80 percent of all accrued liabilities” (p. 9). Figure 2 below illustrates the funded ratio trend from 1994 through 2006. Interestingly, by 2006, fifty-eight percent of the sample state and local governments reported funded levels at or above 80 percent . In contrast, in 2000 - 90% of state and local governments reported funded levels at or above 80 percent. In a similar report by Munnell, Aubry, Hurwitz, Medeica, & Quinby (2012, May) (as cited in Biggs, 2012), by 2011 the average public pension funds dropped to approximately 75 percent versus the 103 percent levels of 2000. The data is very clear that from fiscal year 2000 through 2011, unfunded levels have been trending up.
The Unfunded Pension Plan Angst
To fund - or not to fund - the unfunded portion of the pension plan…that is the question? According to Apostolou, Apostolou, & Brooks (2011, May), “unfunded pension obligations appear to be a material component of the growing deficit problem” (p18). According to Wilson, et al. (2010), the calculated annual pension costs are disclosed in the employer’s financial statement footnotes. A state or local government determines its annual pension costs based on two inputs: the annual required contribution (ARC) and the net pension obligation (NPO) . It is important to note that even though an ARC is determined to be a “required” amount to fund a pension plan, it does not necessarily mean that the state or local government will actually fund the pension plan with the ARC amount. Typically, the ARC is different from the actual contribution that state and local governments make. Figure 3 below provides the yearly trend from 1994 to 2006 in the percentage of states and local government pension plans for which governments contributed more or less than 100 percent of the ARC, by Fiscal Year. In 2006 slight more than 40 percent of the GAO sampled states and local governments were contributing less than 1000 of their ARC.
One of the most interesting findings of this research is that, not only does an economic downturn significantly increase unfunded levels, but as a result, this directly impacts the political decisions state and local government must make to allocate scarcer resources. Another interesting finding is impact that hedge funds have on the financial statements.
Fair Value Measurements
According to FSP FAS 132(R)-1 (2008, December 30), there are three types of fair value measurements levels; Level 1 - quoted prices in active markets for identical assets, Level 2 - significant observable inputs, and Level 3 - significant unobservable inputs. The most controversial are Level 3 which is very high risk derivatives. In an economic downturn all investments will lose, but the biggest losers are the derivative instruments. An important note to make is that in an economic downturn, where a pension fund portfolios lose, the unfunded portions is further exacerbated. And is it the responsibility of the state and local government to replenish the higher unfunded portion?
According to Apostolou et al. (2011), the future looks bleak for state pension plans and many states and local governments are headed towards a fiscal/budgetary cliff as “many have made pension commitments that appear to be unsustainable in the long run and will likely require drastic revenue increases and the elimination of, or severe reduction in, essential public services” (p. 21).
Alternatively, a GAO (2012) indicates that “despite the recent economic downturn, most large state and local government pension plans have sufficient assets to cover benefit payments…” (p. i).
The Road to Recovery
Obviously state and local governments have very little control over driving forces such as macro-economic conditions that cause economic downturns, but they do have control over certain fiscal policy tools they can employ to correct some of deficiencies with pension plans.
This report recommends two initiatives to improve the sustainability and solvency of state and local government pension funds:
1) Modify current employee pension plan formulas and establish key success factors. Figure 4 shows three different types of strategies state and local governments are employing to improve the solvency of their pension plans: a) reduce benefits, b) increase member contributions, and/or c) switch to a hybrid approach. The illustration shows that 35 states reduced benefits in at least one of the following three categories: a) adjusted benefit formula, ) raised the age or increased service requirements, and c) reduced or eliminated postretirement increases.
2) Strengthen Level 3 hedge accounting reporting requirements. During an economic downturn, derivative investments take disproportionately higher hit on losses because of the higher-risk involved in these types of trade. The obvious recommendation is to reduce these risky types of trades. Another recommendation is to strengthen Level 3 hedge accounting standards to provide more timely and accurate information that useful to decision makers.
Conclusions
The solvency and sustainability of pension plan funds are going to depend greatly on the decision state and local government officials make in the next few years. It is obvious that every state and local government is different and is going to require different solutions to fix the problem. External driving forces such as macro-economic conditions and changing demographics also play a key role towards the road to recovery. The stakes are very high, and it is going to take an incredible amount of leadership, skill and discipline to ensure the sustainability and solvency of many state and local government pension plans.
