Why Transparency On Pension Liabilities?

Since the firm’s inception, we, at KCS, have been encouraging for a variety of reasons plan sponsors and their asset consultants to embrace greater transparency of the defined benefit plan’s liabilities. We still believe that with a greater transparency plan sponsors will be able to engage in a more dynamic and responsive asset allocation to changes in the plan’s funded status.

If plan sponsors don’t see the need for this improved insight, U.S. State Treasurers certainly should embrace this movement. Why? Moody’s Investment Service has recently modified their accounting methodology for measuring plan liabilities. According to Moody’s in a December 2017 update, the most recent modifications replace the “Adjustments to US State and Local Government Reported Pensions Data methodology published in April 2013

Moody’s has updated the description of their standard balance sheet adjustment and included a description of the standard income statement adjustment. According to Moody’s, “both of these reflect the implementation of Governmental Accounting Standards Board Statement 68 accounting standards, which requires adjustments that were not previously necessary.”

What is the problem that they are trying to solve?

Under GASB standards, public pension plans with the same benefit obligations and similar asset values may report very different unfunded pension liabilities due to differences in assumed rates of investment return. Issuers may have incentives to use overly optimistic assumed rates of return, which have the effect of understating the unfunded pension liability.

Under governmental actuarial funding and accounting rules, discount rates are largely based on the plans’ assumed rates of investment return on assets. Governmental accounting standards set the reported single equivalent discount rate equal to a given plan’s assumed rate of investment return unless the plan projects that it will deplete its assets. Plans that project asset depletion apply their assumed rate of investment return as a discount rate to projected benefit cash flows up until projected asset depletion, and apply a municipal bond index to projected benefit cash flows thereafter. For these plans, the single equivalent discount rate represents a blend of their assumed rate of investment return and a municipal bond index.

Under these rules, public pension plans with the same benefit obligations and similar asset values may report different unfunded pension liabilities solely due to differences in assumed rates of investment return. Since assumed rates of investment return are linked to pension fund portfolio asset composition, plan funded status can improve under GASB accounting rules solely due to greater asset risk-taking.

Moody’s is using the net adjusted pension liability in their modeling of credit ratings for states and municipalities. Using an inflated return on asset assumption will undervalue the pension plan’s future obligations, which might just impact the governing body’s credit rating. What state Treasury wants to see a credit rating down-grade under their watch. Don’t think it can happen? New Jersey has been impacted by multiple downgrades, and it currently lives with an A3 rating by Moody’s (July 2017).

“AAA is the best you can get, and here in Utah we won’t settle for anything less,” Governor Gary Herbert said in his January 2016 State of the State address. He later added in an interview with Pew, “It may not mean much to the average citizen, but it does have an impact on their wallet.” The higher a state’s credit rating, the lower the cost to repay its bonds.