Defined benefit pension plans offer politicians a convenient way to satisfy public employee demands while providing the means to defer budgeted cash payments and hide the accumulation of public debt from taxpayers. The authors describe how this plays out in practice and how accounting standards facilitate such activity. The accounting profession, and Governmental Accounting Standards Board (GASB) in particular, could do more to inform taxpayers about the state of public finances. The longstanding failure to do so, the authors argue, allows public debt to accumulate until a crisis is reached.

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A Political View of Public Pension Debt

Empirical research indicates that both political parties share responsibility for the current pension crisis (S. Anzia and T. Moe, “Polarization and Policy: The Politics of Public Sector Pensions,” Legislative Studies Quarterly, vol. 42, no. 1). More importantly, the Pew Research Center (“The Fiscal Health of State Pension Plans: Funding Gap Continues to Grow,” March 2014) reports that unfunded state and local pension debt has been steadily increasing since 2000.

The authors argue that current governmental pension accounting rules allow politicians to defer public employee compensation, effectively providing needed services while obscuring the cost from taxpayers. This is a win-win situation for politicians and public employee labor unions. Deferred compensation can appear in many forms, but defined benefit plans have become widely accepted in government. These plans provide politicians a very flexible means of financing staffing resources off the balance sheet. Defined benefit plans appeal to employees because they typically promise annuity payments for the life of the individual. In order to secure the guarantee, employees may also demand that politicians establish sinking funds to finance the promised future payments and place those resources in a separate entity (i.e., a trust fund), outside the reach of future politicians. This off–balance sheet arrangement thus serves the purposes of both public employees and politicians. Control of the trust fund can be negotiated.

Taxpaying voters, who ultimately judge the activities of politicians, should be aware of these contracts and obtain assurances that they are fair and equitable. To this end, actuaries provide the government with estimates of projected benefit obligations (PBO) and the annual required contributions (ARC) necessary for the sinking fund prepared in accordance with actuarial standards of practice. Auditors subsequently provide the public assurances that financial disclosures are audited in accordance with Generally Accepted Government Auditing Standards.

Professional external actuary and auditor services are traditionally selected and paid by the managers of the pension trust fund. To the extent that all parties operate in good faith under enforceable contract provisions, and the actuarial estimates prove to be reliable, the rights of all parties will be reasonably protected and the system will appear sound. However, even the best-laid plans may go awry when unexpected events happen.

Budgeted pension contributions are generally guided by the ARC, which can be reduced on demand through a variety of actuarial procedures. Changing the expected rate of return on plan assets and the discount rate used to value liabilities is one method. Higher estimated future earnings reduce the need for current cash contributions, so higher expected rates of return result in lower ARCs. If the expected rates of return fail to materialize, the accumulated unfunded pension debt grows. The growing balance of unfunded pension debt over the last decade calls into question the actuarial assumptions used to calculate the ARC and PBO, as well as the willingness of politicians to currently fund them.

Government officials hire the actuaries that develop the pension assumptions and calculate the estimated ARCs. They also hire the auditors who attest to the reliability of these calculations, but audit standards allow auditors to rely on the work of outside experts, such as actuaries. These professional fees can ultimately present a conflict of interest when politicians offer to pay for actuarial calculations supporting reduced funding. Regulation and professional codes of conduct are expected to mitigate this risk, but the calculations are complex and compliance is difficult to ascertain. Having multiple expert parties involved also helps to diffuse responsibility for any errors in judgment.

Difficulty and Variability in Public Pension Accounting Standards

In 1978, the Pension Task Force Report on Public Retirement Systems determined that stakeholders were often unaware of actual pension costs. In 1986, GASB issued Statement 5, which prescribed some common disclosure requirements so users could assess the funded status of public pension plans using a common approach. The board updated the standards in 1994 with GASB 25 and GASB 27, which allowed state and local governments to use one of six actuarial cost methods to determine their actuarial liability—that is, the present value of compensation that was deferred to future years. These included entry age, frozen entry age, attained age, frozen attained age, projected unit credit, and the aggregate actuarial cost methods.

The method of attribution is important because it has a direct bearing on the value of the resulting pension liability, funded status, and required contributions. Under unit credit approaches, the projected benefit is based on a consistent formula, such as total service periods times some percentage of future salary times the fraction of service earned to date. Assumptions regarding the projection of service periods, percentages allowed, and future salaries vary. The entry age methods calculate the benefit on a level basis of earnings or service between the beginning of employment (entry age) and the assumed retirement date; again, assumptions vary.

Under the unit credit approaches, contributions tend to increase as employees near retirement, whereas the amount or percentage of pay contributed under the entry age approaches tends to stay consistent throughout an employee’s tenure. Actuarially, this is because a “unit credit” of retirement benefits attributed to a particular period has a lower present value the further away in time it is from when the benefit is actually paid.

Attained age methods have the same actuarial liability as the unit credit methods, but different contribution rates. The standard contribution rate for attained age methods is based on the average age of active members as a group, rising or falling as the average age of the group increases or decreases. The frozen methods allocate the excess of the projected benefits over the sum of the assets plus a frozen unfunded liability on a level basis between the valuation date and assumed exit of a group as a whole, not as the sum of individual allocations. The aggregate methods use a technique similar to the frozen methods, but do not include the frozen unfunded liabilities. The aggregate method is unique in that the unfunded portion of benefits, even those from past service, is allocated as future normal costs resulting in no current net unfunded liability.

In addition to the methods used to project future liabilities, there are several associated assumptions regarding expected investment rates of return, contribution rates, rates of projected salary increases, inflation rates, and so forth. The difference between the present value of the projected liability and fund investments is the net funded position of the pension plan.

Flexibility in accounting methods and assumptions create the opportunity for employers to reduce or eliminate current required contributions, creating a “contribution holiday.”

All actuarial approaches require the discounting of projected liabilities to the present value using a settlement rate and an assumption of the expected investment rates of return in contributed funds. Typically, these are the same rate, but they may be selected independently. Obviously, the higher the assumed rates are, the larger the investment pool grows and the lower the net projected liabilities will be.

Special asset valuation (smoothing) methods are also frequently used to strike a balance between an investment portfolio’s current market value and a theoretically more realistic value that accounts for volatile securities held for long periods. GASB standards simply state that asset valuation should reflect some function of market value, which may include cost, current market value, or an average of market values over several years.

Differences between actual and assumed rates of return, or changes in future benefits, result in actuarial gains and losses that are amortized into expense and contribution rates over time. The intent is to smooth the differences between actual and assumed results, creating a stable pattern for contributions.

Flexibility in accounting methods and assumptions create the opportunity for employers to reduce or eliminate current required contributions, creating a “contribution holiday.” It was not until after the 2009 financial crisis, when the market value of pension assets declined dramatically, that GASB made the standards stricter. In June 2013, GASB issued Statement 67, An Amendment of GASB Statement No. 25, and Statement 68, An Amendment of GASB Statement No. 27. However, even these standards have been criticized as overly complicated and burdensome (C. Eucalitto, “GASB’s Ineffective Public Pension Reporting Standards Set to Take Effect,” American Legislative Exchange Council, 2013; A. Biggs, “Proposed GASB Rules Show Why Only Market Valuation Fully Captures Public Pension Liabilities,” Financial Analysts Journal, vol. 67, no. 2, pp. 18–22, 2011). For example, these new standards prescribe the calculation of a “blended” discount rate, which can be characterized as a sliding scale where better funded plans are allowed to use higher discount rates. Therefore, plan discounts rates will vary along with their funded ratios, resulting in reduced consistency and comparability among plans. This also reduces the usefulness of the disclosures to investors and creditors.

A Taxpayer View of Public Pension Debt

In a democratic society, policy makers should be accountable to those affected by the rules they promulgate. This requires institutions and processes to gather input or feedback from the citizenry. When the voters have difficulty evaluating an issue because of its complexity, they rely on established professions for their specialized knowledge. In this respect, the accounting profession has a mandate to administer complex accounting issues, such as public pensions, with the public’s interests in mind. Democratic principles also suggest that the accounting profession has a responsibility to determine what the public interest is through an honest and deliberative process.

The stated mission of GASB is, in part, to “guide and educate the public, including issuers, auditors and users … through a comprehensive and independent process that encourages broad participation” (FAF 2013, 2). Furthermore, GASB Concept Statement 1 (1987) specifically identifies taxpayers as a defined user group and says that the reports should be understandable. Therefore, not only does the public have a right to know what is taking place with public finances, it has a right to expect understandable disclosure.

According to a recent working paper (Bushee, Gow, and Taylor, “Linguistic Complexity in Firm Disclosures: Obfuscation or Information?,” 2016), linguistic complexity consists of two latent components; obfuscation and information. The obfuscation component increases information asymmetry by imposing cognitive burdens of the reader. Ten years ago (F. Li, “Annual Report Readability, Current Earnings, and Earnings Persistence,” Journal of Accounting and Economics, vol. 45, p. 221–247, 2008), a positive correlation was found between the use of complex language and poor performance in financial disclosures. When this concept is applied to pension disclosures, it suggests that complexity may delay taxpayer understanding.

Criticism of GASB.

GASB is aware of public criticism regarding public pension standards, yet in the authors’ view, it has failed to appropriately respond. A review of public comment letters submitted during the policy formulation period for GASB Statements 67 and 68 reveals an absence of participation by average citizens and a noticeable frustration by those who did participate. The authors retrieved 1,024 comment letters from the GASB website and coded them into NVivo qualitative research software by submission wave, letter number, and interest group. These results indicated that that only 74 letters were submitted by individuals or groups representing the general public. The results are consistent with previous research indicating low public participation by individuals in the accounting standards setting process. This documented lack of participation suggests that the profession does not receive a representative cross-section of concerns about public pension disclosure from the voting public.

Pension accounting disclosures are so complex that average taxpayers are unable to understand their meaning.

The lack of participation by institutional investors (seven letters) also reveals the irrelevance of GASB disclosures. Investors and creditors appear to rely on credit ratings agency models that adjust pension debt using consistent and comparable discount rates and attribution methods (Moody’s Investor Service, “Moody’s Announces New Approach to Analyzing State, Local Government Pensions; 29 Local Governments Placed under Review,” Global Credit Research, April 17, 2013). Fitch Ratings was the only credit agency that commented on the GASB statements. Although they did not advocate a specific method or discount rate assumption, they supported a solution that would minimize the potential for managerial opportunism in the application of accounting standards, thereby increasing comparability.

Failing the Public Interest

The authors’ analysis suggests that politicians use public pensions to satisfy the demands of public employees while retaining the flexibility to choose when to actually fund them. Pressure from other interest groups for spending priority crowds out prudent funding and complex accounting disclosures effectively hides this result from average voting taxpayers. It is only after required cash payments for pension benefits create a crisis by cutting into basic services that the public becomes aware of the consequences of the accumulating debt.

The accounting profession has failed to provide the public with understandable information by circulating pension accounting disclosures that are so complex that average taxpayers are unable to understand their meaning. As long as this cycle continues, public pension debt will continue to accumulate. Some may criticize the authors for not providing a solution, but useful, relevant, and understandable disclosure is its own solution. On the issue of unfunded public debt, the accounting profession must stand by taxpayers, and its own principles, if it is to serve in the public interest.

Steven W. Thornburg, PhD, CPA is an assistant professor in the department of accountancy at the University of Wisconsin–La Crosse.
Kirsten M Rosacker, PhD, CPA is an assistant professor in the department of accounting and business law at Minnesota State University, Mankato.