Accounting rules hurt public pension reform

America’s public employee pension crisis is so dire that leaders of the worst-case states feel they must present reforms even if it runs counter to the interests of their union bases.

Faced with that pressure, for example, Gov. Jerry Brown recently offered changes for California’s broken system centered on extending the retirement age and removing the state’s guarantee of some pension compensation.

But Brown’s plan is just another that doesn’t come close to taking out the state’s massive pension deficit. The holdup to a pension breakthrough is primarily explained by union power over officeholders.

This is legitimate, but does not account for the fact that many states — such as South Carolina — have relatively weak union blocs, yet continue to be blighted by billions in unfunded liabilities. Why can’t they fix their pension systems?

The answer lies with the professionals who oversee public pension accounting, an unelected class of rule makers and contractors holding tremendous power. Pension number-crunching by the state funds has long been thought by financial economists to be illegitimate.

This begins with the fact that they are allowed to value their liabilities using projected investment returns rather than an interest rate derived from the real-world risk characteristics of the debt.

This policy, set by the Government Accounting Standards Board, makes pension deficits appear dramatically smaller than they really are.

Any state seeking to get out of its public pension mess will try and do what the private sector and federal government did decades ago: remove the employer return guarantee.

Taxpayers are on the hook for every unfunded dollar of these defined benefits. Switching to the defined contribution model takes away this hazard because the money allotted to workers comes with the actual return rather than a promised one, which is how most Americans plan retirement.

This change is being sabotaged from the outset by more dubious accounting treatment. When a state inquires about closing its defined benefit program, the actuaries calculate the annual required contribution as a percentage of the plan’s projected falling payroll rather than of overall public payroll or as a level payment.

This means that in the early years of the transition, the government contribution will be large and will decline as the closed plan payroll shrinks. It has the effect of front-loading costs since states are forced to incur expenses earlier than they otherwise would need to, according to cash flow.

The actuaries allow states to make stable payments into pension plans that are going concerns, yet accelerate them when the plans are wound down. For instance, an actuarial report prepared for Nevada projected $1.2 billion in additional contributions the first two years if the state closed its defined benefit plan.

Joshua Rauh, the Kellogg School of Management economist who is a leading expert in this field, writes that “this accounting therefore contains a built-in disincentive against moving towards defined contribution plans, since it forces the repayment of the pension debt sooner when the plan is closed to new workers and does so for no good economic reason.”

The policy mix of the Government Accounting Standards Board and actuaries being lax toward the defined benefit model and punitive toward reform appears to be an effort to preserve the status quo. If public pensions are normalized and taxpayer guarantees are removed, it would eliminate the need for accounting standards and the specialists hired to comply with them.

So the professionals impose artificial costs to dissuade states from cleaning up their pension systems. Governors from California’s Brown to South Carolina’s Nikki Haley need to push back against this tactic to have a chance at real pension reform.

Rich Danker is project director of economics at American Principles Project.

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