Years of balance sheet gimmicks mean trillions in unfunded liabilities
The $1.9 trillion in federal spending signed into law this month is billed as pandemic relief. But buried in the fine print is an $86 billion bailout for deeply underfunded multi-employer pension plans in heavily unionized industries such as construction, transportation and entertainment. This cash infusion comes with no strings attached: It doesn’t require the plans to repay the money or end the practices that helped create the shortfall. What’s more, the money is just a down payment because it rescues only the 350 most troubled plans. There are 1,400 plans in all, covering millions of workers and retirees. As of 2017, these plans were funded at 42% on average, with $673 billion in unfunded liabilities.
For years analysts and policymakers have warned of the funding crisis facing multi-employer plans. So how did it get to this point? It began with balance sheet gimmicks. Unions and pension-plan regulators agreed to accounting compromises to soften the blow of requiring ever-increasing contributions from employers. These compromises included lax funding rules that let plan sponsors “smooth” over liabilities and assets and put less into the plans than they should. Smoothing allows plans to even out volatility by averaging investment returns, or interest rates, over time. Also on the list: optimistic investment assumptions and rules that guarantees underfunding when an industry goes into decline.
The result: sponsors contributed far too little to fully fund the plans. The federally chartered Pension Benefit Guaranty Corp., which insures the private sector plans, acknowledged the problem only when it was too late, and it’s now nearly insolvent itself.
The pension legislation didn’t stop at bailing out multi-employer plans. There are also subtle relief provisions for single-employer pensions. Rather than forcing these pension providers to learn the hard lessons of airbrushing pension assets and liabilities, the bill expands these practices at single-employer plans. It allows them to amortize funding shortfalls over 15 years instead of seven. And it permits interest-rate smoothing in which plan sponsors use a “pumped up” corporate bond rate. Instead of using the actual market rate to calculate liabilities, plans may use an interest rate that is within 5% of 25-year interest rate averages. This gives plans some slack in a low-interest-rate environment to choose higher interest rates to value plan liabilities. The effect is to keep liabilities lower and reduce the annual contribution that employers need to make to fully fund plans.
Congress granted similar accounting dispensations for single-employer pensions in the 2012 Moving Ahead for Progress in the 21st Century Act. Persistently low interest rates were forcing companies to offset the lost income by making larger contributions to their pension plans, so these companies persuaded lawmakers to tweak the accounting rules to keep their contributions from rising. The maneuver didn’t benefit just the companies’ bottom line. Lower pension contributions from companies allowed them to report higher taxable income, generating more tax revenue for the government. The justification: higher corporate income tax revenue would help fund the 2012 bill’s $105 billion in spending.
“Smoothed” Rates Now, Rocky Road Ahead
The temptation to touch up liabilities and assets is not hard to understand. It makes the bottom line look a lot better and gives sponsors a break from escalating contributions. But at what cost? Kicking the can down the road by smoothing interest rates to keep liabilities and contributions low did not suddenly reduce costs for employers or make the plans less valuable for employees.
And in fact, the practice runs the risk of creating a funding shortfall that will eventually need filling by employers. A study by the Society of Actuaries found that with using “smoothed” interest rates, single-employer pension plans are 99% funded. Remove the filter and apply the actual market values to the plans’ assets and they’re only 86% funded, with liabilities of $2.7 trillion. And of those plans with unfunded liabilities, 59% did not contribute enough to keep their liabilities from growing.
Another risk of the multi-employer pension bailout is that it might prepare the ground for bailouts of failing state and municipal pension plans such as the state plans in New Jersey, Kentucky and Illinois, and the citywide plan in Chicago. The spending bill provides $350 billion in direct aid to state and local governments but prohibits them from spending it on pensions. The message of the multi-employer bailout, however, is all too clear: It pays to avoid fiscal reality; eventually it’s someone else’s problem.
As with private sector plans, the funding shortfalls in state and local plans owe their origin to faulty actuarial assumptions and misguided government accounting rules, in particular, rules that allow actuaries to use projected investment returns to measure plan liabilities. It’s the equivalent of calculating your mortgage payment based on how well your 401(k) performs.
Conflating the size of liabilities with the expected return on assets is not an insignificant mistake. Using the government’s less-demanding actuarial methods, a recent study by Joshua Rauh at the Hoover Institution shows that public sector pension plans in the U.S. were underfunded by $1.37 trillion in 2015. Taking the market value of their assets, plans were underfunded by $4.145 trillion in 2017. Lax actuarial methods are compounded by opaque financial reporting, which has delayed by decades the reforms needed to put public pensions on a stronger footing.
Funding shortfalls and budget gimmicks eventually become unsustainable. When faced with deteriorating finances, Detroit started shortchanging its pension contributions rather than making budget cuts or raising taxes—and assumed that future growth and unrealistic rates of return would cover the problem. So as part of the grand bargain to bring Detroit out of bankruptcy, city employees had to accept cuts in pension and healthcare benefits along with lower cost-of-living adjustments. Employees of other governments are well aware of what happened to Detroit’s workers and how they too could be a recession away from facing cuts of their own.
The Impact of Reform
In recent years there has been progress in fixing these illusions. In 2018 the Actuarial Standards of Practice began recommending that public pension plans undertake stress testing and sensitivity analyses. Additionally, it has put forth a recommendation, still under consideration, that plans provide a measure of their financial health based on the market value of liabilities.
Another important reform was the Government Accounting Standards Board requiring governments to report unfunded pension liabilities on their balance sheets, specifically in the government-wide Statement of Net Position. This obvious fix was a long time in coming—the Financial Accounting Standards Board had required companies to do this 30 years earlier. In 2015, the first year the standard was implemented, the net financial position of the states declined by 29%, from $1.3 trillion to $956 billion. This wasn’t due to a sudden decline in the states’ fiscal health; it was a long overdue (and only partial) recognition of their true financial position.
The government accounting board also adjusted other guidelines for measuring liabilities, though not necessarily for the better. One new standard attempted to fix the problem of plans using the high rate of return on riskier assets to value liabilities, which tended to undervalue the liabilities. But the board missed the mark by allowing plans to blend high-risk and low-risk rates. With such broad discretion in selecting the rates for valuing liabilities, public plans still have an incentive to take on investment risk to give the appearance of more robust funding.
Given the progress it’s trying to make, the board’s latest proposal is puzzling. It may introduce a short-term, pay-as-you go accounting approach that would allow state and local governments to recognize debt issuance as revenue while not recording it as a liability. In effect, it would allow governments to issue debt without showing any impact on their budget. At a minimum, the measure would make government financial statements incoherent, presenting two different pictures of an entity’s finances within the same report: the balance sheet and the funds statement. Beyond that, it increases the already significant temptation for politicians to ignore debt and employee pension and healthcare obligations by enshrining a distorted picture of short-term fiscal health in government financial reports.
The lessons of evasive accounting tactics and their real-world impact on taxpayers never seem to stick. Balance sheets that avoid measuring and reporting an accurate value for pension benefits and assets create the conditions for a fiscal crisis. In the case of state and local governments, that means higher taxes, cuts in services, layoffs and poor credit ratings. And beyond that, such tactics betray the public trust and undermine faith in the professionals charged with setting and implementing accounting and actuarial standards.
While patching up pensions via bailouts might seem to be the only option now to make good on retiree benefits, the question must be asked: Does funding employee pensions have to come at the price of less opportunity, lower economic growth and tax hikes for future generations? Pensions were never intended to be a source of economic risk, quite the opposite.
The tragedy of the pension debacles, whether multi-employer or public sector, is that they began with an avoidance of reality on the part of the Pension Benefit Guaranty Corp., the Government Accounting Standards Board and other standard-setting bodies that should have every interest in protecting these plans. Pension funding holes and accumulated debt do not create themselves; they were built over years of accounting choices, actuarial fixes and political bargains. While removing politics from government spending is impossible, compromising the integrity of government finances should not be part of the bargain.