New accounting rules put city's net assets at risk
When an employer sponsors a defined benefit pension, the employer is deferring some of the payment to the employee for the services the employee is rendering. The employer is in reality borrowing money from the employee, taking the employee's services today in exchange, in part, for a payment in the future.
When defined benefit plans were first developed, the accounting rules did not require that the employer recognize that it was, in essence, incurring a liability for these future promises of compensation. Over time, the accounting rules have been tightened to reflect the financial reality of the transaction. Also, employers and employees now almost universally set money aside each year to fund these future benefits.
The problem, however, is that it is difficult to know how much money to set aside today for a benefit that will not be paid for several decades. Over the years, actuaries have developed mathematical models for estimating whether the money that has been set aside will be sufficient to pay the benefits that have been earned.
If these actuarial estimates show that the amount is insufficient, the plan is said to have an unfunded liability, that is, the employer owes the employees more than it has set aside.
For many years, private companies have been required to show these estimated liabilities on their financial statements. However, the accounting rules for governmental entities have been much less rigorous. As a result, governmental entities normally show only a fraction of the actual shortfall on their balance sheet.
For example, the city of Houston's last financial statement only showed about $2.5 billion in pension and retiree health care debts. But according to the actuarial studies the real debt is more than $5 billion.
However, that is about to dramatically change. The Government Accounting Standard Board (GASB), the group charged with promulgating accounting rules for governmental entities, issued two new rules late last year designed to bring the financial statements more in line with reality.
First, the GASB is going to require that the assets in the trust be valued at market. You may wonder why such a rule would be necessary, but retirement plans generally "smooth" the investment gains and losses over a five-year period. Almost all plans today are using this rule to defer loses incurred in recent years.
The second change mandated by the GASB relates to the assumed investment rate. Actuaries "discount" the amount an employer owes at a rate equal to what the plan expects to earn on the assets in its trust. The higher the assumed rate, the lower the estimated liability will be. All three of the Houston plans assume a rate of 8.5 percent.
This is the highest rate used by any plan in the country and is only used by a handful of plans. The new rule forces entities to use a more realistic discounting formula.
The effect of these rule changes is not trivial. Craig Mason, the city's chief pension officer, has estimated that the rule changes could add more than $2 billion to what the city now shows on its balance sheet for pension debt. And he is probably being conservative.
Considering that the city's net assets are now down to just over $3 billion and steadily going downhill, a $2 billion hit would put technical insolvency, (i.e., liabilities exceed assets) just around the corner.
It is important to note that the true underlying financial condition of the city will not change just because the GASB changes the accounting rules. The truth is that the city is probably already technically insolvent. GASB is just going to force us all to acknowledge that the emperor has no clothes.
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