You are here

How Accounting Reform Can Help Address Public Pension Underfunding

Why do state and local governments engage in dubious pension fund accounting practices? Because they can.

That sums up a sound critique of the Governmental Accounting Standards Board (GASB) by Stanford public policy professor David Crane. As he explains in a recent op-ed in Medium:

GASB doesn’t stop state and local governments from treating borrowings as revenues, avoiding cost recognition by simply not paying expenses, or claiming balanced budgets that often are nothing of the sort.

The most costly example takes place in pension accounting. When pension promises are made, GASB allows state and local governments to value those promises at a fraction of their real value. Today, state and local governments use GASB rules to value their unfunded pension liabilities at just one quarter of the $4 trillion the same unfunded liabilities are valued by the Federal Reserve Bank. Put another way, GASB’s rules are today enabling state and local governments to hide $3 trillion of unfunded liabilities.

The incentive for state and local officials to hide liabilities is clear. By deferring compensation, in the form of pensions, and pushing those costs well into the future, politicians can gain favor with government employee unions, which are major political players and donors, while passing on the pain of paying for said compensation on to their successors.

So what can be done? With incentives being what they are, a good option is to limit politicians’ ability to act on them. To that end, Crane and former Secretary of State George P. Shultz, in a recent San Francisco Chronicle op-ed, call for reforming GASB itself. The good news is that there exists a model for GASB to follow, the Financial Accounting Standards Board (FASB), which governs financial reporting in the private sector.

The key to reforming GASB lies in its chair, who is the only full-time GASB board member. At FASB, all board members serve full time and are required to sever connections with firms or institutions they served before joining FASB’s board. But GASB board members other than the chair are part time and may be employed by other organizations, including state and local governments. As a result, at GASB it has been much easier for the regulated to control their regulator. But that can change if GASB’s next chair is a reformer and independent of state and local governments.

One important reform that greater independence by GASB could help accomplish is to require pension funds to use discount rates that take into account both investment risk and the fact that pension benefits are guaranteed, which makes them a fixed liability that continues to grow uninterrupted over time. For years, many public pension funds have used discount rates based solely on their investments’ rate of return. That has resulted in discount rates that are too high, and thus enable state and local governments to make lower contributions toward their future pension obligations.

The bottom line is that addressing public pension shortfalls will require better determining the size of those shortfalls.

As the old saying goes, the first step to getting out of a hole is to stop digging. Just as important is to know how deep the hole is.