Proposed GASB Rules Show Why Only Market Valuation Fully Captures Public Pension Liabilities

The Governmental Accounting Standards Board has released preliminary views on how public sector pension plans should value benefit liabilities. Because the GASB’s proposals ignore government’s contingent liability to pay plan benefits should assets fall short, they omit the full value of plan liabilities and contradict the GASB’s own standard of “interperiod equity.”In recent years, financial economists have charged that public sector pension accounting methods, which allow plans to discount virtually riskless pension benefits at the interest rate projected for a risky portfolio of assets, understate pension liabilities and encourage plans to take on excessive risk. The Governmental Accounting Standards Board (GASB) recently proposed changes to public pension discounting rules that may be viewed as a middle ground between current actuarial methods and a market valuation approach. In fact, the GASB’s proposals violate its own standard that each generation fully fund its pension commitments and demonstrate why only a true market valuation approach can fully capture the liabilities of taxpayer-supported public pension plans. Under the GASB’s proposed changes, pensions may continue to discount asset-backed liabilities at the expected return on assets but liabilities that are not backed by assets are to be discounted at the interest rate on an index of high-quality municipal bonds. But these revisions ignore the fact that government—and thus taxpayers—has a contingent responsibility to pay benefits that are currently backed by assets should those assets fall short of the value needed to meet liabilities in full. In a sense, the government acts as an implicit put option, the value of which is large but is ignored under both current practices and the GASB’s proposed revisions. This proposal violates the GASB’s own standard of interperiod equity, whereby each generation fully funds its own accrued benefits and does not leave liabilities, contingent or otherwise, for future generations. Under the GASB’s proposed rules, a plan could be considered fully funded even if it imposes a significant contingent liability on future generations. If the value of this contingent liability is included, then full plan liabilities will equal those calculated under a standard market valuation approach, whereby the discount rate is risk adjusted to match the guaranteed nature of accrued pension benefits.