Posted by Jeffrey Brown on Nov 29, 2011
Filed Under (Finance, Retirement Policy)
Over the years, many of my academic colleagues and I have pointed out the significant conceptual flaws in the way that the Government Accounting Standards Board (GASB) computes the value of public pension plan liabilities. Financial economists are virtually unanimous that using expected rates of return on pension assets to discount future benefits obligations is inconsistent with basic economic and finance theory, and that it has the bad outcome of massively understating the size of the unfunded liabilities.
Our frustration only increased when GASB issued an exposure draft of new rules that were portrayed as a compromise, but which in fact were a step backwards in terms of consistency with basic financial principles. Under these proposed new rules, public pensions would be allowed to use expected asset returns to discount liabilities for the part that is funded, and then use municipal bond index to discount the unfunded portion.
Unfortunately, we have often had a difficult time explaining why this is so, because our explanations often rely on having our audience understand difficult concepts such as “risk adjusted returns” or “options pricing.”
Finally, however, one of our colleagues – Robert Novy-Marx of the University of Rochester – has come up with a brilliantly simple way to illustrate the flaws of the proposed new GASB approach. In a new working paper from the National Bureau of Economic Research, entitled “Logical Implications of GASB’s Methodology for Valuing Pension Liabilities,” Professor Novy-Marx highlights three logical implications of the new rules, all of which fail even the most basic idea of common sense. I will use today’s post to highlight my favorite of the three – the idea that under the GASB proposal, a public pension plan can improve its funding status by burning money.
He gives the following example, which I will simplify a bit further than he does in his paper:
Take plans A and B. They have identical liabilities of $175,000 payable in exactly 30 years. The only difference between the two plans is that plan A has $10,000 of stocks, while plan B has $20,000 of assets, including $10,000 invested in stocks and another $10,000 invested in bonds. Put differently, plan B is identical to plan A in all respects except that it has an extra $10,000 of funding invested in a relatively risk-free asset.
It does not take any formal training in economics or finance to understand that plan B is better funded. Indeed, I daresay that 100% of my 8-year-old son’s 2nd grade class could tell us that $20,000 is worth more than $10,000.
Yet, ironically, under the proposed GASB rules, plan A is better funded than plan B! Indeed, plan B could improve its funding status by taking the $10,000 of bonds and lighting them on fire!
How can this be?
Because in the alternative universe in which GASB operates, public plans are guided to discount future cash flows by the expected rate of return on plan assets, while ignoring risk. Thus, if stocks have a 10% expected return, and bonds have a 4% expected rate of return, then plan A gets to discount the $175,000 liability with a 10% rate. Plan B has to use a 7% rate (the average of 10% and 4%). When one does this, one discovers that plan A is almost exactly funded, while plan B is under-funded by $3,000.
This is an absurd result. It proves by example that the GASB approach to measuring pension liabilities is meaningless because it does not provide a reliable measure of anything that we care about.
If GASB wants to follow its own guidelines of providing accounting standards that improve transparency and improve public-sector decision-making, then they should immediately replace these standards with ones that are consistent with basic finance.