Posted by Jeffrey Brown on Jun 11, 2012
Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy)
I have written numerous blogs about the frustration that the financial economics community has with the Government Accounting Standards Board (GASB) rules that govern the way we account for public pension liabilities in the U.S. The basic problem is that GASB standards do not account for risk in an appropriate way (in fact, they do not really account for it at all!) Instead, they allow public plans to under-state the size of their liabilities by acting as if they have a risk-free approach to investing money at approximately 8 percent per year forever.
On occasion, someone will ask me if this is really just an accounting issue, or whether it actually has real effects on real-world behavior. Although I can give countless anecdotes for why it affects real behavior, it is always better when a highly respected and disinterested party can provide rigorous empirical evidence to support the claim.
Well, now we have such evidence. Just last month, three financial economists (Andonov, Bauer and Cremers) publicly released a rigorous new research paper entitled “Pension Fund Asset Allocation and Liability Discount Rates: Camouflage and Reckless Risk Taking by U.S. Public Plans?” In this paper, the authors use an international database to look at the asset allocation decisions and discount rate assumptions of both public pension funds and non-public pension funds in the U.S., Canada and Europe. What is particularly nice about this paper is that it is able to show what outliers U.S. public plans really are. Not only do they look quite different from corporate DB plans in the U.S., but they also look different from both public and non-public plans in other countries.
Specifically, the authors state that “U.S. public funds seem distinct in that they can decide their strategic asset allocations and liability discount rates largely without much regulatory interference, due to wide latitudes allowed in the currently applicable Government Accounting Board (GASB) guidelines. In particular, these guidelines link the liability discount rates of U.S. public funds to the (assumed) expected rate of returns of the assets, rather than to the riskiness of the liabilities as suggested by economic theory.” As I have written before, this is an intellectually vacuous approach to discounting. What I had not fully realized is how unique this mistake is to U.S. public plans. The authors go on to state that in Canadian and European funds – both public and private – liability discount rates are “typically … a function of current interest rates,” an approach which (assuming the interest rate is chosen appropriately) is much more in line with basic economic theory.
The most striking finding is the impact that this difference in accounting has on real behavior. The authors find that “in the past two decades, U.S. public funds uniquely increased their allocation to riskier investment strategies in order to maintain high discount rates and present lower liabilities.” This really is a case of the tail wagging the dog – by allowing an intellectually flawed approach to discounting to be codified in GASB standards, we have provided incentives for public pension fund managers and their boards to over-invest in risky assets.
There are many losers from GASB-induced deception. Public workers end up with less-well-funded pensions. Taxpayers end up bearing financial risk without realizing it. Investors in public debt are given inaccurate information about the size of the pension liabilities. Isn’t it time that we fix this?