The more time I spend with accountants, the more I have come to respect the importance and the enormity of what they do. At their best, financial accounting rules provide transparency, structure and consistency to the public disclosure of oftentimes very complex transactions. And public disclosure of information is absolutely critical to the functioning of a market-based economy.
But, on occasion and despite my respect for the importance of what they do, the accounting profession sometimes surprises me with a set of rules that are so bizarre that all I can think to say is “what were they thinking?” This is especially true when it comes to government accounting standards.
I have written before about what I perceive to be a fundamental problem with the way the Government Accounting Standards Board (GASB) allows public pension plans to discount future liabilities. In essence, they make a classic mistake of confounding the risk of the liabilities with the risk of the assets held to fund those liabilities.
I was optimistic when I heard that GASB was reviewing the standards in this area, as I was hopeful that it would lead to a more rational policy. But, I was destined to be disappointed. After much time, but apparently not sufficiently clear thought, GASB has decided that the new policy should be:
“Discount rate. To the extent current and expected pension plan assets are projected to be sufficient to provide for payment of benefits in future periods, the projected benefit payments should be discounted at the long-term expected yield on plan assets. Additional benefit payments, if any, beyond the point at which plan assets are projected to be fully depleted should be discounted using an appropriate high-quality tax-exempt municipal bond index rate.”
Yes, I know this is pretty technical stuff, but it matters enormously for providing the public with full and transparent information to taxpayers about the enormous liabilities that are being dumped onto them and to participants in these systems that want to know whether the system is setting aside adequate money to fund their promised benefits.
In essence, GASB has used circular reasoning. They appear to have decided that so long as there are “sufficient” assets to pay for future benefits, then they can discount using expected returns. But this begs the question – how does one determine whether assets are sufficient without specifying an interest rate or discount rate assumption?
I realize that this debate over discount rates is a bit abstract, so let me give a more “personalized” example of why I find the practice of discounting pension liabilities using the expected rate of return on assets so troubling.
Imagine that I went to the bank and borrowed $100,000 as an unsecured personal loan. Let’s suppose that the bank charged me a market interest rate of 6% for this loan, and that I had to pay it back over 10 years. My monthly payment would be about $1,110 per month.
What is the appropriate way to value this liability? In this case, it is incredibly easy – on the day I took out the loan, the present discounted value of my loan is … $100,000. No tricky math here! Note that when it comes to valuing the value of what I owe the bank, it does not matter what I do with the proceeds from the loan. Whether I spend it, stick it under my mattress, or invest in pork belly futures, the fact is that the loan is worth $100,000. (Obviously, this value will change over time, but at least at the very start, its value should be pretty non-controversial!)
Now suppose that I follow the GASB rules on how to value the liability. If I were to invest in a diversified portfolio of stocks and bonds and argue that the expected return on that portfolio is 8%, then when I discount 10 years worth of monthly payments of $1,110 by 8%, the measure of my liability falls to under $92,000. If I invest in an even more aggressive, high-return/high-risk portfolio that has an expected return of 10%, the present-value of my liability falls to $84,000.
This should make it clear why such an approach is total economic nonsense. Can you imagine the look on my banker’s face if I walked in and offered the following deal?
“I just borrowed $100,000 from you at 6%. But I have figured that if I give you $84,000 today, and you invest this money in an aggressive portfolio with an expected return of 10%, you will, on average, come out even at the end of 10 years. Thus, I think you should accept my $84,000 as payment-in-full for the $100,000 loan you just made me. Okay?”
Obviously, any banker (or anyone else) would be considered financially illiterate if they accepted such a deal. Any financially literate individual knows that the higher returns are compensation for more risk – they are not “free.”
Yet this is precisely the same logic that is being applied when we allow state and local governments to discount their liabilities using the expected return on assets, rather than using a discount rate that reflects the risk characteristics of the liabilities. It is disheartening that GASB did not take advantage of this opportunity to bring some good economic reasoning to this important issue.