How ratings agencies will approach pension liabilities
The New York Times recently ran a piece discussing how new pension valuation methods, put in place by the Government Accounting Standards Board, were far superior to the historical methods of valuing unfunded pension liabilities. They were even endorsed by some academic commentators. I have not heard of any state or local plan using these new methods to increase the funding of their pensions. Governments are not forced to use them, rather only to do the calculations and show the results on their balance sheets. Despite the revisions, governments will likely continue to use the averages of their historical rates of return on their pension investments to make decisions about the size of their annual contributions to their pension funds.
Here is the rationale that pension funds have used for decades, according to the Times:
Much of the theoretical argument for retaining current methods is based on the belief that states and cities, unlike companies, cannot go out of business. That means public pension systems have an infinite investment horizon and can pull out of down markets if given enough time.
This is not quite the case. I think public pension fund managers and those responsible for funding decisions look at the chart below from the Public Fund Survey (Figure L) and see that pension funds have earned 8 percent returns over the last 25 years. The two bars represent funds that have fiscal year ends at different times of the year, which does greatly impact fund returns.
The other method for valuing pension fund liabilities is based on the use of U.S. Treasury securities returns, which have been artificially suppressed for the last five years due to the Federal Reserve’s bond-buying policy. The Times conflates the discussion of the low-risk U.S. Treasury rate methodology and the new GASB standards, which are in fact different approaches. Using either of these methods will make the liabilities of public pension funds look monstrous, but it is disconnected from funds’ actual experiences.
Academic discussions will do little to persuade public officials who have to juggle their budgets and fund education, healthcare and pensions to change their methods. The more that officials fund pensions, the less they have left for other priorities. Instead the parties who matter in these discussions are the credit rating agencies, because they have already begun lowering credit ratings based on new methodologies (see Moody’s 3 notch downgrade of Chicago recently).
So how are the raters approaching the new GASB methodology issue?
We view the use of a blended discount rate as one of the most significant changes made under the new statements and as an improvement to financial accounting and reporting of pension liabilities.
Under the new statements, the rate used to discount a government’s pension liability will be a blend of the long-term assumed rate of return, to the extent that assets are projected to be available to fund projected benefits, and the use of a 20-year tax-exempt, ‘AA’ category or better, GO municipal bond index rate.
This blended rate approach is based on GASB’s recognition that investment returns can’t be earned unless there are assets invested on which to earn those returns. We consider this approach as more reflective of reality than the current practice of discounting the entire liability at the long-term expected rate of return.
This is more generous than the U.S Treasury method and less generous than the current use of 8 percent investment returns. Note S&P’s use of a municipal bond index.
Accrued actuarial liabilities will be adjusted based on a high-grade long-term taxable bond index discount rate as of the date of valuation (of the fund).
Rather than using the average historical investment return rate of 8 percent, Moody’s uses a return on a taxable bond index. This return would be no higher than that on a basket of high-rated corporate bonds ranging from 4.4 to 6.2 percent, the FT says.
Fitch believes that the new Government Accounting Standards Board (GASB) standards, covering pension systems themselves (effective June 2013) represent a net improvement in disclosure. Given the extensive changes to reported pension data being implemented with the new standards, Fitch expects to review its approach following the new standards’ implementation.
Fitch has not decided how to approach this yet. But waiting may be the best decision. The ramifications of these changes could be enormous, and it’s best to let it unfold a little.
Kroll has begun rating municipal bonds but I was unable to find any commentary on its approach to the new standards.
Clearly the use of some varied methodologies will impact how harshly raters evaluate different issues and their pension liabilities. Keep your focus here. There are likely many changes to come.