The User's Perspective
Preliminary Views on Improving the Effectiveness of the GASB’s Pension Standards
In June 2010, the GASB issued a Preliminary Views entitled Pension Accounting and Financial Reporting by Employers that contains a preliminary set of views about how to improve the effectiveness of the existing accounting and financial reporting standards for state and local governments.
The reexamination of the GASB’s pension standards is a part of the Board’s broader effort to examine the effectiveness of its standards of accounting and financial reporting for postemployment benefits—which also include other postemployment benefits (OPEB). (For more information about the background of reexamination of the GASB’s pension standards, please see the article in the December 2008 issue.)
The Preliminary Views relates only to accounting and financial reporting and does not extend to how governments approach pension plan funding. While there is a close connection in existing standards between how governments fund pensions and how they account for and report information about them in financial statements, the preliminary views at issue would separate these areas. The document also is limited to pension recognition issues associated with government employers; issues related note disclosures and supporting information (including trend information) for governmental employers and pension plan reporting issues will be addressed by the Board immediately after the release of the Preliminary Views. OPEB accounting and financial reporting issues are expected to be addressed at a later date.
Preliminary Views about the Nature of a Government’s Pension Obligation
In return for their labor, employees of state and local governments generally receive two types of compensation—current compensation and deferred compensation. Both types of compensation are earned by the employees as they work. While salaries and other forms of current compensation are received by employees while they are employed, deferred compensation is not received until after leaving the employment of the government. Pension benefits are the most common form of deferred compensation.
The Preliminary Views affirms this understanding of pension benefits, which already underlies the current accounting and financial reporting standards.
Once earned, a government has a present obligation to pay those benefits in the future. Most governments attempt to meet that obligation by making annual contributions to a pension plan to accumulate resources for the purpose of making future payments when they come due. The Preliminary Views states that, for accounting and financial reporting purposes, the pension plan is primarily responsible for the obligation to the extent that assets have been set aside to fund the obligation. The employer government is secondarily responsible for that part of the obligation.
The GASB’s preliminary view is that the employer is primarily responsible for the portion of the pension obligation not covered by assets in the pension plan—the unfunded obligation. Furthermore, that unfunded obligation is a liability of the employer, referred to as a net pension liability.
Implications for Users
The question currently arises, when calculating financial ratios, about what to do with the pension obligation—either the actuarial accrued liability or the unfunded actuarial accrued liability, which are disclosed in the notes and required supplementary information but are not reported in the financial statements. Should a measure of the obligation be included with other liabilities in, say, a ratio of total assets to total liabilities, or in debt per capita? Many users leave it out of their ratios, citing the fact that it is not actually recognized in the financial statements, but raise it as an additional issue to consider.
Were the GASB’s preliminary views to become an amendment to existing standards, a net pension liability would be recognized in the statement of net assets.
Preliminary Views about Measuring a Government’s Total Pension Liability
Because pension benefits are paid in future years and are partially based on events that have not happened yet, governments employ actuarial methods to estimate what benefit payments will be in future years. An actuary’s estimate or valuation is the product of many assumptions regarding the factors that determine the level of benefits that will need to be paid in the future. These factors may include how many employees of a government are expected to receive benefits, how long employees are expected to work for the government, and how long employees are expected to live and receive benefits after retiring.
The projected future cash outflows for pension benefits are converted to their present value, or their estimated value in today’s dollars .Portions of the present value generally are attributed to the past, current, and future years during which employees work in exchange for the benefits.
The portion of the present value related to pension benefits earned to date by employees serves as a basis for determining the total pension liability as of a specific financial reporting date.
Projection of Benefits
The Preliminary Views affirms the general current practice of incorporating expectations of future employment-related events (such as salary increases and years of continuing employment until retirement) into projections of pension benefit payments.
Some pension plans include provisions for adjusting benefits to keep pace with rising prices—automatic cost-of-living adjustments (COLAs). Ad hoc COLAs, on the other hand, are made at the discretion of the government. Automatic COLAs are currently included in benefit projections, but ad hoc COLAs are not.
Under the Preliminary Views, ad hoc COLAs also would be included when relevant facts and circumstances indicate that such COLAs are not substantively different from automatic COLAs.
Discounting Projected Benefits
The process of converting or discounting projected pension benefit payments into their present value requires using an interest or discount rate. At present, the accounting and financial reporting standards require governments to apply a discount rate that is based on their long-term expected future rate of return on the investments of the pension plan.
However, in some cases, the assets held by a pension plan over time, including future contributions and investment earnings, may not be expected to fully cover projected benefit payments. In such circumstances, the Board does not believe that it is appropriate to use the long-term expected rate of return on plan assets to calculate the present value of future benefit payments for which plan assets will not be available.
The discount rate should be the single rate that reflects both (a) the long-term expected rate of return on plan investments to the extent that current and expected future plan net assets available for pension benefits are projected to be sufficient to make benefit payments, and (b) a high-quality municipal bond index rate beyond the point when plan net assets available for pension benefits are projected to be fully depleted.
Attributing Present Value of Projected Benefits
Once the projected benefit payments have been discounted to their present value, an actuary allocates that present value over a period related to the years when the employees earn benefits. At present, governments can choose among six methods for allocating the present value. The way in which the present value is divided among prior, current, and future years has an effect on the amount of the pension expense and total pension liability reported in the financial statements.
The allocation of the present value of benefit payments is done either in level dollaramounts or as a level percentage of projected payroll.The level dollar method divides the liability into equal dollar amounts over the selected number of years. The level percentage method calculates payments so that they equal a constant percentage of payroll over time.
It is the GASB’s preliminary view that, for accounting and financial reporting purposes, all employers would use the entry age normal actuarial cost allocation method and allocate the present value of benefit payments as a level percent of payroll. The GASB views entry age as a better representation of how pension benefits are earned. Further, the selection of level percentage of payroll over level dollar reflects the GASB’s view that projected pension benefits incorporate the effects not just of inflation, but also salary adjustments and other changes over time.
Implications for Users
A common concern expressed by users is that the multiplicity of options afforded to governments in estimating the pension-related numbers that appear in a financial report undermines the ability to make comparisons between governments. If these preliminary views became amendments of existing standards, they would reduce options and should improve comparability.
Preliminary Views about Reporting Changes in a Government’s Net Pension Liability
The size of a government’s net pension liability changes from year to year for several reasons: employees work and earn more benefits; the outstanding liability accrues interest; actual economic and demographic changes differ from what was assumed; changes are made in assumptions about economic and demographic factors; changes in the terms of the pension plan affect benefits already earned in past years; and, the value of plan investments changes.
A key accounting and financial reporting issue is when to recognize period-to-period changes in the net pension liability as a cost of a government’s operations—as expenses in the accrual-based financial statements.
It is the GASB’s preliminary view that changes in the amount of the net pension liability that result from new pension benefits earned and interest on the start-of-year balance of the net pension liability would be reported as expenses each year as they occur. Differences between expected and actual changes in relevant economic and demographic factors, changes in assumptions about those factors, and changes in pension plan terms that affect the amount of benefits attributed to past years would be reported as expenses over a period approximately equal to the remaining service periods of employees. Finally, differences between assumed returns on pension plan investments and actual returns would be deferred, not expensed, as long as the accumulated deferred inflows or deferred outflows do not exceed the equivalent of 15 percent of the fair value of plan investments; any amount exceeding 15 percent would be incorporated into the calculation of pension expense immediately.
Implications for Users
Several causes of changes in the net pension liability would be incorporated into the calculation of annual pension expenses sooner than they would under existing standards. Of particular note are the implications for retroactive benefit increases that apply to former employees—because these beneficiaries no longer work for the government and have no remaining period of employment at the time of the increase, the cost of their benefit improvements would be reported as expense immediately.
Preliminary Views about Governments in Cost-Sharing Multiple-Employer Pension Plan
In agent multiple-employer pension plans, separate accounts are maintained to ensure that each employer’s contributions are used to provide benefits only for the employees of that government. The plan is like a collection of single-employer plans. In a cost-sharing multiple-employer plan, on the other hand, governments pool or share the costs of financing benefits and administering the plan and the assets accumulated to pay benefits. A single actuarial valuation is conducted for all of the employees of the participating governments combined, and all employers pay the same contribution rate.
The accounting and financial reporting requirements for governments participating in cost-sharing plans reflect the pooling of risks and assets by not requiring actuarial information to be presented for individual employers. Instead, this information is currently required to be presented in the cost-sharing pension plan’s own financial statements.
Similar to the tentative conclusion that the unfunded portion of the pension obligation of a single or agent employer is a liability of the government that should be reported in the financial statements—a net pension liability—the GASB believes that the unfunded portion of a cost-sharing pension plan’s obligation is the primary responsibility of the participating governments as a group. Each participating government, therefore, should report a net pension liability based on its proportionate share of the unfunded obligation of all of the participating governments.
Implications for Users
Some users find it frustrating that they cannot obtain pension information that is specific to a government that participates in a cost-sharing plan. These preliminary views would provide users with liability data about individual governments in cost-sharing plans.
Preliminary Views about the Timing and Frequency of Pension Measurements
It is the GASB’s preliminary view that the net pension liability should be measured as of the end of a government’s fiscal year. An actuarial valuation of the pension obligation would need to be performed at least once every two years according to the Preliminary Views. The valuation date would not need to be the employer’s fiscal year-end; however, it should be a date no more than 24 months prior to the fiscal year-end on which the net pension liability is being reported. Measurements made earlier than the fiscal year-end would have to be updated to incorporate changes that took place in the interim that have an effect on the net pension liability.
Implications for Users
At present, it is possible that the underlying actuarial valuation on which a government’s pension expense is based could be three years old if a government has valuations done every other year. The implications of these preliminary views should be more up-to-date information about a government’s pension costs and net pension liability.
For more information about this project, please click on this link to the Postemployment Benefit Accounting and Financial Reporting project page on the GASB website.