The User's Perspective
In June 2011, the GASB approved two Exposure Drafts that propose changes to how state and local governments report and account for the pension benefits provided to their employees. The proposals would lead to significant improvements in usefulness of pension information for making decisions and assessing accountability. One document relates to reporting by governments (“employers”) that provide pension benefits, and the other relates to reporting by the pension plans that administer those benefits through qualified trusts. The GASB also has published a plain-language supplement to the employer document that explains the proposals for non-accountant users with a minimum of technical jargon.
The proposals arise from the GASB’s reexamination of its current pension standards, which is a part of the GASB’s broader effort to periodically examine the effectiveness of its existing standards. (For more information about the reexamination of the GASB’s pension standards, please see the article in the June 2010 issue.)
It should be noted that the proposals relate only to accounting and financial reporting and do not extend to how governments approach pension plan funding. There is a close connection in existing standards between how governments fund pensions and how they account for and report information about them in audited financial statements. As proposed, Governments Would Recognize a Pension Liability on the face of their financial statements.
Employees of state and local governments generally receive two types of compensation in return for their labor—current compensation and deferred compensation. Both types 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 employment with government has ended.
Once earned, a government has a present obligation to pay the benefits in the future—a total pension liability. Most governments try to meet this obligation by making annual contributions to a pension plan to accumulate resources in an irrevocable trust for the purpose of making future payments when they are due. To the extent that the total pension liability is greater than the value of the net assets available in the plan for paying benefits, a government has a net pension liability, and would report that amount as a liability in its accrual-based financial statements (for example, the government-wide Statement of Net Position).
Implications for Users
At present, the difference between a government’s total pension obligation and assets available for benefits—often called the unfunded liability—is disclosed in notes, but does not appear on the face of the financial statements. Consequently, some analysts are uncertain whether to incorporate the unfunded liability into financial ratios that include debt and other long-term liabilities. Some analysts include it, some do not. Recognition in the financial statements, alongside other liabilities such as outstanding bonds, claims and judgments, and long-term leases, will clearly put the pension liability on an equal footing with other long-term obligations.
How Governments Would Measure the Total Pension Liability
To determine the amount that will be recognized as the total pension liability, a government first has to measure the total pension liability. Calculating the total pension liability involves three essential steps: projecting future benefits payments for current and former employees or their beneficiaries, discounting the projected future benefit payments to their present value, and attributing (allocating) the present value to past and future years during which the employees have worked or are expected to work.
Projection of Benefits
The proposal would carry forward the general current practice of incorporating expectations of future employment-related events (like salary increases and years of continuing employment until retirement) into projections of pension benefit payments. Pension plans provisions for automatic cost-of-living adjustments (COLAs), generally included as part of an employment agreement, statute, or ordinance, would continue to be included in projections as well. Ad hoc COLAs, which are made at the discretion of the government, would only be included if they occur with such regularity that they are substantively automatic. For some governments, then, the amount of projected future pension benefit payments would be higher than under current standards. As a result, the present value of the future benefit payments and the net pension liability to be reported by those governments would be larger.
Discounting Projected Benefits
The process of converting or discounting projected pension benefit payments into their present value requires assuming an interest or discount rate. Current standards require governments to apply a discount rate that is equal to the expected future rate of return on the investments of the pension plan over the long term. However, the net assets held by a pension plan over time associated with current employees may not be expected to fully cover projected benefit payments for those individuals. If plan net assets will not be available to be invested for the long-term to make benefit payments, then the GASB does not believe their expected rate of return should be used.
Under the proposals, governments would project the future benefit payments in each year and the amount of plan assets available for paying benefits to current employees, retirees, and their beneficiaries. As long as plan net assets are projected to be available to make the projected benefit payments, governments would discount projected benefit payments using the long-term expected rate of return. Beginning with the point at which plan net assets are not projected to be sufficient, governments would discount using a tax-exempt, high-quality (rated AA or higher, including equivalent ratings) 30-year municipal bond index rate. This proposal reflects that those future benefits payments are not expected to be made with the pension plan’s long-term investments, but with the general resources of the government.
Implications for Users
At present, municipal bond index rates are lower than the expected returns on long-term investments. Therefore, if any projected benefit payments are discounted using the lower rate, then the present value will be higher. As a result, the liability would be larger.
Attributing Present Value of Projected Benefits
Once the projected benefit payments have been discounted to their present value, they are allocated over a period related to the working years when the employees earn benefits. Under the proposal, governments would use the entry age normal actuarial cost method to allocate present value, and would do so as a level percentage of payroll. Under this method, projected benefits are discounted to their present value when employees first begin to earn benefits and attributed to employees’ expected periods of employment until they leave.
Implications for Users
Because governments can now select from six actuarial cost methods to attribute the present value of projected benefits to specific years, making comparisons across governments can be highly complex. The use of a single approach would considerably improve the consistency and comparability of reported pension information.
How Governments Would Measure the Annual Cost of Pensions
A government’s net pension liability changes from year to year for a variety of reasons: employees work and earn more benefits; the outstanding liability accrues interest; contributions to the plan increase or decrease; actual economic and demographic changes differ from what was assumed in actuarial calculations; changes are made in assumptions about economic and demographic factors; changes are made in the terms of the pension plan that affect benefits already earned in past years; and, the value of plan investments change. An important issue is when to recognize these period-to-period changes as a cost of a government’s operations—as expenses in the accrual-based financial statements.
Several causes of changes in the net pension liability would be factored into the calculation of pension expense immediately in the period the change occurs, including:
Other causes of changes in the net pension liability would be recognized initially as deferred pension outflows of resources or deferred pension inflows of resources (see related article on Statement 63), and then introduced into the expense calculation gradually over the remaining years of employment of active employees:
The effect of differences between the expected return on plan investments and actual experience would be recognized as deferred outflows of resources or deferred inflows of resources and included in expense in a systematic and rational manner over five years. All other changes would be included in the calculation of pension expense in the period in which they occur.
Implications for Users
Most governments would recognize pension expenses sooner than they currently do under the proposal. The full impact of changes in pension benefit terms would be recognized as expense immediately, for example, rather than gradually over up to 30 years.
Cost-Sharing Multiple-Employer Pension Plans
In cost-sharing multiple-employer plans, governments share the costs of providing benefits, administering the plan, and investing the assets accumulated to pay benefits. Governments participating in cost-sharing plans are not currently required to present actuarial information about the plan. Instead, this information is required to be presented in the cost-sharing pension plan’s own financial statements for all of the participating governments combined.
However, the needs of the users of information about cost-sharing plans and their participating governments are no different from the needs of people interested in governments participating in single-employer and agent multiple-employer pension plans.
The GASB is proposing that a government participating in a cost-sharing plan would report a net pension liability in its statement of financial position based on its proportion of the collective net pension liability of all of the governments participating. The proportion would essentially equal the government’s long-term expected contributions to the plan divided by those of all governments in the plan.
Implications for Users
Users would have access to essentially the same pension information about individual governments regardless of what kind of plan they participate in.
Note Disclosures and Required Supplementary Information Governments Would Provide
The GASB’s proposed standards contain requirements for disclosing information in the notes to the financial statements and presenting required supplementary information (RSI) following the notes. All governments participating in a defined benefit pension plan would include the following information in their note disclosures:
Governments participating in single-employer and agent multiple-employer pension plans also would disclose:
Governments would present RSI schedules with the following information for each of the past 10 years:
A government participating in a cost-sharing multiple-employer plan would present both of these schedules for the plan as a whole. It also would present the latter schedule with information for its proportionate share of the plan.
If a government has an actuarially calculated annual pension contribution, it also would present an RSI schedule with the following information for each of the past 10 years: (a) the actuarially calculated employer contribution; (b) amount of employer contribution made; (c) the difference between a and b; (d) covered payroll; and (e) b divided by d. A government participating in a cost-sharing multiple-employer plan would present this schedule for its individual plan and for the plan as a whole.
Governments also would present notes to the RSI schedules regarding significant assumptions underlying the actuarially calculated contributions (if not disclosed in the notes), and factors that significantly affect the trends in the schedules.
Implications for Users
If the proposals regarding note disclosures and RSI ultimately become requirements, users would have access to highly significant information that may not have been available previously, including information regarding the measurement and funding approaches a government utilizes. Because employers would be required to disclose a schedule of changes in the net pension liability, users will be able to determine what has driven changes in the net position liability in the period—was it factors beyond a government’s control, such as the performance of the economy, or factors a government controls, such as retroactive changes in benefit terms. Similarly, users will be better able to understand what portion of each year’s pension expense resulted from newly earned benefits, benefit changes, or investment returns that varied from projections.
Special Funding Situations
In some pension plans, an entity other than the employer government is legally responsible for contributing to the plan. For instance, some state governments are legally bound to make contributions to the teacher pension plans of school districts. The legal responsibility to contribute is either conditional on a particular event or circumstance that is unrelated to the pension plan or unconditional. An example of a conditional responsibility is a requirement to contribute a certain percentage of a tax revenue stream. An unconditional responsibility might be a requirement to contribute a certain percentage of the employer government’s covered payroll.
Conditional Special Funding
A conditional special funding situation is much like a government receiving a grant. The recipient government recognizes the contribution from the other government as revenue. The other government reports the contribution as an expense, but not as a pension expense.
Unconditional Special Funding
Under an unconditional special funding situation, the non-employer government legally responsible for contributing has basically taken a portion of the pension obligation of the employer government as its own. Consequently, the non-employer government would recognize its proportionate share of the net pension liability, deferred inflows of resources, deferred outflows of resources, and pension expense.
The employer government would calculate its net pension liability and related financial statement elements, prior to the other government’s support, but would recognize amounts net of the other government’s proportionate share. The employer government would recognize “on behalf” revenue equal to the portion of the other government’s pension expense related to the government’s employees.
Implications for Users
Currently, it may be difficult for users to understand the extent to which states and other governments are obligated to make contributions to another government’s pension plans. This proposal would allow users to better understand what portion of a government’s pension liability and expense relates to its own employees versus the employees of other governments.
How Governments in Defined Contribution Plans Would Report
Defined benefit plans specify the amount of benefits to be provided to the employees after the end of their employment. Participating governments make contributions to the plan in order to accumulate assets which will be available in the future to make the promised benefit payments. Conversely, defined contribution plans stipulate only the amounts to be contributed to an employee’s account each year, and not the amount of benefits employees will receive after the end of their employment.
The GASB’s proposed standards would essentially carry forward the existing requirements regarding defined contribution plans. Participating governments would report an expense equal to the amount they are required to contribute for employee service each year and a liability equal to the difference between that required contribution and what the government actually contributes. These governments also would make descriptive disclosures about the plan and its terms, and the method by which contributions to the plan are determined.
How You Can Provide Feedback to the GASB
The GASB has prepared a supplement to its proposals that discusses them in plain English and focuses on the information that would result from them. You can help the GASB to finalize the new standards for pensions by reading the plain-language supplement, along with the Exposure Draft, Accounting and Financial Reporting for Pensions, and answering the questions posed in the supplement. (Links to both documents can be found below.) Your answers can be shared with the GASB via letter or email. (Instructions for doing so can be found at the back of the supplement and the front of the Exposure Draft.)
You also can voice your opinions directly to the GASB members and staff by participating in one of three user forums the GASB is conducting in New York City (October 4), San Francisco (October 14), and Chicago (October 21). Further information about the forums and instructions for letting the GASB know you would like to participate can be found in both the supplement and the Exposure Draft.