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The GA(A)P in underfunded State Pension Liabilities: GASB seeks better reporting.

Many state government pension plans are seriously underfunded, which is looming as a significant financial crisis for the United States. State government financial statements often fail to reflect the full extent of the impact of the commitments made by state governments to their employees when the employees retire. (See Roger Lowenstein, "Looking for the Next Crisis," New York Times Magazine, June 27, 2010, pp. 9-10.) The current standards as set by the Governmental Accounting Standards Board (GASB) provide information that may be inadequate for users to accurately assess pension obligations for states. On June 16, 2010, GASB issued its Preliminary Views on "Pension Accounting and Financial Reporting by Employers." The comment period deadline was September 17, 2010. Prior to issuing its Preliminary Views, the board received nearly 120 written comment letters in response to its March 2009 Invitation to Comment (ITC) on the topic. That feedback plus what was heard during two days of public hearings was considered by the board in developing its Preliminary Views. The board plans to issue an exposure draft of a Statement of Governmental Accounting Standards in June 2011. According to its timetable, a final standard is expected to be issued in May 2013.

The purposes of this article are to briefly discuss the pension crisis facing state governments, explain current pension accounting and financial reporting standards for state government employers, present the steps GASB has taken thus far to examine current pension accounting standards, and describe the direction in which GASB appears to be moving with regard to this complex topic.

The State Funding Crisis and Unfunded Pension Liabilities

The magnitude of the state funding crisis is depicted in Exhibit 1, which shows the top 10 states in terms of the anticipated size of the budget deficit for fiscal year 2011. Data are presented for both fiscal years 2011 and 2010 to demonstrate the growing problem. In addition, the deficit as a percentage of general fund revenues is reported to offer a sense of the relative magnitude of the deficit. The crisis in state funding across the nation is severe. Unfunded pension obligations appear to be a material component of the growing deficit problem.

Evidence of the State Funding Crisis: Highest Budget Deficits FY 2011

               Estimated Budget Deficit        Estimated Budget Deficit
                     (millions)                    as a Percentage of
                                                 General Fund Revenues

State              FY 2011         FY 2010       FY 2011      FY 2010

California     $14,400-$14,003  $6,300-$6,325  14.1%-14.6%    6.8%-7.1%
Illinois       $11,500-$12,800  $4,295-$5,000  30.8%-34.3%  14.3%-16.5%
New Jersey     $         8,000  $  500-$1,000  27.2%-27.5%    1.7%-3.4%
New York       $  6,796-$7,400  $3,159-$3,200  11.3%-13.4%    5.7%-5.8%
Pennsylvania   $         4,100  $    160-$450        15.4%    0.6%-1.7%
Texas          $         3,300  $           0         7.6%           0%
Massachusetts  $         2,700  $         600         9.7%    2.1%-2.2%
Arizona        $  2,600-$3,000  $1,600-$1,900  26.7%-30.0%  18.0%-19.7%
Maryland       $                $682.8-$936.0  14.5%-20.5%    5.1%-6.8%
Florida        $  1,788-$4,700  $         1.4   7.5%-18.1%         0.6%

Source: State of the States Scorecard, BMO Capital Markets GKST Inc.,
April 20, 2010.

A study conducted by the Pew Center on the States reports that at the end of fiscal year 2008, there was a $1 trillion gap between the $3.35 trillion in pension, healthcare, and other retirement benefits promised by the states to their employees and the $2.35 trillion actually set aside to pay those promises (http://downloads. Dollar_Gap_final.pdf). Eight states had more than one-third of their pension liability unfunded: Connecticut, Illinois, Kansas, Kentucky, Massachusetts, Oklahoma, Rhode Island, and West Virginia. According to the Pew study, in 2000 just more than half the states had fully funded pension plans. By 2008, only four states could claim that success: Florida, New York, Washington, and Wisconsin. Illinois has an estimated pension funding shortfall of anywhere between $61 billion and $166 billion, depending on the source (David Griesing, "Pension Financing Shortfall Is a Threat on the Horizon for State," New York Times, April 23, 2010). To meet its required contribution to its pension funds in 2010, Illinois sold securities worth $3.47 billion and is planning to borrow an additional $4.6 billion to make its required contribution in 2011.


The gap between the promises made by states to retirees and the level of funding continues to widen. Joshua Rauh of the Kellogg School of Management at Northwestern University provides evidence that six states will exhaust their pension funds by 2020 (Connecticut, Hawaii, Indiana, Louisiana, New Jersey, and Oklahoma), and 31 states could be in the same position by 2030 ("Are State Public Pensions Sustainable? Why the Federal Government Should Worry About State Pension Liabilities," working paper, May 2010). Rauh observes that the ultimate cost of a federal rescue could top $1 trillion. The most populous state in the nation, California, has experienced pension woes that have received extensive publicity, and its situation continues to worsen. Then-Governor Arnold Schwarzenegger, a strong advocate for pension reform, issued a statement on April 5,2010, warning that if steps were not taken to address the issue of the funding gap, then "increasingly large portions of state funding for programs Californians hold dear, such as schools, parks and health care, will be diverted to pay for this debt" (Mary Williams Walsh, "Analysis of California Pension Funds Half-Trillion-Dollar Gap," New York Times, April 6, 2010).

The worst recession since the 1930s has resulted in a record decline in state tax receipts throughout the nation. The high unemployment rate continues to lessen personal income tax receipts, while falling home prices and subdued retail sales are reducing property and sales tax collections. In response to declining revenues, many states have cut spending and reduced services further, thus exacerbating overall economic activity. At least 46 states have eliminated jobs, furloughed employees, or restricted new hires since the recession began (Nicholas Johnson, Phil Olif'f and Erica Williams, "An Update on State Budget Cuts," Center on Budget and Policy Priorities, November 5,2010). All of these fiscal woes make the funding of pension plans for government employees more difficult. Exhibit 2 presents the 10 states with the largest unfunded pension liabilities.

10 States with the Largest Unfunded Pension Liabilities

State            Unfunded Pension Liability

California             $59,492,498
Illinois                54,383,939
New Jersey              34,434,055
Massachusetts           21,759,452
Ohio                    19,502,065
Colorado                16,813,048
Connecticut             15,858,500
Texas                   13,781,228
Pennsylvania            13,724,480
Oklahoma                13,172,407

Figures are in thousands. Data are from 2008, except Ohio (2007).

Source: The Pew Center on the States, "The Trillion Dollar Gap,"
(April 6, 2010), p. 4,

Pension Plan Accounting

Qualified pension plans are divided into two major categories: 1) defined contribution plans, and 2) defined benefit plans. Defined contribution plans are easier to account for than defined benefit plans because they specify the amount of money an employer must contribute to the plan. No explicit promise is made by the employer regarding the amount of the periodic payments that retirees will receive, and the employer has no additional liability to provide pension benefits after the defined contribution is made. The amount ultimately payable to the retiree is determined by the accumulated contributions made by the employer (and employees, in some plans) over the term of service plus the earnings on those contributions. State government accounting for these plans is straightforward. Each year the employer records an expense equal to the amount of the annual contribution. Consequently, this plan has no unfunded actuarial liabilities.


Unlike the private sector, most state governments maintain defined benefit plans. Under a defined benefit plan, the employer specifies the payments or benefits that the employee will receive upon retirement via a formula. Length of service and salary are typically the two most important variables determining me payments to be made to retired employees. The risk in defined benefit plans is borne by the employer, who must accurately estimate the amount to be contributed currently to fund the eventual retirement benefits to be paid to retirees. Defined benefit plans raise many financial reporting complications caused mainly by 1) uncertainties associated with the future amounts to be paid, and 2) estimates of earnings on the pension plan investments.

Current GASB Pension Rules

GASB Statement 27, Accounting for Pensions by State and Local Governmental Employers, issued in November 1994, and Statement 50, Pension Disclosures--An Amendment of GASB Statements No. 25 and No. 27, issued in May 2007, provide guidance to state and local governments regarding pension accounting and reporting. Under these standards, the annual pension cost to a state equals the annual retirement contribution with certain adjustments if the employer's actual contributions in prior years differ from the annual required contribution. An actuary calculates how much should be contributed each period to provide adequate resources to meet pension commitments in the future. The future cash outlays are then discounted to the actuarial present value using a discount rate equal to an assumed long-term rate of return on investments. It should be noted that future pension benefit payments are dependent upon myriad estimates and assumptions. For example, the amount and period over which pension benefits will be paid to retirees depends upon assumptions regarding future employee salary levels, turnover, and mortality.

One portion of the actuarial present value relates to costs attributed to prior years for benefits employees have already earned through the provision of services to the employer in past periods. Another portion can be attributed to benefits expected to be earned by employees in the future via the provision of services to the employer in future periods. The actuarial present value allocated to prior years of employment is called the actuarial accrued liability.

The value of pension plan assets, computed by an actuary, is referred to as the actuarial value of assets. The actuarial value of these assets generally is not the same as the market value of assets in any given year because actuaries may use techniques to smooth out short-term volatility (e.g., gains or losses). The excess of the actuarial accrued liability over the actuarial value of assets is the unfunded actuarial accrued liability (also called the unfunded accrued benefit obligation). Under existing standards, the unfunded liability may be amortized over a period of up to 30 years using one of six acceptable actuarial cost methods; among these, the entry-age method is by far the most widely used. Under this method, governments discount projected benefits to the present value when employees first enter the government's employment.

The employer's normal cost is the portion of the actuarial present value of benefits earned by retirement system members in a particular year. The normal cost plus the unfunded accrued benefit obligation to be amortized in the current period equals the annual required contribution of the employer for the period. The unfunded accrued benefit obligation can still grow even if the government consistently makes its annual required contribution to the pension plan because of changes in actuarial methods or assumptions.

GASB's Pension Project and Preliminary Views

GASB, as a matter of policy, periodically reviews existing standards to determine whether they continue to meet the needs of users of governmental financial statements. GASB's standards for reporting on pension benefits by state and local governments with minor revisions have been in effect since 1994. In 2006, GASB initiated a research project to evaluate the effectiveness of the current standards for pension accounting and reporting. The results of that research were presented to the board in April 2008. The board responded by formally adding a project to its technical agenda to examine the fundamental accounting and financial reporting issues related to pensions. On March 31, 2009, GASB issued an ITC on "Pension Accounting and Financial Reporting." The ITC described key issues related to pension accounting and explored alternatives to address those issues. The board's tentative views regarding the issues outlined in the ITC were expressed in its Preliminary Views on "Pension Accounting and Financial Reporting by Employers," issued June 16, 2010. A Preliminary Views document generally is issued when GASB anticipates that its position may be controversial or when the board itself is sharply divided over the issues under consideration.

The board's Preliminary Views on "Pension Accounting and Financial Reporting by Employers" presents a dramatic change. Currently, neither the total obligation for pensions nor the unfunded portion is reported as a liability in a government's financial statements. Instead, a liability is reported if a government contributes less than the annual required contribution determined by its own actuaries, subject to certain constraints. This method can seriously understate the accrued pension liability of the government. In its Preliminary Views, the board takes the position that the portion of the pension obligation that is not covered by assets in the pension plan (i.e., the unfunded obligation) is a liability of the government and should be reported in the government's accrual-based financial statements. Furthermore, the board recommends a significant change in the interest rate used to discount projected benefit payments.

For financial reporting purposes, actuaries discount future benefit payments to the present value to determine the annual required contribution necessary to fund those benefits. The discount rate used in this calculation is a particular bone of contention in pension accounting and reporting. The purpose of using a discount rate is to adjust future amounts for the time value of money, that is, estimate the value today of payments made in the future. At present, the discount rate that determines the present value of the projected future benefit payments is based upon the assumed long-term rate of return. This assumed discount rate is based upon the types and mix of investments held by the pension fund and the estimated risk associated with such investments.

Currently, typical state pension plan discount rates vary from 7.5% to 8.5%. As a point of comparison to the private sector, Warren Buffett, CEO of Berkshire Hathaway, projects a 6.9% return on his plan assets. The 1TC identified three alternatives in the choice of the discount rate used to compute the present value of the projected future benefit payments:

* Risk-free rate of return is based upon long-term U.S. Treasury obligations or inflation-protected Treasury securities that essentially are considered to be risk-free.

* Employer's borrowing rate reflects the employer's own credit risk.

* Average return on high-quality municipal bonds is based upon the credit risk derived from high-quality municipal bonds as a group.

The choice of discount rate significantly impacts the balance of the calculated liability and, consequently, the amount that would have to be contributed each year to fund the obligation. All things equal, the lower the discount rate, the larger the present value of the obligation requiring a greater annual contribution. Each of the above alternatives generally would produce a lower discount rate than the average return on long-term assets currently used by states, thereby resulting in a larger present value for the obligation and an increase in the annual required contribution to the pension fund.

Based upon comments received on its Preliminary Views and public hearings held in October 2010, the board tentatively reaffirmed, during its deliberations in December 2010, its view that the discount rate should be a single rate that produces a present value of total projected benefit payments equivalent to what would be obtained by discounting projected benefit payments using 1) the long-term expected rate of return on plan assets to the extent that current and expected future net assets are projected to be sufficient to cover the future benefit pension payments; and 2) a high-quality municipal bond index rate for those payments that are projected to be made beyond the point at which plan net assets available for pension benefits are projected to be depleted.

The 1TC presented two different approaches to assess pension obligations for accounting and financial reporting by employers offering defined benefit pension plans:

* The process by which an employer incurs an obligation to employees for pension benefits; or

* The process by which an employer finances those same pension benefits.

GASB's current standards reflect the second approach within certain parameters because the required measurement of pension costs is essentially based upon the funding of those costs. By contrast, private-sector standards focus upon allocating the full economic cost of the employer's obligation to pay future pension benefits over the period of service of the employee. This amount can differ dramatically from the funding of the obligation.

GASB shifted course to give clear support to the first approach in its June 16, 2010, Preliminary Views. Based upon comments received on its Preliminary Views, and public hearings held in October 2010, the board tentatively reaffirmed, during its deliberations in December 2010:

For accounting and financial reporting purposes, an employer has an obligation to its employees for pension benefits by virtue of the employment exchange between the employer and employees of salaries and benefits for employee services, and this obligation is not satisfied until the defined pension benefits have been paid to the employees or their beneficiaries when due. In the board's view, an employer remains primarily responsible for the portion of its benefit obligation to employees in excess of the plan net assets available for pension benefits and secondarily responsible to the extent that plan assets have been accumulated. ("Pension Accounting and Financial Reporting," Governmental Accounting Standards Series. No. 309-D, December 2010, p. 10) In projecting future pension benefit payments, many estimates and assumptions are factored into the actuarial calculation. The Preliminary Views recommends that the four future changes listed below be incorporated into the projection of benefit payments:

* Automatic cost-of-living adjustments;

* Ad hoc cost-of-living adjustments (unanticipated adjustments);

* Salary increases; and

* Projected service credits (assumptions about length of service).

The existing pension standards allow for a choice of one of six acceptable actuarial cost methods. Critics assert that the number of actuarial cost methods currently permitted and the resulting variation in the financial statement effects of the pension commitment reduces comparability across governments. However, two actuarial methods account for 90% of large public pension plans: 1) the entry-age method is used by approximately 75% of plans, and 2) the projected unit credit method is used by about 15%. The Preliminary Views requires that all governments discount projected benefits to the present value when employees first enter the government's employment (the entry-age method) and attribute that value to employee expected periods of employment as a level percentage of projected payroll. The level-percentage method computes payments so that they equal a constant percentage of projected payroll over time.

Under current standards, the unfunded accrued benefit obligation can be amortized over as many as 30 years. The JTC provided three alternatives to the maximum 30-year amortization period:

* Amortization over the average remaining years of service of employees.

* Amortization of different components of pension cost over different periods, such as benefit increases and actuarial gains and losses, over different amortization periods.

* Immediate recognition of pension costs (i.e., no amortization at all).

In its Preliminary Views, the board chose to 1) amortize the unfunded accrued benefit obligation over the employee's remaining service, and 2) report each year's portion as an expense. This change would significantly increase pension expense because governments tend to have employees with remaining service lives of less than the 30-year maximum amortization period.

The value of plan assets currently is computed by reference to current market value but is adjusted by averaging (smoothing) investment gains and losses over a future period of typically three to five years, This amount is called the actuarial value of assets and is used to measure the plan's funded status (annual required contribution) and unfunded liabilities. The pension obligation less the actuarial value of assets equals the unfunded accrued benefit obligation. Smoothing of investment gains and losses is favored by those concerned that annual gains and losses introduce undesired volatility in the computation of the annual required contribution from year to year.

Those opposed to averaging of gains and losses argue that pension assets and liabilities should be reported at their fair values, and that changes in the balance of the unfunded accrued benefit obligation should be recognized in the period of occurrence. They contend that the effort to avoid volatility by averaging gains and losses provides an inaccurate measure of funded status in any given year; in other words, to critics the avoidance of volatility is less significant than providing the most accurate, current information. GASB disagrees with the critics of smoothing gains or losses because the difference between actual and assumed returns should not be included in expenses, as these amounts are expected to offset each other over time. However, a limit is placed regarding how much would be deferred and not included in the pension expense by using a "corridor" approach. If the deferred outflows or inflows accumulate to an amount that exceeds 15% of the plan's investments, then the excess amount would be reported as an addition to or reduction of expenses immediately.

Making the Burden Clear

Evidence continues to mount that states are headed toward a fiscal crisis in part because many have made pension commitments that appear to be unsustainable in the long run and will likely require drastic revenue increases and the elimination of, or severe reduction in, essential public services. GASB is revisiting governmental accounting and reporting standards for pensions, which appears to be timely in view of the unfunded pension liability component of the widespread state budget shortfalls. GASB's Preliminary Views published June 16, 2010, indicates a move toward requiring the unfunded pension obligation be reported as a liability in the financial statements. Recognizing the liability in the financial statements as opposed to in note disclosures will make explicit the financial burdens that public employee pension benefits place on state governments.

Barbara Apostolou, PhD, CPA, is a professor of accounting, Nicholas G. Apostolou, DBA, CPA, is a visiting professor of accounting, and Richard C. Brooks, PhD, CGFM, is the Dean's Professor of Accounting, all at West Virginia University, Morgantown, W.Va.
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Title Annotation:In Focus; Governmental Accounting Standards Board
Author:Apostolou, Barbara; Apostolou, Nicholas G.; Brooks, Richard C.
Publication:The CPA Journal
Geographic Code:1USA
Date:May 1, 2011
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