Will New Rules Force California Pensions to Admit the Truth?

We've been thinking about the implications of the new rules the Government Accounting Standards Board is proposing to improve accounting practices and reporting on the part of public pensions nationwide. The rules, which are expected to take effect in 2013, are a potential time bomb for beleaguered pension funds in California: were they forced to assess their unfunded liabilities using risk-free (as opposed to "ridiculously optimistic") returns, they could appear much more troubled than they do now, requiring much higher taxpayer contributions that would sink government budgets statewide. Yet a post on the Calpensions blog yesterday suggests that higher payments may not be in store after all.

According to CalPERS actuaries, the devil is in the details on the new GASB standards. While the new accounting rules will require the use of a risk-free rate of return in the neighborhood of 4% (as opposed to the 7.5%-8% rates that many California public pensions use), this requirement only applies to its unfunded liabilities. In other words, the lower rate is only required for future payments not projected to be covered by investment earnings and contributions. As such, as long as a plan is meeting its actuarially required contributions each year, it can use projected earnings to discount unfunded liabilities away.

In our opinion, this is a little too clever. For one thing, the new standards will call for public pensions to use a five-year period for smoothing in fluctuations in the value of assets. CalPERS currently uses a 15-year period, which allows it a great deal of flexibility in mitigating the estimated effects of events like the 2008-2009 market downturn. Once they're forced to use market returns starting in 2007 in estimating portfolio values, we're guessing that the required contributions to funds like CalPERS and CalSTRS will jump once they realize how little cash they have on hand. Second, many California pensions funds, including CalPERS, CalSTRS, and a number of local-government pensions, are already deeply in the red, even using optimistic assumptions to estimate liabilities. One recent study warned that fully funding the three big state pensions would require California to begin annual payments of $28 billion. While the state may be spared being required by law to make these contributions to pensions, a sizable fraction of this number would still devastate California's perpetually shaky finances.