The User's Perspective
GASB Pension Revamp Introduces Major Improvements
In June 2012, the GASB approved two new Statements that substantially improve how both pension plans and state and local governments report and account for pension benefits. These new Statements will bring about significant enhancements in the usefulness of pension information for making related decisions and for assessing accountability.
Statement No. 68, Accounting and Financial Reporting for Pensions, relates primarily to reporting by governments (employers) that provide pension benefits, and Statement No. 67, Financial Reporting for Pension Plans, relates to reporting by the pension plans that administer those benefits. The new Statements arise from the GASB’s reexamination of its existing pension standards, which is a part of the GASB’s broader effort to examine the effectiveness of its standards on an on-going basis to determine whether they remain well attuned to the evolving government environment and continue to yield essential information.
It should be emphasized up front that these new Statements relate only to accounting and financial reporting—that is, how pension costs and obligations are measured and reported in audited external financial reports. The new pronouncements do not address how governments approach pension plan funding—their policy regarding how much money to contribute to a pension plan each year. While for some time there has been a close relationship between how governments fund pensions and how they account for them, the new Statements decisively shift from a funding-based approach to an accrual accounting-based approach. The GASB crafted the new Statements with the fundamental belief that funding is a policy decision for government officials to address primarily as a part of the government’s budget approval process.
How Pension Benefits Give Rise to a Liability
Generally speaking, state and local government employees receive two types of compensation in return for their years of service—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 during their employment, pensions and other types of deferred compensation are not received until after employment with government has ended.
Once earned by employees, a government has a present obligation to pay the pension 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 that are invested long term for the purpose of making benefit payments when they come due. To the extent that the total pension liability is greater than the value of the assets available in the plan for paying benefits, a government has a net pension liability, and will now report that amount as a liability in its accrual-based financial statements.
What This Means for You
Until now, the difference between a government’s total pension funding obligation and net position available for benefits—often called the unfunded liability—has been disclosed in the notes, but has not appeared on the face of the financial statements. This has resulted in some analysts being uncertain whether to incorporate the unfunded liability into financial ratios that include debt and other long-term liabilities. Recognition in the financial statements, alongside other liabilities such as outstanding bonds, claims and judgments, and long-term leases, emphasizes that the net pension liability is another obligation that governments will be required to fulfill. It is a major step toward getting all significant resources and obligations into the financial statements and more accurately depicting a government’s financial standing.
Measuring the Net Pension Liability
In order to determine the amount to be recognized as the net pension liability, the total pension liability must first be measured. Calculating the total pension liability is a three-step process. It involves projecting future benefits payments for current and former employees and their beneficiaries, discounting the projected future benefit payments to their present value, and allocating the present value to past, present, and future years.
The new Statements carry forward the general current practice of incorporating expectations of future employment-related events (like salary changes and years of continuing employment until retirement) into projections of pension benefit payments. Provisions for automatic cost-of-living adjustments (COLAs), generally included as part of an employment agreement, statute, or ordinance, will continue to be included in projections as well. Ad hoc COLAs, which are made at the discretion of the government, will also be included only if they occur with such regularity that they are substantively automatic.
The process of converting or discounting projected pension benefit payments into their present value requires the assumption of an interest or discount rate. Standards have required governments to apply a discount rate based on the expected future rate of return on the investments of the pension plan over the long term.
Under the new Statements, governments will 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 assets are projected to be greater than the projected benefit payments, governments will discount those projected benefit payments using the long-term expected rate of return. This is appropriate because, unlike other liabilities, pension liabilities are paid off in part with the income generated by long-term investments held in an irrevocable trust, thus reducing the cost of those benefits to the taxpayers.
If the projections of plan assets cease to be greater than projected benefit payments at some point, then from that “crossover point” forward governments will discount projected benefit payments using a municipal borrowing rate—a yield or index rate for tax-exempt, 20-year general obligation bonds rated AA/Aa or higher (or an equivalent rating). This rate reflects that those future benefits payments are not expected to be made in part with the pension plan’s long-term investments held in an irrevocable trust but, rather, with the general resources of the government—like many other long-term liabilities.
Once the projected benefit payments have been discounted to their present value, they are allocated to past, present, and future periods of employee service. Under the new Statements, governments will use the entry age actuarial cost method to allocate present value 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 all of the employees’ expected periods of employment.
What This Means for You
The changes in the new Statements improve the measurement of both components of the net pension liability—the amount of the total pension liability and the value of plan assets (plan net position).
The following changes in how the total pension liability is measured will result in a potentially very different amount than what is currently reported as the “actuarial accrued liability”:
- The potential for including ad hoc COLAs in the projection of benefits will mean the amount of projected future pension benefit payments may be higher for some governments than under the requirements now in place. Consequently, the present value of the future benefit payments and the net pension liability to be reported by those governments will be larger.
- Because current municipal bond index rates are lower than expected returns on long-term investments, governments that discount projected benefit payments using the bond rate will have a higher present value and, consequently, the net pension liability reported will be larger.
- Regarding allocating the present value of projected benefit payments to periods, users of pension information have let the GASB know that making comparisons across governments can be difficult, if not impossible. This is due in part to the fact that governments have been able to select from among six allocation methods, each of which has multiple additional options. The use of a single approach under the new Statements will significantly improve the consistency and comparability of the pension information you will receive.
The unfunded liability calculated under the previous standards is the difference between the actuarial accrued liability and the “actuarial value of assets.” The actuarial value of assets is not the fair value of the plan’s investments as of the measurement date of the liability. Rather, annual changes in the fair value of the plan’s investments are “smoothed” into the actuarial value of assets—in other words, they are added to the actuarial value incrementally, generally over three to five years.
Under the new standards, however, the net pension liability is the difference between the total pension liability and the fair value of the plan’s assets, with no smoothing. The result is a liability measurement that will be more up to date and will better reflect current conditions than under the previous standards.
Calculating the Annual Cost of Pensions
A government’s net pension liability is the difference between its total pension liability and the value of pension plan net position available to pay pension benefits. This amount changes from year to year for a variety of reasons, such as: employees work and earn more benefits; the outstanding liability accrues interest; contributions are made to the plan; actual economic and demographic factors that affect the projection of benefit payments differ from what was assumed in actuarial calculations (“experience” gains and losses); changes are made in those assumptions; the features of pension benefits are changed (often, they are enhanced); and the value of plan investments changes. An important issue is when to recognize these increases and decreases in the net pension liability as a cost of a government’s operations—as pension expenses in the accrual-based financial statements.
Under the new requirements set forth by the GASB, 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:
- Benefits earned each year
- Interest on the total pension liability
- Enhancements and other changes in benefits
- Projected earnings on plan investments (which reduce expense)
- Changes in plan assets other than from investments.
The effects on the total pension liability of (a) selecting different economic and demographic assumptions and (b) experience gains and losses will be recognized initially as deferred outflows of resources or deferred inflows of resources and then introduced into the expense calculation systematically and rationally over the average remaining years of employment of all employees (active employees and inactive employees, including retirees), beginning in the year in which they occur.
The effect of differences between the expected earnings on plan investments and actual experience will be recognized as deferred outflows of resources or deferred inflows of resources and included in expense in a systematic and rational manner over a five-year closed period, beginning in the year in which they occur.
What This Means for You
The new pension Statements more closely link the recognition of pension expense with the period over which pension benefits will actually be earned—as employees provide services. As a result, most governments will recognize pension expenses more quickly than they do at present. The full impact of changes in pension benefit features would be recognized as expense immediately, for example, rather than gradually over up to 30 years as has been allowed. The period over which deferred amounts will be included in pension expense—the average remaining years of employment—is likely to be significantly shorter than 30 years as well. Previously, changes in the value of plan investments often were introduced into the actuarial accrued liability over a three- to five-year period (as described earlier) and then recognized as part of expense over a period up to 30 years. The new five-year closed period, which is intended to reflect a typical market cycle, is clearly a considerably quicker introduction into pension expense.
Cost-Sharing Multiple-Employer Pension Plans
In cost-sharing multiple-employer plans, governments share the costs of providing benefits and administering the plan, and pool 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 only in the cost-sharing pension plan’s own financial statements for all of the participating governments combined. However, GASB research has demonstrated that the needs of the users of information about cost-sharing plans and their participating governments are essentially the same as the needs of people interested in governments participating in single-employer pension plans and agent multiple-employer pension plans (those in which separate accounts are kept for each participating government).
Accordingly, in developing the new Statements, the GASB determined it is important that users have equivalent information about cost-sharing plans and their participating governments so that they are able to make the same types of decisions as they are about governments participating in single-employer and agent multiple-employer plans.
The new Statements require that cost-sharing governments report a net pension liability, pension expense, and pension-related deferred inflows and outflows of resources based on each participating employer’s proportionate share of the collective amounts for all the governments in the plan.
What This Means for You
Under the new Statements, you will have access to essentially the same pension information about individual governments irrespective of the type of plan they participate in. This represents a major advance in transparency and users’ ability to make comparisons from government to government.
Note Disclosures and Required Supplementary Information
The notes and other information that governments provide to accompany their reported financial statement pension amounts are necessary to allow users to gain a full understanding of those government’s financial picture as it relates to pensions. The new Statements contain requirements for disclosing information in the notes to the financial statements and presenting required supplementary information (RSI) following the notes. Governments participating in a defined benefit pension plan will include the following information in their note disclosures:
- Descriptions of the plan and benefits provided
- Significant assumptions employed in the measurement of the net pension liability
- Descriptions of benefit changes and changes in assumptions
- Assumptions related to the discount rate, including a sensitivity analysis of the impact on the net pension liability of a 1 percentage point increase and decrease in the discount rate
- Net pension liability, pension-related deferred outflows of resources and deferred inflows of resources, and pension expense
Governments in single and agent plans also will disclose, for the current period, the beginning and ending balances of the net pension liability, and the effects of changes during the period (such as the effects of service cost, benefit changes, and actual investment earnings).
Single and agent governments will also present RSI schedules with the following information for each of the past 10 years (generally on a prospective basis):
- The beginning and ending balances of the total pension liability, the plan’s net position, and the net pension liability, and their components (the same information as the single-year note disclosure described above, but for the past 10 years)
- Total pension liability, the plan’s net position, the net pension liability, a ratio of the plan’s net position to the total pension liability, the covered-employee payroll, and a ratio of the net pension liability as a percentage of the covered-employee payroll. If there is a special funding situation, as discussed below, the net pension liability will be divided between the amount associated with the employer and the amount associated with the nonnemployer entity.
If a single, agent, or cost-sharing government has an actuarially determined annual pension contribution (or, if not actuarially determined, then a statutorily or contractually determined contribution), it is also required to present an RSI schedule with the following information for each of the past 10 years (generally on a prospective basis): (1) the actuarially (statutorily or contractually) determined annual pension contribution; (2) the amount of employer contribution actually made; (3) the difference between 1 and 2; (4) covered-employee payroll; and (5) a ratio of 2 divided by 4.
The new Statements also require governments to present notes to the RSI schedules regarding factors that significantly affect the trends in the schedules. Single and agent employers also should present significant assumptions if not disclosed elsewhere.
What This Means for You
Under the new pension Statements, you will have access to significantly enhanced information about how governments measure their pension liabilities and expenses. The information required to be disclosed under the new Statements will allow users to determine what has driven changes in the net pension liability in the period—was it was factors beyond a government’s control, such as the economic environment, or within a government’s control, such as retroactive changes in benefit features?
The 10-year RSI schedules will help users to understand not just where a government stands now regarding its pension obligations, but how it got there. That historical perspective is an important aspect of evaluating government finances.
Special Funding Situations
Special funding situations are circumstances in which (a) a nonemployer contributing entity (such as a state government) is legally responsible for contributions directly to a pension plan for the employees of a government (such as school districts located within that state) and (b) one or both of the following is true:
- The nonemployer is the only entity with a legal obligation to make contributions directly to the plan
- The amount of the contributions for which the nonemployer is legally responsible is not dependent upon one or more events unrelated to the pensions.
In a special funding situation, the nonemployer has essentially assumed a portion of the employer’s pension obligation as its own. Consequently, if the nonemployer is a government, it will recognize in its own financial statements its proportionate share of the employer’s net pension liability, pension expense, and deferrals.
The government benefitting from the nonemployer’s contributions in a special funding situation will calculate its net pension liability, pension expense, and deferrals prior to the nonemployer government’s support in certain cases, and will disclose those amounts. However, it will recognize in the financial statements only its proportionate share, net of the portion assumed by the nonemployer contributing entity.
What This Means for You
At present, it may be difficult for you to understand the extent to which governments are obligated to make contributions to another government’s pension plans. This new requirement will allow users to gain a better understanding of all of the liabilities and expenses a government has incurred for pensions—both for its own employees and the employees of other governments.
Defined Contribution Pensions
The provisions discussed thus far related to defined benefit pensions—those that specify the 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 pensions stipulate only the amounts to be contributed to an employee’s account each year, and not the benefits employees will receive after the end of their employment.
The new Statements generally carry forward the existing requirements regarding defined contribution plans. Participating governments will report an expense equal to the amount they are required to contribute for employee service each year and a liability, if any, 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.
Statement 67 will take effect for pension plans in fiscal years beginning after June 15, 2013 (June 30, 2014, and later financial reports). Statement 68 will take effect for employers and governmental nonemployer contributing entities in fiscal years beginning after June 15, 2014 (June 30, 2015, and later financial reports). However, the GASB encourages plans and governments to implement the new standards earlier.