New pension rules will nearly double debt on Connecticut’s balance sheet

Connecticut owes its employees billions of dollars in future pension benefits, a fact that is currently hidden in the footnotes of its financial reports, but a few changes on the way will make these debts more transparent.

In addition to the money invested in the state’s pension funds, Connecticut owes employees about $25 billion in future pensions. Adding this deficit to the balance sheet will nearly double the state’s liabilities from $32 billion to $57 billion.

Connecticut already has more liabilities than assets. The state’s net assets will fall from negative $9.3 billion to negative $34.3 billion.

That means if the state liquidated its assets and tried to pay off its debts, each resident would be left with a $9,800 bill to pay.

The Governmental Accounting Standards Board, a nonprofit based in Norwalk, Conn., sets the rules for government accounting. In July, GASB proposed changes to pension accounting with the hope they will take effect next summer.

GASB officials emphasize the new rules won’t change how much states and cities owe – or how much they have to contribute to their plans – but they will increase transparency and uniformity.

In addition to moving pension liabilities onto the balance sheet, the rules will require states and municipalities to use similar accounting and actuarial methods to calculate these liabilities.

“My office supports these draft standards because they will significantly strengthen pension fund transparency in Connecticut and nationwide,” said Comptroller Kevin Lembo.

“These draft changes would have no immediate material budget impact, but will rightly require states to reflect their full accumulated unfunded pension liability and they will establish uniform reporting standards for all states. This consistency will facilitate state-by-state comparisons – and provide policy makers with more accurate information about the implications of poor pension funding standards.”

The changes will also change the way actuaries calculate Connecticut’s annual contribution. Instead of spreading pension costs over more than 20 years, the payments will be based on when the average state employee will retire.

If the average state employee will retire in 12 years, for example, Connecticut will have only 12 years to fully fund its pensions.

Despite the rule changes, Connecticut will still be free to ignore actuarial recommendations. If Gov. Dannel Malloy’s plan to implement Generally Accepted Accounting Principles – or GAAP – goes into effect, underfunding pensions will become more difficult.

The transition to GAAP will cost money the state doesn’t have and Malloy’s administration has used incompatible accounting methods to budget the recent income tax increases. Given the delays to implementing GAAP, it could take a while before Connecticut feels the full impact of the new GASB rules.

GASB first mandated the reporting of pension liabilities in 1997. It more recently required governments to report their retiree health care liabilities, known as other post-employment benefits or OPEB.

The deadline for public comments on the proposal is Oct. 14. The board expects to finalize the changes by June 15, 2012.

State pensions around the country, according to the Pew Center on the States, have $2.28 trillion in assets set aside to pay $2.94 trillion in promised benefits, leaving an unfunded liability of $660 billion.

Pew collects the information reported by state governments. Many financial economists question the assumptions used by states, saying they drastically underreport their liabilities.

Joshua Rauh, an associate professor of finance at the Kellogg School of Management at Northwestern University, estimates the total unfunded liability of all 50 states is actually $2.5 trillion or four times the Pew estimate.

Rauh estimates Connecticut’s unfunded liability would nearly double from a reported $25 billion to $45 billion using his calculation method.

The difference between Rauh’s estimate and the numbers reported by state governments like Connecticut is the discount rate.

Connecticut expects a return of 8.5 or 8.25 percent on its pension assets. The state uses these assumptions to determine how much future benefits will cost in terms of today’s dollars.

Financial economists like Rauh say there is no connection between the expected rate of return and the value of a liability. Instead, they argue, the value of a liability is based on the likelihood that it will be paid.

Since pension benefits are guaranteed, the discount rate should be one that can be guaranteed as well. This rate, known as the risk-free rate, is usually approximated by U.S. Treasuries.

The new GASB rules will continue to allow governments to publish their unfunded liability based on their chosen discount rate, but they will have to also calculate their liability based on that discount rate plus 1 percent and minus 1 percent.

These calculations will show how sensitive pension funds are to their chosen discount rate.

According to Rauh, a 1 percent change in the discount rate is roughly equal to a 15 percent change in liabilities for most pension plans.

In Connecticut’s case, using the 15 percent guideline, if the state’s discount rate were 1 percent lower, the state would owe $28.75 billion or $3.75 billion more than currently reported.

A higher discount rate would reduce the liability by about $3.75 billion, down to $21.75 billion.

In May, the Congressional Budget Office estimated that using a discount rate of 4 percent to calculate unfunded pension liabilities – rather than the more common 8 percent – would more than quadruple the total unfunded liability for all American states and cities.

By pursuing higher returns, pension funds have to take on risk. In the stock market, Rauh said, “there is a distribution of possible outcomes.”

“The higher the return you target, the greater the chance you’re going to fall short,” he said.

Rauh said it can make sense for people to invest their retirement savings in the stock market, but unlike governments they are able to reduce their spending if their investments don’t meet expectations.

In the case of state pension plans, Rauh said, taxpayers are “providing a tremendous amount of downside insurance.”

Read more: State and local pension accounting takes a step toward transparency