From the PensionDialog blog archives
Understanding public pension-related terms and numbers promises to get more confusing with the coming changes from the Governmental Accounting Standards Board (GASB). In this post, we continue the translation, and hopefully education (you can read the first installment here), by asking three of the most basic questions.
To answer them, PensionDialog sat down with Kim Nicholl, a senior vice president and actuary with The Segal Company in Chicago, IL. She and her colleague, Paul Angelo, have written many articles on GASB including most recently for the Society of Actuaries.
PD: There's much talk about this new number – pension expense. What is it and can you explain how it differs from pension funding?
KN: Let's start with pension funding. Pension funding is the basis for determining an annual contribution to the pension plan – in other words, how much the plan sponsor – the governmental entity sponsoring the plan – should pay into the pension trust to cover the future retirement benefits of its current employees.
There are many factors used to determine this amount including number of years of service, expected lifespans, level of salary increases, time-value of money, and more. This is the work of actuaries. The pension funding contribution is deposited into the pension trust, along with employees' contributions, to earn interest. The intention is that the accumulated assets will equal the value of benefits over some time period.
Pension expense refers to the annual change in net pension liability, with certain deferrals depending on the nature of the change. It does not mean what it sounds like: how much needs to be contributed to the plan – that's the pension funding we just discussed. This number is the accountant's determination of the annual cost of the plan to be reported on the employer's income statement.
In other words, each measure reflects the cost of the benefits but for different purposes.
Net pension liability can be confused with the term “unfunded liability,” which many are more familiar with, but a net pension liability has some major differences. The unfunded liability is based upon long-term investment return assumption and actuarial assets which smooth investment gains and losses over a period of years, typically five.
On the other hand, the net pension liability is based on the market value of assets, so there is no smoothing of investment gains and losses.
The net pension liability is also based on a “blended” discount rate, which is determined by projecting the benefit payments and assets for the current membership. If the plan is receiving contributions that are actuarially based, then the “blended” discount rate will most likely be equal to the long-term investment return assumption. If not, the “blended” discount rate is based upon a blend of the long-term investment return assumption and 20-year tax-exempt municipal bond rates.
The net pension expense number will fluctuate from year to year, just like the market goes up and down. Right now, with interest rates low, this number will be very high—much higher than the pension funding number. But, if interest rates go up, net pension expense will go down.
What is most confusing for many people is that looking at just this number, whether it's high or low, does not give a realistic view of the health of the pension fund.
PD: So does having these two numbers – one for pension expense and one for pension funding – help or hurt policy makers or retirement system board members in their decision making processes?
KN: Each of the numbers has a different purpose and each is important.
The pension funding number is important as it establishes the amount of contribution that is made to the pension plan to fund benefits over a set period of time, with the ultimate outcome being the ability of the pension trust to pay benefits.
The pension expense number is reported on the employer's financial statements and could impact the employer's ability to borrow or the rate at which funds are borrowed.
Policy makers and board members need to understand the differences between, and the purpose of, each of these numbers when making their decisions.
PD: What will be the biggest challenge in communicating these two different numbers?
KN: It's difficult to discuss these two different numbers without getting into details that lose most people. But I'd say there are two key messages that are critically important.
The first message is that inevitably some— particularly naysayers—will assume that the pension expense is the “correct” pension funding number. It needs to be clearly explained that pension expense has nothing to do with how much the government has to contribute to the pension trust. It is an accounting number that GASB will require. That's it.
Once that's understood, the pension expense number may be helpful because it provides a basis of comparability across plans. The calculation will be made using a consistent set of rules which provides information we have not had before. People just need to know what it is that they are looking at.
The second message relates to the confused idea that GASB sets funding standards and now there will be none. This is not true.
Nearly all state and local governing bodies have established distinctive statutory, administrative, and procedural rules that govern how retirement benefits are financed. Whether they follow their own advice is another matter, and GASB never had punitive powers to make them do so.
State and local governments are—or should be—continually assessing the effectiveness of their pension funding policies and adhering to them. And, if they have not considered their funding policies recently, now is a good time to do so.