Yesterday the Governmental Accounting Standards Board (GASB) approved new standards for public employee pension accounting. The new standards will not directly affect pension liabilities; rather, they make the true nature of those liabilities more clear.

As GASB’s chairman said of the changes,

The new standards will improve the way state and local governments report their pension liabilities and expenses, resulting in a more faithful representation of the full impact of those obligations.

Under the new standards, governments providing defined benefit pensions will “recognize their long-term obligation for pension benefits as a liability for the first time, and to more comprehensively and comparably measure the annual costs of pension benefits.” Additionally, there will be “immediate recognition of more pension expense than is currently required.” As a Wall Street Journal article notes, “currently, underfunding is disclosed only in the footnotes to the government’s financial statements.”

As we have discussed before, governments discount future benefit costs using an assumed rate of return on investment (typically about 8 percent). They expect that future benefits will be covered by those investment returns, lessening the need for contributions. The unfunded liability of a plan is sensitive to the discount rate used.

Under the new GASB standards, changes are made to the discount rate. For years in which the plan is expected to be able to pay the pensions of current employees and retirees, the discount rate will be the long-term expected rate of return (about 8 percent). For other years, the discount rate will be “a yield or index rate on tax-exempt 20-year, AA-or-higher rated municipal bonds” (under 5 percent).

Also, governments use the actuarial method of accounting in valuing assets and liabilities. Washington smooths gains and losses over an eight-year period. Under the new standards, when reporting, governments will have to use the market value of plan assets as of that date.

These provisions “are effective for fiscal years beginning after June 15, 2014.” For Washington, they take effect in FY 2015 (which begins July 1, 2014). The complete versions of the new standards will not be released until August.

Earlier this month, the Center for Retirement Research (CRR) at Boston College released a report considering the possible effects of the proposed changes. It notes:

Most economists contend that the discount rate should reflect the risk associated with the liabilities and, given that benefits are guaranteed under most state laws, the appropriate discount factor is closer to the riskless rate.

The paper concludes that

employers and plan administrators should be prepared for funded ratios reported in their financial statements to decline sharply under the new rules. But accounting changes do not alter the underlying fundamentals.

The report looks mainly at the changes to the discount rate and to the practice of smoothing market gains and losses over a period of time. The paper shows that using the market valuation instead of actuarial valuation reduces the funded ratio, and making the discounting changes reduces it even further.

The report uses 2010 data for 126 public plans, and if the new standards had been in effect, the funded ratios overall would have gone from 76 percent to 57 percent. The report includes the numbers for individual plans; the table below summarizes the results for plans in Washington.

During the legislative session this year, Washington made some changes in the discount rate used (along with other pension reforms). Lawmakers approved a plan to reduce the assumed rate of return from 8 percent to 7.9 percent for 2013–15, 7.8 percent for 2015–17, and 7.7 percent for 2017–19.

It is important to stress that the new GASB standards do not, as CRR notes, “alter the underlying fundamentals”—they merely change how they are reported. Josh Barro argues that “better financial reporting is a good thing, but it’s not likely to spur governments to reform their pension systems.” That’s because “what really moves taxpayers and pensioners to demand reform is when changes in liabilities translate to changes in cash flows.” And that doesn’t always happen.