Future cost versus market value: the great debate over pension valuation.

• Author: Rizzo, James J.

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For several years, the actuarial community has debated the proper way to calculate the value of pension obligations. This had been settled in the actuarial profession's worldview many years ago. However, over the last decade or two, a branch of academics and research called financial economics has influenced corporate finance, including the effects pension plans have on corporate financial reporting and stock values. More recently, advocates of financial economics have turned their attention to conforming public pensions to their worldview.

Proponents of these two worldviews disagree on the way pension liabilities should be measured and accounted for. Under conventional practice, public-sector retirement plans have calculated their liabilities and the contributions that will be required to fund those liabilities based on what the plan's assets are expected to earn over a fairly long timeframe (more than 50 years). This view focuses on the current and long-term expected cost to taxpayers for funding the plan. According to financial economics, a pension liability should be valued at the current market or settlement value, as if it were a marketable instrument or as if the liability were settled with an insurance company in a plan termination. The conventional approach to accounting and funding is based on a long term funding view of the pension obligation, while the financial economics approach is based on a snapshot benefit accrual view.

Focusing on the cost of funding the plan is different from focusing on the value of the benefits in the financial markets; in fact, the two worldviews are polar opposites in several ways. Government finance officers need to make sense of these broad perspectives, which means looking at what is right and wrong with the current approach, and whether the financial economics approach might lead to any unintended consequences.

ONGOING DISCUSSION

Until now, this discussion has resembled a family feud: Actuaries arguing among themselves over actuarial methods, using actuarial and economics terminology about esoteric pension finance matters--not unlike debates among medieval theologians over how many angels could dance on the head of a pin.

In the past year or so, however, the debate has boiled over, spilling into the mainstream. It is no longer brewing just within actuarial circles, no longer limited to corporate finance evaluations by Wall Street's stock and bond analysts, and no longer confined to the halls of academia or scholarly papers. The debate between the two worldviews--those who think conventional methods capture the essence of the obligation and those who think financial economics will improve public-sector pension accounting--now touches almost every state and local government and its respective pension and other postemployment benefit (OPEB) plans.

Certain large public-sector retirement systems have now weighed in. Large and influential public-sector trade associations have staked out their positions. Media outlets have splashed attention-getting headlines and articles on the topic. And in April 2008, after a lengthy research period, the Governmental Accounting Standards Board (GASB) embarked on a major project to reexamine accounting and financial reporting for postemployment benefits (including GASB Statement No. 25, Financial Reporting for Defined Benefit Pension Plans and Note Disclosures for Defined Contribution Plans; GASB Statement No. 27, Accounting for Pensions by State and Local Governmental Employers; GASB Statement No. 43, Financial Reporting for Postemployment Benefit Plans Other Than Pension Plans; GASB Statement No. 45, Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pensions; and GASB Statement No. 50, Pension Disclosures--an Amendment of GASB Statements No. 25 and No. 27). Recently, the GASB issued an invitation to comment on this topic, soliciting input from preparers and users of financial statements before the agency issues a preliminary views document or an exposure draft. The invitation to comment presents background commentary and explanations of the two competing viewpoints, along with other related issues. (1)

Actually, this debate is not new to governmental accounting. During the years leading up to the issuance of GASB Statement No. 25 and Statement No. 27 in November of 1994, the GASB wrestled with this matter in great detail, as did many other organizations. Now, a number of factors have converged to bring the debate to the front burner.

The positions being staked out by interested parties fall within a spectrum. One side seeks to maintain the conventional approach, with or without certain changes, and the other seeks to adopt a more or less financial economics approach. The financial economics approach constitutes a tectonic shift in philosophy from the status quo. The following descriptions of these two positions are necessarily painted with a broad brush and...