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Early Christians felt convinced, mere years after the death of Christ, that the second coming was imminent. They did not know when it would occur, but all believed it would happen soon. It was only a matter of time.
Two millennia later, the public pension industry faces a similar inevitability. The Governmental Accounting Standards Board (GASB) permits US public pension plans to value their liabilities using a discount rate of their own selection—typically an assumed rate of return of about 8%. Opponents argue that this status quo is unsustainable; no public pension comes close to earning such returns on a consistent basis, they assert, and GASB is far out of step with international funds and US corporate pension plans in regard to their accounting procedures. Analysts contend that a change to mark-to-market valuation of public pension liabilities is inescapable. It is only a matter of time.
The shift to mark-to-market valuation would be consequential. This summer, the Pew Center on the States released a study that valued the funding shortfall of state pension funds alone at $1.38 trillion in fiscal 2010. Although fiscal 2010 was an annus horribilis for institutional investors, that figure reflects the liabilities calculated at inflated discount rates. Valuing liabilities at a riskless discount rate of 3%, and adding county and municipal pension funds into the mix, would have produced a far larger number. The true enormity of unfunded public pension liabilities in this country would come into view after the implementation of mark-to-market liability valuation. Steep tax hikes, savage benefit cuts to workers and the already retired—such would be the new normal. It is this reckoning that has kept politicians and public fund executives awake at night for years. And it is one reason why GASB has heretofore dragged its feet regarding tightening up accounting standards.
Yet one group would likely prosper from such a change—asset managers, specifically those selling liability-driven investing (LDI) strategies. The hundreds of billions of public pension dollars, which for generations flowed toward risky assets in the vain hope of keeping up with liabilities, would be forced by the accounting change to migrate into duration-linked bonds. After a switch to mark-to-market valuations, “public plans would have to cut back on risk taking,” says Michael Peskin, CEO of Hudson Pilot, a pension plan and endowment advisory firm. “Chasing high returns in a sub 3% interest rate environment exposes taxpayers to a ridiculous amount of risk.”
The large equity managers, but also alternative firms, would all would see massive outflows, and LDI shops and the purveyors of fixed income would suddenly become the centers of the asset management universe. It is only a matter of time.
Depending on your perspective, GASB has either moved toward that reality or is continuing to resist actuarial gravity. This summer, GASB passed two new accounting standards—statements 67 and 68—that will come into effect for fiscal 2014 and 2015, respectively. The principal upshot: “Insufficiently” funded plans will have to use a lower discount rate to calculate their liabilities, but plans above that threshold can continue to use whatever metric they see fit.
Do these changes presage a move toward mark-to-market valuation? Unlikely, says Robert North, the chief actuary for the New York City Retirement Systems. “GASB was given an opportunity to move to mark-to-market and they chose not to,” says North. “I personally think it is off the table for quite some time. Given that they have gone through all this work to come up with new rules, I do not think it is coming out of GASB in the foreseeable future.”
Others are more sanguine, perhaps expectedly so. Aaron Meder, the head of US pension solutions for Legal & General Investment Management America, thinks that the new GASB rules are small but significant steps in the direction of mark-to-market liability valuation. “I think that GASB rules represent a big change for them,” he says. “They show a clear shift in how GASB is thinking about this.” He points to the example of US corporate plans, which began to move toward LDI three to five years after the 2006 Pension Protection Act, which mandated mark-to-market liability valuations. As a result of the new GASB rules, Meder suggests, public pensions could start looking at beginning the LDI educational process today and implementing LDI around 2016 or 2017. He acknowledges that there may be some of wishful thinking at work here: “When they do, it will be certainly good for Legal and General’s business,” he says.
Meder and others may have to wait. For its part, GASB has signaled that no more regulatory changes are forthcoming: “The GASB currently does not have any plans to revisit these two pension accounting standards in the near future,” says John Pappas, an agency spokesman.
So what will it take to crack open Pandora’s Box? Even the bullish suspect that something ugly will have to happen. “Things typically do not get fixed until after they break,” says Legal & General’s Meder. “Judging by the size of the funding deficit, the public pension system may not be working, but until it becomes officially broken there probably will not be the necessary regulatory changes.” To spur some action, “a large public fund may need to run out of money.”
Indeed, analysts agree that that eventuality is approaching inevitability. But outside of speculation, it is impossible to know when public pension plans will be required to value liabilities on a mark-to-market basis. One thing, however, is certain: it will not take two thousand years.
—Benjamin Ruffel
