As cities and states struggle with ballooning retirement costs, accounting rule makers started an ambitious project Thursday to force state and local governments to issue better numbers and reveal the true cost of their pension promises.
The effort is likely to take years, and to be contentious from beginning to end. In the meantime, more places are likely to end up like Vallejo, Calif., which declared bankruptcy earlier this year after locking itself in to paying police officers and firefighters benefits so costly that they swamped the city’s finances.
No one would knowingly create a pension plan like that. But under the current accounting rules for governments, officials can get in over their heads rather easily, without knowing it, because the current methods can understate the cost of benefits, making them look affordable even when they are not. The hidden costs can then compound over time and become crushing.
In a public meeting here on Thursday, the Governmental Accounting Standards Board began the project by tackling just this issue: whether the accounting rules must be changed to stop systematically undercounting pension costs. Proponents of sweeping change say the rules now give rise to bad numbers everywhere — not just when governments are cutting corners or making mistakes, but even when the plans are run responsibly.
“Mispricing is the issue,” Jeremy Gold, an actuary and economist from New York, told the accounting board. “Good accounting will expose the fact that this generation has borrowed from the next generation. I think that’s valuable information.”
Governments pensions typically cannot be rescinded because they are protected by law and state constitutions, even if they prove unaffordable — hence Vallejo’s bankruptcy. In some places with rising pension costs, like Illinois, New Jersey and Pennsylvania, officials are weighing sales of turnpikes, airports and parking garages to help generate cash. The problems are especially acute in places that have also promised to provide comprehensive health benefits for retirees.
Even mogul-studded East Hampton had to be bailed out by New York State last month after its employee benefit costs went out of control. The New York State comptroller is now auditing East Hampton’s books to determine exactly what went awry.
But the New York State comptroller’s office is also being investigated for possible pension misconduct. Until recently, the New York State pension fund used an unusual accounting method that made it look fully funded at all times, even when there were big investment losses. Although the method was allowed under the current rules, it appears to have papered over questions of whether money managers were being hired on the basis of political connections rather than expertise. The New York State comptroller is sole trustee of the pension fund.
A report recently prepared by the accounting board’s staff shows a variety of ways in which cities and states have been losing track of their pension obligations, even as they issued detailed annual statements. The report said, for instance, that many places had given retirees retroactive pension increases without recognizing the added cost. The practice may be unsound, but the current accounting rules do not proscribe it.
The report also said that nearly one-fourth of large public pension plans had used “skim funds” — accounting devices that allow officials to declare certain investment income to be “excess,” skim it out of the pension fund, and spend it on other things. Skim funds are not allowed in the private sector.
New Jersey and San Diego had versions of skim funds, and won “excellence in accounting” awards from the Government Finance Officers Association for many years while operating them. Each ended up with far less money in its pension fund than its books showed. The Securities and Exchange Commission found that San Diego had committed securities fraud by overstating the soundness of its pension fund; it is still investigating New Jersey.
In its report, the accounting board’s staff said that such practices suggested weaknesses in the current rules, and recommended that the board address them. But the researchers also found many instances in which governments were simply breaking the rules.
For instance, the rules now call for pension deficits to be closed over 30 years, in a process called amortization. But the researchers found that some places have begun using 50-year and even 100-year amortization schedules. Others use the required 30-year schedule, but restart the 30-year period at Year 1 every year.
Although the G.A.S.B. can write tighter accounting rules, it has no authority to crack down on governments that go astray. Its sister rule-making body, the Financial Accounting Standards Board, writes rules for companies and is backed up by the S.E.C.
This question of whether government accounting is essentially flawed has become the subject of intense debate among actuaries, and the accounting board heard from outspoken proponents of each side.
Mr. Gold told the board Thursday that traditional actuarial methods conflicted with modern economic theory, by suggesting that government pension funds can achieve high investment returns without actually bearing the associated risk.
Paul Angelo, an actuary from the Segal Company in San Francisco, took the opposite point of view. He said that modern pricing theories were poorly suited to measuring governmental pensions, because the theories were market-based, and while corporations may be creatures of the financial markets, governments are not.
Mr. Angelo also expressed concern that if the accounting rules changed, governments would feel compelled to change their pension contribution rates, and their investment practices as well. These changes are so daunting and potentially costly that some governments are likely to stop offering pensions altogether and start giving their workers inferior benefits.
“This is not a result to be desired,” he said.
The accounting board did not indicate whether members found one or the other argument more compelling.