Rough road ahead for 'pension smoothing'

Construction workers pour concrete as part of the Caltrans Bridge expansion project to widen State Route 76 in San Diego County, Calif.
Sam Hodgson/Bloomberg | Getty Images
Construction workers pour concrete as part of the Caltrans Bridge expansion project to widen State Route 76 in San Diego County, Calif.

Next time you drive by a road crew fixing up your local highway, you can thank a government accounting gimmick known as "pension smoothing."

It's one of the biggest rabbits Congress has pulled out of its budget hat in a long time.

With Congress and the White House unwilling to raise the gasoline tax to bail out a Highway Trust Fund running on empty, President Barack Obama last week signed a stop-gap funding bill designed to keep the fund solvent until next summer.

By letting companies defer tens of billions in pension fund contributions, the government expects those companies to report bigger profits—and pay higher taxes.

But—because companies will have to make up those payments in the future—the law simply kicks the highway funding can down the road.

Here's how it works:

What, exactly, are pensions allowed to "smooth"?

Pension fund managers have to make very long-term projections and assumptions when they try to figure out how much money they'll need to set aside today to pay for a given worker's retirement decades in the future. A lot depends on the ups and downs of interest rates over those decades.

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Interest rates affect those projections several ways, starting with the investment returns the pension fund can expect on the money it sets aside. Interest rates also affect the way pension accountants estimate the future cost of writing all those retirement checks. Accountants look at something called the "time value of money" to compare how a given amount of money today will be worth decades in the future.

This may be more than you want know, but the formula goes like this:

Future Value = Today's Value times (1 + i)^n, where i is the interest rate per period and n is the number of periods.)

You're right. That's more than I wanted to know. So what is getting smoothed?

While interest rates have always moved higher and lower, they've been pinned at unprecedented low levels—near zero—since the financial collapse of 2008. That's had the effect of boosting the amounts that pension funds have to set aside—and cut the returns they earn on their investments.

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So Congress changed the accounting rules to let companies "smooth" out the sharp drop in rates by using long-term averages.

The change makes a big difference in how much money companies have to set aside, resulting in what amounts to a $51 billion corporate piggy bank. That's how much Moody's figures companies will save in lower pension fund contributions thanks to the road repair bill.

"In effect, it allows (companies) to borrow cash from their pension plans," Moody's analyst Wesley Smith wrote in an analysis of the bill's impact.

But it also means those companies will pay more corporate taxes, right?

Yes, but only for the next six years. After that, they'll have to make up the contributions they deferred, which will lower those corporate taxes, turning this short-term revenue boost into a drain on the Treasury. Congress, in effect, used another time value of money trick: borrowing money from future income to pay today's bills.

According to an analysis by the Joint Committee on Taxation, the pensions smoothing provision will generate $19 billion in new revenues through 2020. And then it will cost the government roughly $12.5 billion through 2024.

What happens to the pension funds? Are they in danger of going broke too?

Overall, U.S. pension funds have been gradually recovering from the financial meltdown of 2008, which left a giant crater in their investment balances. That shortfall has gradually receded as rising stock prices and a bottoming in interest rates have helped them rebuild their portfolios.

But the largest 100 U.S. pension plans were still underfunded to the tune of $122.3 billion in 2013, down from $301.6 billion in 2012, according to a survey by the newspaper Pensions & Investments.

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Barring another financial calamity—or congressional accounting gimmick—those funds are moving back toward being fully funded. But the pension smoothing gimmick only delays that process.

So what happens to highway funding when this short-term patch runs out?

One logical solution would be to raise the gasoline tax that is paid into the Highway Trust Fund. The fund has been losing ground for two decades because the tax is not indexed to inflation. Declining fuel consumption has also reduced tax receipts and left the federal funding for road repair and construction running on empty.

But don't expect Congress to approve such a measure. This is the fifth time in the last five years that Congress has patched the road repair fund with a grab bag of budget tricks designed to avoid raising the gas tax.

The latest patch is expected to run out by next summer.

By CNBC's John Schoen