Eric S. Berman, MSA, CPA, CGMA, is principal of Brown Armstrong Accountancy Corporation and can be reached at eberman@bacpas.com.

Municipal government is in the midst of profound economic change. Some of this change may be attributable to the cost of defined benefit post-employment benefit programs, which have never been the most transparent operations. Yet costs for defined benefit post-employment benefit programs seem to rise annually unabated. With some municipal governments either in or on the verge of bankruptcy, due in some cases to the spiraling costs of post-employment benefits, the release of new defined benefit pension standards by the Governmental Accounting Standards Board (GASB) could not have come at a better time or a worse time, depending on one’s point of view.

How important are these new provisions? California State Controller John Chiang remarked in a speech to the Association of Government Accountants professional development conference on Aug. 1, 2012, that California’s defined benefit pension issues pose the second biggest challenge in the state for the foreseeable future, behind the spiraling costs of post-employment health care and ahead of invigorating best practices for local governments.

Key Elements of the New Standards

Important aspects of the new standards for pensions (and in a few years, other post-employment benefits including health care) include:

• The actuarially required contribution (ARC) becomes a decision point for funding rather than an accounting element that defines benefit expense. GASB defines the ARC as “the employer’s required contributions for the year, calculated in accordance with certain parameters.” The traditional view of the ARC is that it drives pension costs. However, the ARC bears only a minimal relationship to an employee’s work in exchange for future defined benefits. The ARC will now be a measure of the amount of contributions, rather than benefit expense.
• Because the ARC will not be a measure of pension expense, the annual expense will be derived largely from the sum total of an employee’s pensionable work in exchange for benefits that they have earned. The sum total of these expenses, adjusted for demographics and other core assumptions that are embedded in the pension plan of a local government, will now be used to calculate the total pension liability, which leads to the next and perhaps most important point.
• For the first time, the net pension liability will be shown on the face of every government’s financial statements. The net pension liability is the sum of the total pension liability less the total amount held in trust for pension benefits. If the total pension liability is less than the assets, then for those few governments that are well-funded this number will indeed be a net asset.
• For governments that are members of cost-sharing plans (including county retirement systems) or agent-multiple employer plans (including large statewide systems like the California Public Employees’ Retirement System, also known as CalPERS), their portion of a net pension liability, expense and other accounting elements will also be shown on their financial statements for the first time.
• One of the more volatile and talked-about elements of pension costs is the discount or interest rate used in determining the total pension liability. This will now be a calculation rather than an estimate. The rate will be a measure of investment return coupled with a 20-year AA municipal bond index rate, depending on when a pension fund is projected to run out of funds to pay for benefits. That point in the future — known as the crossover date — will become very important. The further that day is from today, the higher the discount rate will tend to be and the lower the liability may tend to be, all other assumptions being equal.

Many other aspects of the new standards will result in differing effects for each government. Pension plans will still administer the pension programs for many governments, including the investment and actuarial calculations. But information will now have to be transmitted to municipal governments to be recorded in their financial statements on a timely basis.

Local Officials’ Perspectives on the Changes

Following a discussion about some of these changes, Vice Mayor Margaret McAustin of the City of Pasadena remarked that, in general, she likes the changes as they will show more transparent information for her decision-maker colleagues and constituents. She indicated that the city will not panic over a potentially large liability that it will be reporting for the first time. Rather, she believes the clearer reporting of future pension obligations will help the city come together around the issue and continue to deal conservatively with this economic reality through communication and shared understanding of the true costs of defined benefit plans. Vice Mayor McAustin believes that the new information will more accurately report the costs of a defined benefit pension, allowing for better decision-making in the future.

Mary Lewis, chief financial officer of the San Diego City Employees’ Retirement System, believes that the new standards are a crucial step that is a natural progression in the city’s continuing pension reform. She indicates that communication will be crucial and agrees with Vice Mayor McAustin that the new standards will bring fiscal reality and transparency to defined benefit pensions. As Lewis was making these observations, a judge in the City of San Diego denied an injunction sought by organized labor to delay the implementation of a voter-mandated proposition to change the city’s pension structure. The proposition requires new non-police hires to be members of a defined contribution plan rather than the city’s defined benefit pension plan. The City of San Jose passed a similar measure as well.

Looking at the Potential Impacts

The future effects of these changes are largely a matter of speculation. For most governments with defined benefit plans, the result may be a large negative net position. But this number’s impact for many governments may depend on what a bond analyst decides. Rating agencies are highly in favor of this transparency and are already adjusting models to present ratings in the future.

Some observers have indicated that the new standards could be “the death of defined benefit pensions” in the future. This could not be further from the truth. Rather, the new standards may usher in an era of better decision-making with regard to post-employment benefits.

This article appears in the November 2012 issue of Western City
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