If you are a homeowner, you have probably estimated your net worth. You know the balance left on your mortgage, and you have a sense of the market value of your home. Perhaps you also have some financial assets. If you are very cautious, most of these are in cash or bonds. If you prefer more risk, you own stocks. But whether your savings is in cash, bonds or stocks does not affect your net worth today, or the reported balance on your debts.
Unless, that is, you are a public pension system following Government Accounting Standards Board (GASB) rules. GASB has recently held hearings on proposed changes to their public pension accounting standards. Unfortunately, the changes under discussion maintain the flawed framework. State and local governments will still be able to hide trillions of dollars of borrowing in the form of improperly valued pension promises.
Under current standards, state and local governments value pension liabilities using the expected return on pension fund assets. Arguing that diversified investment portfolios have an 8% expected return, governments typically use a discount rate of around 8%. Under these procedures the 50 states report unfunded liabilities of around $1 trillion.
But this practice misrepresents the cost of the government promises. The value of a financial obligation has nothing to do with the allocation of the debtor’s assets. If a state wanted to pay an investor to take over the pension liability, the amount the investor would accept would not depend on the state’s asset allocation. If a state tells its employees that their pensions are secure — not risky like the stock market — then it should use the yields on safe government securities such as Treasury bonds to discount the benefits.
Do the GASB rules make sense? Let’s consider an underwater homeowner’s financial situation under common-sense financial logic, and then under GASB rules.
Suppose you are substantially underwater on your mortgage. For example, imagine you own a house worth $200,000 on which you have a $300,000 mortgage, and that you also have $40,000 in a money market account. If you have no other assets, then by any reasonable calculation your liabilities exceed your assets, and your net worth is negative $60,000. If you decide to sell the money market funds and buy stock, nothing has changed. You are still $60,000 in the red. Reducing your cash holdings and increasing your stock market exposure has no impact on your wealth today.
But under the logic of GASB, moving your savings of cash into stocks, while having no effect on the value of your assets, magically reduces the reported amount that you owe on your mortgage. Since the financial assets you own now have a higher expected return, you can mark down your mortgage on your personal balance sheet. GASB effectively says that by moving some savings from your left pocket to your right pocket you instantly make yourself richer. If you take on enough risk, you can claim positive net worth — and even take out a second mortgage on the same home.
The GASB magic is even more impressive for a recent college graduate with $100,000 in student loans, a mere $100 in money market funds, and no other assets. By taking that $100 out of the bank and buying stocks, the graduate would be able to write down the value of his debts by as much as one-third, even though his savings is trivial in comparison to his debts. Under this logic banks hit by the 2008 financial crisis could even “recapitalize” by taking on more risk in their loan portfolios and writing down debt accordingly.
The proposed GASB changes maintain this discounting to the extent that plan assets are projected to be sufficient to make benefit payments. The remainder would be discounted at a high-grade municipal rate. However, plans are given wide discretion to include projected future contributions from all sources in determining when that depletion point comes. Without actually doing anything about it, states can claim that they have planned sufficient contribution increases in future budget years to cover benefits.
As such, the proposed GASB rule changes will have little effect on stated liabilities. In fact, Alan Milligan, the chief actuary of CalPERS, has even written that “the liability that would be reported under the proposed rules would be the same as CalPERS currently reports.” It seems that even the graduate with only his $100 equity investment could claim that his future earnings will allow him to pay off his loans.
If the GASB logic appeals to you then you can sleep easy, trusting that state pension plans are underfunded by “only” the $1 trillion that they themselves report. If you doubt, however, that moving funds from cash into stocks reduces the amount you owe on your mortgage, then states have underreported their pension liabilities. The true unfunded liability using Treasury rates is around $3 trillion for state governments, plus an additional $0.6 trillion in local governments. Whether or not your mortgage keeps you up at night, your future tax bills and the ability of state and local governments to provide essential services certainly should.