Government Pensions: Understanding the New Reporting Requirements
It’s no secret: State and local governments have been struggling financially. The uncertain economy of the past few years has introduced a broad set of challenges, including stagnant financial markets, poor performance of investments, and budgetary dynamics that favor short-term spending over long-term funding of pensions. As a result, in many cases there’s a significant gap between public employee retirement benefit obligations and the funds set aside to pay for them—despite intensifying fiduciary responsibilities and growing pressures to maintain benefit levels.
This gap is one of the reasons the Governmental Accounting Standards Board (GASB) has decided that more information about unfunded pension liabilities will begin appearing on the balance sheets of state and local governments that provide defined benefit pensions. This change will provide citizens and other users of these financial reports with a clearer picture of the size and nature of the financial obligations to current and former employees.
The GASB has approved two new standards: Statement No. 67, Financial Reporting for Pension Plans, which revises existing guidance for the financial reports of most pension plans, and Statement No. 68, Accounting and Financial Reporting for Pensions, which revises and establishes new financial reporting requirements for most governments that provide their employees with pension benefits. These new guidelines significantly change the requirements that were previously in Statement Nos. 25, 27, and 50.
It’s important to note that the new statements relate to accounting and financial reporting issues only. The standards establish a shift in expense and liability recognition from a funding-based approach to an accounting-based approach. Under the previous standards, pension expense was more closely aligned with the annual funding of the plan; under the new standards, expense and liability recognition will be more closely aligned with actuarially determined amounts. The new statements don’t address how governments should approach pension-plan funding, a policy decision better left to elected officials.
New plan reporting requirements under Statement No. 67 are effective for fiscal years beginning after June 15, 2013. But for the purposes of this article, let’s focus on Statement No. 68, which applies to employers’ reporting of their single, agent, cost-sharing, and defined contribution plans administered through trust arrangements and sponsored by governmental entities. It’s effective for fiscal years beginning after June 15, 2014.
With that in mind, let’s examine some of the changes more closely.
Disclosing Net Pension Liability on the Balance Sheet
Under the previous standards, the pension liability on a government’s balance sheet was based on the difference between the contributions it’s required to make to a pension plan in a given year versus what it actually funded for that year. Statement No. 68 changes this, reflecting the view that pension costs and obligations should be recorded as employees earn them rather than when the government contributes to a pension plan or when retirees receive benefits.
As a result, it will require governments with defined benefit pension plans to disclose either a net pension liability or a net pension asset on their balance sheets. That liability or asset is the difference between the total pension liability and the value of assets set aside in a pension plan to pay benefits. The statement calls for immediate recognition of more pension expense than had previously been required, including annual service cost and interest on the pension liability plus the effect of changes in benefit terms on the net pension liability.
In addition, under the previous standard, cost-sharing employers recorded pension expense equal to required annual contributions to the plan, and they had to present actuarial information in their footnotes. But they hadn’t been required to recognize a liability for their individual portion of any actuarially determined underfunding for the plan in total. Instead, information on the funded status of the plan was presented in the plan’s financial statements for all the participating employers combined.
The new standard states that information for cost-sharing employers shouldn’t differ significantly from that of single and agent employers. This means cost-sharing governments must report a net pension liability, pension expense, and pension-related deferred inflows and outflows based on their proportional share of the collective amounts for all the governments in the plan.
The result? Users of financial statements from cost-sharing employers will now gain access to better, more transparent financial data. Indeed, reporting the net pension liability on balance sheets will portray the government’s financial status more clearly and accurately, because the pension liability will be placed on an equal footing with other long-term obligations.
Deferred Outflows and Inflows
The effects of changes in assumptions and differences between assumptions and actual experience on the total pension liability are to be recognized initially as deferred outflows of resources or deferred inflows of resources. They’re then to be introduced into the expense calculation systematically and rationally over employees’ average remaining years of employment (active employees and inactive employees, including retirees). This period is likely to be significantly shorter than the period of up to 30 years over which governments have been recognizing portions of their pension expense.
In addition, the difference between the expected earnings on plan investments and actual investment earnings is to be recognized as deferred outflows of resources or deferred inflows of resources and included in expense in a systematic and rational manner over a closed five-year period rather than longer periods that have been allowed under the previous standard.
New Assumptions in the Process
Two new assumptions will also come into play. The first is that governments will now embrace one actuarial cost allocation method—“entry age”—to determine the allocation of the present value to both the past and future years during which employees worked or are expected to work. Previous standards permitted a choice of six methods.
The second is a change in the discount rate used to determine the present value of future benefit payments. Previous rules allowed the use of the plan’s assumed investment rate of return. The new rules require use of a single blended rate that results from a calculation of discounting projected benefit payments for all years covering current participants in the plan.
The discount rate used for all years the plan is projected to have positive net position will be the assumed investment rate of return for the plan. The discount rate used for all benefit payment years the plan is projected to have insufficient net position to cover the payments will be a lower rate based on an index composed of municipal bonds rated AA or better. Plans that are significantly underfunded and that have either a prior history of contribution levels insufficient to cover both current service costs and amortization of the unfunded liability or are projecting an inability to do so in the future will find they will have to use the lower single blended rate.
Special Funding Situations
The new standard takes into account certain circumstances, called special funding situations, in which governments that are non-employer-contributing entities must recognize in their own financial statements their proportional share of other governmental employers’ net pension liability and pension expense. A special funding situation takes effect when either the non-employer is the only entity with a legal obligation to make contributions directly to the plan or the amount of the contributions for which the non-employer is legally responsible isn’t dependent on one or more events unrelated to the pension plan.
Seeking Greater Transparency
Statement No. 68 requires all governments participating in a defined benefit pension plan to present more extensive note disclosures and required supplementary information (RSI), including:
Descriptions of the plan and benefits provided
Significant assumptions employed in the measurement of the net pension liability
Descriptions of benefit changes and changes in assumptions
Assumptions related to the discount rate and the impact on the total pension liability of a one-percentage-point increase and decrease in the discount rate
Assumptions concerning the net pension liability and deferred outflows and inflows of resources
Single and agent employers will have to disclose additional information, such as the composition of the employee population covered by the benefit terms and the sources of changes in the components of the net pension liability for the current year.
Employers will also have to present RSI schedules covering the past 10 years. The schedules will include sources of changes in the components of the net pension liability, ratios that help assess the magnitude of the net pension liability, and comparisons of actual employer contributions to the pension plan with actuarially determined contribution requirements, if an employer has actuarially determined contributions.
New RSI requirements aren’t retroactive, and they merit more information and clarification—especially when it comes to what’s required for each type of plan. Look for further in-depth discussion of this topic in a subsequent article.
We're Here to Help
Statement No. 68 becomes a reality in about a year and a half, but it’s critical that discussions between actuaries, auditors, and retirement fund or plan administrators begin now to fully understand the new standard and its major implications.
One challenge is figuring out how the information needed to comply will be objectively developed and delivered. For instance, the new standard requires an abundance of new data for the RSI and note disclosures that may or may not be automatically provided by the plan.
The stakes are high, however, because there are several other interested parties that are watching. For example, the SEC completed a two-year study of the municipal securities market and issued its report in July 2012. It included several recommendations about improving disclosures in governmental financial statements, including specific recommendations regarding pension plans. The Government Accountability Office also conducted a study of municipal securities as required by the Dodd-Frank Act and issued its report in July as well. It also had a specific section addressing public pension plan reporting.
As a result, timely education and planning in this area are absolutely essential. We’ll continue to provide perspective on the new GASB changes in future articles, but in the meantime, to gain further insight into this important topic and for help preparing to comply, contact your Moss Adams LLP professional.
A New Way to Calculate and Report Pension Liability
The new pension standards change how governments will have to calculate and report their total pension liability. The measurement process now entails three steps:
Projecting future benefit payments for current and former employees and their beneficiaries
Discounting those payments to their present value
Allocating the present value over past, present, and future periods of employee service
In addition, governments must now report their net pension liability as a liability in their accrual-based financial statements. And the pension plan’s net position available for paying benefits must be measured using the same valuation methods used by the pension plan when it prepares its financial statements, including measuring investments at fair value.
Taking Cost-of-Living Increases into Account
Another important shift means the pension obligation will now have to include cost-of-living increases, future salary increases, and future service credits. Projections of benefit payments to employees will also include ad hoc postemployment benefit changes (those not written into the benefit terms), including ad hoc cost-of-living allowances.
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