Today, the Congressional Budget Office released a report on state and local pension underfunding, and they came down firmly in the camp supporting market valuation of pension liabilities. Money quote:
By accounting for the different risks associated with investment returns and benefit payments, the fair-value approach provides a more complete and transparent measure of the costs of pension obligations [than GASB accounting.] ...
[E]ven over very long periods, higher returns on risky investments are not a sure thing. Although a strategy of investing in relatively risky assets produces higher returns on average, compared with a strategy of investing in relatively safe assets, there is no certainty of obtaining higher returns for a particular portfolio or over any given period of time. Those potential higher returns would be obtained by imposing added risk on taxpayers--particularly the risk of experiencing severe losses during protracted economic downturns--which represents an equal and offsetting cost. Such long-run risk, which investors view as costly, is reflected in the premium that investors require to bear it. Fair-value measures account for that cost.
CBO notes, correctly, that there would be certain challenges associated with a shift to fair-value accounting. One is that such a shift might lead pension funds to require significantly greater pension contributions from participating governments in the near term. That's true, but it would really be a reflection of the fact that governments have long been understating the cost of public employee pensions (and got lucky with an outstanding 20-year run of equity returns from 1988 to 2008.)
They also note that a fair-value standard could make required pension contributions more volatile. That's also true, but (as CBO also notes) pension funds do not have to use the same figures for reporting funding ratios and determining required contributions. As I discuss in my paper on pension transparency, pension funds should report their funding status based on the market value of assets, but should continue to use a smoothed asset value to determine contributions.
It's great to see CBO endorsing the fair-value standard, and it's really a reflection of the near-unanimity on this question among financial economists. Tomorrow, I'll be testifying before the House Ways and Means Subcommittee on Oversight about this issue (1100 Longworth, 9:30 AM), discussing a bill that would encourage state and local pension funds to make certain additional financial disclosures, including a fair-value measure of liabilities.
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