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Impact of GASB’s new pension rules on government bond ratings

For many public sector retirement plan sponsors, the Governmental Accounting Standards Board's new pension reporting rules couldn't have come at a worse time. The changes, effective June 15 and encapsulated in GASB Statements 67 and 68, mandate that governmental balance sheets reflect unfunded pension liabilities. This has been met with grave concern by plan sponsors.

Since a legion of state and local plans are underfunded, there is little doubt that the new GASB reporting rules will add substantial liabilities to governmental balance sheets. The widespread fear is that this could result in severe credit-rating downgrades. The rating agencies can make or break state budgets by ascribing credit ratings to state and municipal bonds, a vital source of funding for such governments. The increased cost of debt financings can significantly affect government budgets.

It is our view that much of the hand-wringing over the issue is overblown, and that the new GASB reporting scheme will not materially affect the credit ratings of most public plan sponsors. This is because the rating agencies themselves have signaled their understanding that the new GASB reporting rules might be mere window dressing that, ultimately, does not change the already apparent realities of the marketplace.

Before we address how the rating agencies perceive the new GASB rules, we need to explain a bit about what changes the rules require. The changes compute a plan's unfunded liabilities by ascertaining “net pension liability” or the difference between a plan's total pension liability and the assets available to pay for such liability at a specific time. The upshot of this change will mean that for the first time, governments will have to report net pension liability as a balance sheet item on their financial statements.

The rule changes will result in the reporting of greater volatility in government liabilities from year to year, as market swings in the value of plan assets will be more apparent from year to year and because smoothing fair value determinations of plan assets over a three- to five-year period will no longer be the norm. Instead, plan asset values will be quantified as of a single date. Underfunded plans also will be required to apply a much smaller rate of return to the underfunded portion of their liabilities. Projected benefit obligations — previously discounted by the long-term assumed rate of return on plan assets, generally in the 7% to 8% range — will now be subject to a combined rate discounting the effective rate. A portion of the discount rate will reflect, as always, the assumed rate of return, but only for the portion of liabilities projected to be covered by the plan's current assets. The remainder of the plan's liabilities not covered by existing assets will be assumed to earn a much lower return based on the rate for high-grade municipal bonds, which recently was 2.5% and 4.5%, depending upon maturity.

Despite these seemingly draconian changes, we believe the perceived impact of these changes on government credit ratings is grossly exaggerated. This is because the rating agencies themselves fully recognize that GASB's changes in financial reporting merely disclose in a different manner liabilities that frankly, were already known through different channels. Thus, while changes in reporting brought about by the new GASB rules will likely result in plan sponsors reporting markedly weaker balance sheets, the increased liabilities reflected are of no surprise to the rating agencies and therefore, may not affect their evaluation of the plan sponsor in the slightest.

The bottom line is that the new GASB reporting standards changes do not affect reality; they merely provide a different means of reporting it. Each plan sponsor is in no better or worse shape than it was in prior to the change in reporting, and the rating agencies not only know this, they have proclaimed it from the highest banner. Thus, we expect that, following the first round of reporting under the new GASB standards for the period ending in June, the credit ratings of most plan sponsors will not be seriously impaired, despite widespread fear otherwise. n

Mark Lasee and Marc Lieberman are Scottsdale, Ariz.-based partners in the public pension/alternative investments group of Kutak Rock LLP, a public finance law firm.

This article originally appeared in the April 14, 2014 print issue as, "Impact of GASB's new pension rules on government bond ratings".