By Les Richmond.

New public sector pension accounting rules that take effect for fiscal years ending June 30, 2015 and later are likely to have a significant impact on your city’s financial statements. Because pensions can often be a controversial issue for employees and taxpayers, now is a good time for city leaders to prepare all stakeholders for the change — including elected officials, union leaders, and even the local media – so any resulting policy decisions are not made in a “crisis atmosphere.”

The new accounting rules, known as “GASB 68,” are designed to provide public-sector leaders with more useful information for calculating the cost of their community’s pension promises, and provide insights into whether they have set aside adequate assets to pay them. Understanding the rules and the new financial information they provide will enable your community to improve its long-term financial strength, and will also put you ahead of the curve in preparing for additional accounting changes for retiree health benefit plans that are coming in a few years. Here are a few of the key concepts to understand about the new rules:

Pension Accounting Will Be More Volatile: The balance sheet liability for pensions will be the difference between pension fund assets and liabilities (the unfunded liability) based on the market value of assets. Annual returns on pension fund investments like stocks can fluctuate dramatically. That volatility on the asset side of the balance sheet can spill over to the calculation of pension costs: When below-average asset returns lead to an unfunded liability in the pension fund, that gap will have to be amortized over a much shorter time period than allowed under prior rules. In addition, for reasons described in the next section, the discount rate for determining pension liabilities can change from one year to the next, which can have a huge impact on plan liabilities and accounting expense. Though public-sector political leaders who appreciate stability in their financial statements are likely to be uncomfortable with the new rules, the new accounting does provide a clearer, real-time picture of the plan’s status to all stakeholders.

Underfunding Pensions Will Have Bigger Consequences for Your Financial Statements: Under GASB 68 rules, the discount rate used in the accounting measurements is no longer simply the expected long-term rate of return of pension fund assets. Instead, to determine the discount rate each year, the fund’s actuary will have to project assets and liabilities into the future to determine whether the fund’s assets will be exhausted. The date this fund exhaustion is projected to occur is called the “depletion date.”

It will be more likely that a depletion date will occur if the employer has been contributing less than the full actuarial amount. The consequence of this underfunding can be a lower discount rate, because the expected return on pension assets after the depletion date will be based on a 20-year AA bond rate, which is much lower than most funds’ current expected returns. So underfunding the contribution not only directly reduces the assets in the fund, it also can lead to higher plan liabilities.

This Is a Good Time to Adopt a Pension Funding Policy: If your pension contribution has been based on the Annual Required Contribution (ARC), then you have a decision to make about your pension funding policy, because under GASB 68 the ARC will no longer be calculated. Consult with your municipal advisors and actuaries about a new funding policy — preferably one that avoids pushing unfunded liabilities to future generations, which will, in turn, avoid a depletion date.

Adopting a clear and credible pension funding policy can help manage the impact of the new information on the value of your community’s municipal bonds, by sending a strong message that you understand the pension funding situation and are dealing with it. (It may also make sense to build an investor-relations outreach program or purchase bond insurance to market your bonds to investors more effectively.) At Build America Mutual, our analysis of public sector pension liabilities is already in line with most of the new rules, so we’re comfortable taking a “long view” of a community’s pension funding status, rather than having an extreme reaction to the GASB 68 numbers.

— Finally … Don’t Panic: While it is possible that cities’ pension liabilities will climb under the new rules — some sharply — the pension commitments the city has made aren’t changing, and neither is the amount of assets available to repay them.  In most cases, pension underfunding accumulated over multiple years, and the problems can be fixed with discipline applied over multiple years.

Good luck for a smooth implementation!

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About the Author: Les Richmond is the in-house pension actuary for Build America Mutual, which NLC’s preferred provider of municipal bond insurance and the leading insurer of municipal bonds sold by small- and mid-sized governments in the U.S. He reviews the pension risks for every issuer BAM considers for insurance, and is an expert on the impact of the new accounting rules on municipal financial statements.