Tuesday, September 18, 2012

Moody's to Apply 5.5% Discount Rate to Governmental Plan - "Backdoor PEPTA?"

Moody’s has announced plans to adjust the pension liability and cost information reported by state and local governments and their pension plans, and has requested comments from interested parties.   In addition to using a uniform 5.5% discount rate for all plans, Moody’s intends to apply a single, 17-year amortization period to annual pension contributions, and replace asset smoothing with the market value of assets as of the actuarial reporting date.  The results, according to Moody’s own estimates, will be to nearly triple fiscal 2010 reported unfunded actuarial accrued liabilities for the 50 states and the local governments that Moody’s rates.  Ironically, while Moody’s thinks that these uniform standards will improve the comparability of pension information across governments, it has strongly opposed similar standardization efforts for credit rating agencies.  NCTR and NASRA are very concerned with the Moody’s proposal, and have drafted joint comments strongly objecting to the planned adjustments, which member retirement systems can also sign onto.  If Moody’s succeeds in their goal of publically restating governmental pensions’ unfunded liabilities using a discount rate based on a bond index, why would Congressman Devin Nunes (R-CA) and certain other members of Congress need to continue to push for the adoption of a Federal law requiring the U.S. Treasury to provide virtually the same thing?

On July 2, 2012, Moody’s Investor s Service (“Moody’s”) announced that it was requesting comment from market participants on its plan to implement several adjustments to pension liability, asset, and cost information reported by state and local governments and their pension plans.  Initially, Moody’s placed a deadline of August 31, 2012, on its comment period, but later extended this until September 30th.

The Moody’s Proposal
Saying that "Pension liabilities are widely acknowledged to be understated," Moody's Managing Director Timothy Blake explained that the proposed adjustments would “improve the comparability and transparency of pension information across governments, enhancing our approach to rating state and local government debt."   In addition, the adjustments are intended to permit the assessment of the scale of pension liabilities in a way comparable to debt obligations.

Moody’s is considering four principal adjustments to as-reported pension information:
  1. Multiple-employer cost-sharing plan liabilities will be allocated to specific government employers based on proportionate shares of total plan contributions, similar to the way in which the Governmental Accounting Standards Board (GASB) has required cost-sharing plan liabilities to be allocated.
  2. Accrued actuarial liabilities will be adjusted based on a high-grade long-term corporate bond index discount rate (5.5% for 2010 and 2011).  Moody’s says that it proposes to replace the varying discount rates with this uniform high-grade bond rate because investment return assumptions used by public plans today “are inconsistent with actual return experience over the past decade (when total returns on the S&P 500 index grew at about 4.1% annually);” a high-grade bond index is a reasonable proxy for government’s cost of financing portions of its pension liability with additional bonded debt; and high-grade bonds are an available investment that could be used in a low-risk strategy to “match-fund” pension assets and liabilities.
  3. Asset smoothing will be replaced with reported market or fair value as of the actuarial reporting date.
  4. Annual pension contributions will be adjusted to reflect the foregoing changes as well as a common amortization period of 17 years which reflects Moody’s estimate of the average remaining service life of employees based on a sample of public pension plans.  Moody’s says that this proposed adjusted contribution “translates our other adjustments into a pro-forma measure of annual fiscal burden that can be compared across plans and issuers, relative to capacity to pay.”
    These adjustments are necessary in order “to address the fact that government accounting guidelines allow for significant differences in key actuarial and financial assumptions, which can make statistical comparisons across plans very challenging,” according to the formal Moody’s Request for Comment.

    Based on Moody’s own analyses, the impact of the adjustments will be to significantly increase reported unfunded actuarial accrued liability and annual pension contributions:
    • After adjusting for the discount rate alone, the State sector’s unfunded actuarial accrued  liabilities (UAAL) would grow 129% to $894 billion from $391 billion, decreasing the funded ratio to 55%.  With the additional adjustment of asset valuation, the State sector’s UAAL would grow to $1.056 trillion, or 74% of total annual State revenues, from $391 billion, or 28% of revenues, an increase of 170%.  This would further decrease the funded ratio to 46%. 
    • Adjustments to State sector annual pension contributions would result in an increase of 252%, from $36.6 billion to $128.8 billion, or from 2.6% of revenues to 9.1% of revenues. 
    •  For the local government sector, the discount rate adjustment would increase the UAAL by 158%, to $967 billion from $375 billion, and reduce the funded ratio to 59% from 79%.  The asset value adjustment would likely result in an additional increase in UAAL to $1.135 trillion and a further reduction in the funded ratio to 52%. 
    • Adjustments to reported annual contributions for local governments are not made because the necessary data is not uniformly disclosed, according to Moody’s.
    Moody’s says that it will publish its specific adjustments for states and selected local governments “when we have finalized our analytical approach later this year.”


    NCTR Response
    NCTR and NASRA take strong exception to Moody’s proposals for several reasons:

    1. Moody’s proposed adjustments will reduce transparency and consistency in the analysis of pension liabilities by adding yet another set of calculations that will result in increased, widespread confusion and misunderstanding of the meaning and implication of public pension actuarial measures.
    2. GASB, the public body charged with setting public pension plan financial rules, has just completed a comprehensive examination of public pension accounting that has taken more than 6 years to complete.  GASB considered the issue of the discount rate, and after careful analysis and public comment, it rejected the idea of a uniform rate in favor of a blended rate that more accurately reflects the unique composition of each pension system.  Thus, Moody’s decision to apply a rate based on long-term corporate bonds not only ignores the fact that this metric has been deemed inappropriate for the public sector, but also the fact that such rates are currently at historic lows.
    3. The application of a single, 17-year amortization period fails to account for both the diversity of public pension plan demographic structures and the essentially perpetual nature of their plan sponsors.
    4. The use of a point-in-time measure, in lieu of one that recognizes longer-term trends through the use of smoothing, will result in near-term volatility of pension plan funding conditions.  For an entity with virtually a perpetual expected life, a smoothed asset value more fairly reflects the true condition of the plan than does a “spot price’ as of the plan’s fiscal year-end date.
    The NCTR/NASRA comment letter also points out that when Moody’s filed comments with the Securities and Exchange Commission (SEC) in February of 2011 in connection with the SEC’s Credit Rating Standardization Study, Moody’s opposed the imposition of uniform standards on credit rating agencies such as itself.  Arguing that increased transparency was a reasonable substitute for standardization, Moody’s stressed that “ratings cannot be reduced to an output from a formulaic methodology or model.”   Furthermore, Moody’s insisted that a single quantitative interpretation of credit factors “would miss a myriad of considerations that arise naturally in the rating process,” and that “a single-dimensioned definition likely would underemphasize ratings stability, which many investors value.”

    NCTR and NASRA believe that these concerns about the application of uniform, standardized credit rating factors also apply to the analysis of public pensions, and that the new GASB standards, with their increased transparency,  will permit the public to develop an adequate and consistent understanding of the public pension community’s approach to the discount rate appropriate to each plan.      

    Outlook
    Will Moody’s change direction in response to these and other comments from public sector organizations, elected officials, and public pension actuaries?  And if they do not, will the presence of one more set of liability measurements be that problematic?

    As we know, GASB, as the independent standard setter of generally accepted accounting principles for state and local governments, has already taken action in this area.  As the Government Finance Officers Association (GFOA) has pointed out in its comments, Moody’s “expedited three-month process of soliciting and collecting comments from stakeholders stands in marked contrast to the systematic and transparent approach used by the GASB over a three-year time period, which involved the issuance of no less than three separate due-process documents that preceded the final standard.”

    Moody’s is a private sector organization with no mandate or authority to regulate public pension accounting or actuarial standards, and Moody’s has no accountability to GASB or other oversight bodies when it comes to its proposed adjustments.  Furthermore, Moody’s methodologies for rating state and local government debt already incorporate an analysis of pension obligations, underscoring the fact that seeking public “feedback” is not necessary for them to make such changes.  Indeed, a close reading of their request for comments reveals that they are not seeking advice as to whether or not to proceed, but rather to see if their adjustments will be seen as useful in enhancing the comparability of pension obligations among state and local government entities.  

    Therefore, it would appear that Moody’s is committed to making its proposed adjustments.  It firmly believes that they “are material, feasible and practical given current disclosures.”   Finally, on August 17th, when Moody’s extended it deadline for comments to September 30th, it also released a “Frequently Asked Questions” document intended to provide responses to questions that have been raised by investors, issuers and other interested parties.  In this document, Moody’s indicates that it will publish its specific adjustments for states and selected local governments “when we have finalized our analytical approach later this year. “  Note that they say “when,” not “if.”

    So what would be the significance of Moody’s actions?  After all, Moody’s goes out of its way to state that its proposal “is not intended to provide an alternate or replacement actuarial valuation of public pension liabilities.”   Furthermore, Moody’s says that “We are not suggesting that [Moody’s adjustments] be a guide, standard or requirement for a state or local governments to fund these obligations.”  Finally, with regard to its proposed adjustments to annual contributions, Moody’s states that “We would not intend it to be a prescriptive funding strategy.”

    Nevertheless, a new set of public pension liabilities – in addition to the actuarial calculation required to meet new GASB requirements and another to inform policymakers of the plan’s funding requirements --  will, at best, be confusing to decision makers and to the public, compounding the selective use that already surrounds these various measurements of liabilities.  At worst, the new Moody’s numbers, coming from an organization with a high profile and degree of credibility, will be seen as an independent,  third-party reliable source of information.  And notwithstanding Moody’s representations to the contrary, what is the purpose of measuring a financial obligation if not to assist it satisfying it?

    In short, many are concerned that the new Moody’s numbers will become a generally acceptable benchmark, free from the taint of politics and abstract academic theory.  And if this happens, it would seem to satisfy one of the primary goals of the “Public Employee Pension Transparency Act” (PEPTA), which is to have public pension liabilities restated using a bond rate as the discount rate.
    Indeed, in many ways, having the Moody’s adjustments would be worse than having  PEPTA, in that the Moody’s process is not dependent upon Federal appropriations to fund the development of a Treasury database, nor the annual filing of such information by pension plans, all of which could take several years to fully implement.  Instead, as Moody’s has indicated, it intends to have these new, adjusted numbers available by the end of this year.

    Therefore, the filing of comments, however convincing they may be, may not be sufficient to alter Moody’s intended course of action.   Accordingly, it is very important that elected officials involved with the obtaining of credit ratings for municipal bonds make their concerns known to Moody’s in as direct a manner as is possible.  Given that Moody’s has indicated that its proposed changes could have an impact on ratings for local governments “where the adjusted liability is outsized for the rating category and without mitigating factors such as demonstrated flexibility to respond to higher fixed costs,”  it is particularly important that local officials make their voices heard.  NCTR is working with national organizations representing State and local governments to ensure that they are aware of the implications of Moody’s actions. 

    Investment performance and the discount rate have a considerable effect on a pension plan’s current and projected cost and funding condition.  Applying a single discount rate to measure these plans will result in distortion and confusion, not clarity and transparency, and any comparability among plans will not be meaningful.  State and local government officials need to understand this and to convey their concerns to Moody’s as soon as is possible.  NCTR members are encouraged to help in this educational process, and to this end, comment letters from national organizations and actuarial firms with a deep understanding of public pensions may be very helpful.  Links to several of these are found below.  NCTR members are also encouraged to file their own comment with Moody’s, or join in signing onto the joint NCTR/NASRA letter, a link to which is also provided.  Please contact Leigh Snell, NCTR’s Director of Federal Relations, at lsnell@nctr.org to add your system to this letter.

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