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Why Market Value is Inappropriate in Determining Public Defined Benefit Plan Expense and Liabilities
Rick Roeder, FSA, MAAA July, 2009
Response to March 31, 2009 Exposure Draft on Pension Accounting and Financial Reporting:
RE: Method of Determination of Actuarial Value of Plan Assets for Accounting and Financial Reporting Purposes (Chapter 5, Page 48)
I wish to express deep concern as to one potential change to the status quo regarding GASB Standards pertaining to expense and liability recognition for public sector defined benefit plans.
The previous drafters of GASB Standards #25 and #27 should be commended for their insight and wisdom in setting sensible accounting treatment for public sector plans.
There has been a shift both in sentiment, by those who dub themselves advocates of “Financial Economics” and in certain accounting standards, toward explicit reflection of market value. In this proposed standard and numerous other standards, market value has been repeatedly referred to as “fair” value. For a plan sponsor, with a 50+-year time horizon, today’s market value can be anything but fair. There are literally thousands of examples of the irrationality of market value in the short term, even among our largest and most stable corporations. Consider Ford Corporation. There have been no underlying cataclysmic events affecting Ford recently. Yet consider Ford’s recent share price volatility. Is Ford Motors worth the $7 per share this month or the $1.70 per share four months earlier? Clearly, at least one of these per share values do not “fairly” reflect Ford’s long-term value.
Suppose one opines that the recent demise of the stock makes any examples, such as Ford, suspect. The advocates of Financial Economics gained much increased attention in 2002-03 – in the wake of the burst dot com bubble in 2001. Let’s take a look at what happened to one of the bellwethers of the airline industry, American Airlines, in that time frame. As of January 31, 2003, AMR stock value was $2.90 -- down precipitously from its $25 valuation one year earlier. Yet another example of market irrationality is vividly illustrated by the October 19, 1987 crash. One trading day reduced the Dow Jones Industrial Average by 22.6%. I doubt that any rational investor would assume that the intrinsic value of stocks were really that much lower as October 19 drew to a close -- especially when such decline was not triggered by any horrible event other than “market jitters.”
Public pension plans have avoided the numerous pitfalls associated with overreliance on short-term market values. While public pension plans do reflect the market values on their financial statements, expense and liability calculations are almost universally based on smoothed values, which gradually factor in the unexpected ups and downs of the market over a number of years. Per a recent study completed by the National Association of State Retirement Associations (“NASRA”), 58% of respondents smoothed valuation assets over a 5-year period.
I calculated the volatility of the market on each July 1 going back to 1970, using the S&P 500. The standard deviation for annual changes in the index was quite large -- 13. 6%. I then calculated standard deviation for trailing 5-year averages. The volatility of the trailing 5-year averages was 6.3 % (See below). Thus, the volatility of the 5-year average was less than half the volatility of one-year returns. For plan sponsors with long-term time horizons and with little chance of going out of business, use of multi-year averages is much more rational than using market value. The use of more stable values gives stakeholders a much better view. Simply put, use of unadjusted market value significantly increases volatility and undermines the usefulness of relying on a market-driven standard.
Whatever one views as the merit of the use of market value in accounting standards for private sector plans, there is one gaping difference that should stop any analogy in its tracks: Private sectors entities usually have a finite lifetime and often go out of business, get bought or merge with another entity. Public entities rarely go out of business and never get bought. And I doubt that anybody’s imagination is vivid enough to imagine the merger of states such as Kansas and Missouri or Ohio and Michigan.
Overreliance on market value in accounting standards can have unintended and deleterious effects. I have attached a short article by Ralph Katz (“The Folly of Mark to Market Accounting” -- see March 17, 2009 Ramble) in regard to the 2006 issuance of FASB Statement #157. In addition to large added compliance expense, this statement helped create illiquidity in the banking industry and was a significant factor in freezing the banking system in the 2nd half of 2008. In addition, previous FASB standards, relating to private pension plans, created significant short-term profits or losses that were often a significant part of overall profitability – even though such profits/losses usually had little to do with the ongoing operations or viability of the entity. This volatility has been one of many reasons that potential plan sponsors are justifiably wary of establishing new private sector defined benefit plans and has been a factor in the significant decline of private sector defined benefit coverage of its employees.
I think of today’s market value as being analogous to one “dot” in a “connect the dots” picture. The use of one dot, two dots or even 10 dots provides little or no illumination. It is only through connecting a significant series of dots that a picture starts to emerge. This analogy holds well in terms of market value – particularly when the vast majority of “the market” is on the sidelines on any one day. For large institutional investors, such as public pension plans, “buy and hold for the long term” means that they will often be on the sidelines for years at a time. This is due both to the enormity of this group’s equity holdings and the asset allocation policy established by such trusts.
I am respectfully requesting that GASB continue to allow the use of smoothed actuarial value in determining actuarial expense and liabilities. If GASB wishes to change the existing expense standards in any sense, I recommend that the maximum amortization period for expensing unfunded liabilities be reduced from 30 years. However, mandating use of market value in the actuarial process does not “shore up” existing standards – it would just make the standards more volatile.
There are a number of public plan sponsors who face daunting problems in regard to current pension contribution levels because of flat or declining actual and projected revenue streams. In a number of cases, such sponsors, in the latter years of the 1983-2000 bull market, placed way too much reliance on near-term market values and unwisely raised benefits to unprecedented levels. I ask you not to make the same mistake that those public plan sponsors did and overemphasize near-term market values in your deliberations. When it comes to market value, Rudyard Kipling’s poignant saying, “If you can meet with Triumph and Disaster and treat those two imposters just the same” resonates in the financial arena. Mr. Kipling ‘s sentiment applies so well to the near-term peaks and valleys in the financial markets. I hope his famous saying factors into your standard setting.
The author is one of a handful of people who ever passed all the exams offered by both the American Institute of Certified Public Accountants and the Society of Actuaries. He has 30+ years of experience in consulting with public sector benefit programs.