The effect of financial constraints and political pressure on the management of public pension plans
Introduction
Defined benefit pension plans promise benefits to workers at retirement, usually in proportion to service and final wage. Assets set aside to fund this promise are held in trust. When sufficient assets have been set aside to make good on these future promises, the plan is “fully funded,” otherwise the plan is “underfunded” (Ippolito, 1985). Because of uncertainty in factors such as the employee's salary progression and the pension fund's investment rate of return, the plan sponsor does not know the final cost of the promise until retirement. Therefore, actuarial assumptions are made. These assumptions directly affect the calculations for determining the level of funding in the plan and the required annual contribution from the sponsor, which is the state or local government in the case of public pension plans. The funding level of a public pension plan has implications for not only current and future taxpayers, but also for local wages and employment (Inman, 1982). While some evidence exists that corporate plans are subject to some degree of external pressure, public pension plans may have a greater propensity for influence as they are subject to both political pressures and external budget constraints.2
In many respects pension funding had improved over the past several decades. This is partly due to the dramatic bull market in stocks over the 1980s and 1990s. Pension plans in our sample average over 40% of their assets in equities. Some plans have over 90% in equities. However, the recent bear market has also taken its toll. For example, in 2000 the Public Employee Retirement System of Idaho was 116% funded. By the summer of 2002, the funding level had fallen to 85% (Caldwell, 2003). This comes during a poor economic period were the state budget is under great fiscal pressure because of lower revenues. Instead of increasing contributions to begin making up the shortfall, the state legislature decided to delay the increases for at least one year. The level of underfunding in the state of Oregon's pension plan now exceeds the state's annual budget. Similar problems are also occurring in the private sector. General Motors announced its intent to contribute up to $8 billion spread over two years to make-up underfunding in its pension fund. Also, the federal agency that insures private pension plans, the Pension Benefit Guaranty Corp. (PBGC), suffered its largest annual shortfall to date, $3.6 billion, in 2002 (Dugas, 2003). The total deficit of the PBGC in 2002 was over $5 billion (Associated Press, 2003). In 2003, it grew to over $11 billion (Bater, 2004). Both private and public pension funds are under great pressure. In many ways overall public pension funding has gotten worse in the past few years. For example, Wilshire Associates recently reported that 51% of all state retirement pension funds were found to be underfunded in 2001 up dramatically from the previous year when only 31% were underfunded (Miller, 2003).3 At the same time, governments face revenue shortfalls from a slow economy. This creates a scenario where political pressures could lead to pension accounting manipulation.
This study examines the role of accounting manipulations and political pressure in the funding of public pension funds. Two specific research questions are addressed: (1) Do public pension funds use actuarial accounting assumptions to reduce cash contributions when facing fiscal constraints? (2) Do states, which engage in political pressure of the pension system, manipulate accounting assumptions and/or under fund the system? To answer these questions, this study utilizes data from state pension funds included in the Survey of State and Local Government Employee Retirement Systems for the years 1991–1997. This comprehensive database contains 86% of total public employee system retirement assets (Zorn, 1993).
Overall, the cumulative results of this study provide support for the hypothesis that governmental entities under financial stress have actuarial assumptions that help reduce the required payment to the pension plan. These optimistic accounting assumptions also make the plan appear better funded. However, plans with these “friendly” assumptions are also associated with greater underfunding, which compounds the impact on the stakeholders. Even though the required contribution is reduced due to accounting manipulation, the actual cash contribution is still significantly lower than the required level.
Additionally, states that use political pressure on their pension plans also use optimistic accounting assumptions. Further, the presence of abusive practices is associated with an underfunded plan. That is, governments that politically pressure their pension plans are also more likely to engage in other practices such as manipulating expected rate of return (ERR) and underfunding the plan.
The remainder of this paper is organized as follows. Section 2 discusses the motivation and prior literature related to the development of the research hypotheses. Section 3 identifies the research methodology including data collection and variable design. The initial analysis of the relationship between fiscal constraints and actuarial assumptions is conducted in Section 4. We add political pressure and funding levels to the analysis in Sections 5 Political pressure and actuarial assumptions, 6 Pension funding. The relationship between sponsor incentives, funding flow, and funding level is addressed in Section 7. The concluding remarks are provided in Section 8.
Section snippets
Motivation
Recent figures for total US pension fund assets now total three trillion dollars. Two-thirds of these assets are held in corporate pension funds. Throughout the 1990s, several anecdotal stories focused on the ramifications of the manipulation in earnings that could be realized through changes in the expected rate of return on fund assets (ERR).4 Blankley
Data
The data for this study comes from five surveys of state and local government pension systems conducted by the Public Pension Coordinating Council (PPCC)
The relation between fiscal constraints and actuarial assumptions
We begin the analysis by testing the relationship between our fiscal constraint measures and the pension plans' actuarial assumptions. Specifically, we test Hypothesis 1A: Sponsors with high fiscal constraints have actuarial assumptions that reduce required contributions. Table 2 reports the coefficients for univariate regression analysis of each fiscal constraint variable on each accounting variable for each survey and the pooled sample. Because the assumed ERR should be based on the
Political pressure variables
To test Hypothesis 2 (about political pressure and pension plan manipulation) we specify two variables indicating political pressure on public pension plans from the previous literature review. The value of both variables is obtained from the survey data. The first is ETI, a dummy variable equal to one if the plan invests in economically targeted investments and zero otherwise. A total of 5.89% of the sample uses ETIs.
ETIs are the result of politicians directing plan assets into specific types
Pension funding
In this section we examine the funding status of the public pension plans in relation to the state's level of fiscal constraint, the sponsor's pressure of the system, and the actuarial assumptions.
Funding flow
In the preceding analysis, the magnitude of the pension fund flow variable is consistent with the hypotheses. However, results lack statistical significance. We argue that this is because the flow variable is very sensitive to the accounting assumptions. Having optimistic actuarial assumptions causes the funding flow to be biased toward full funding. In Section 2.3 we cited a case where New Jersey changed its actuarial changes to lower the required contribution from $773 million to zero (Sundén
Summary and concluding remarks
During periods of tight financial constraints, public pension plan sponsors may wish to use the resources of the plan to benefit other areas of the government, the constituents, or special interest groups. Political pressure and budget constraints provide incentives for the manipulation of accounting assumptions and the underfunding of public pension plans. Actuarial assumptions are used to calculate the public pension plan's actuarially required contribution. This study examines the role of
Acknowledgements
The authors would like to thank two anonymous reviewers, Mike Alderson, Bruce Behn, Joe Carcello, Kip Krumwiede, Terry Neal, Vaughan Radcliffe, Jonathan Sokobin, and Rebecca Todd for comments on an earlier version of this paper as well as participants at the American Accounting Association meeting and the Financial Management Association meeting. Dr. Nofsinger is also grateful for funding from the Bradley Institute for Public Policy.
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