A year ago this past July, Moody's Investors Service issued a request for comment that solicited the views of interested parties on a proposal to henceforth evaluate the creditworthiness of state and local governments using its own measures of the cost of pension benefits rather than using the measures presented in audited financial statements prepared in conformity with generally accepted accounting principles.
In the guise of "bringing greater transparency and consistency to the analysis of pension liabilities," Moody's proposed an essentially "one-size-fits-all" approach to pensions that would effectively overstate pension obligations by applying an unreasonably low discount rate, rather than the long-term rate of return on investments prescribed by GAAP in most circumstances. In April, Moody's announced that it was going forward with the changes proposed in the RFC, with only minor modifications, over the strong objections of many respondents, including the Government Finance Officers Association.
Moody's has now issued a second proposal (August 2013) that will double the weight assigned to pensions and debt at the expense of the weight assigned to economic factors. This second proposal, like its predecessor, appears to be a reaction to recent widely publicized but ultimately unfounded claims that state and local governments face a looming "pension crisis." Thus, The Bond Buyer, reported in its announcement of the release of the new proposal from Moody's that:
"Moody's announcement comes just three weeks after Detroit filed for Chapter 9 bankruptcy, making it the largest such municipal filing in U.S. history. Detroit, which has struggled with an array of economic challenges for decades, has more than $18 billion of debt, including sizeable unfunded pension liabilities.
The city's pension funds have reported a $644 million gap, according to 2011 actuarial valuations. However, Michigan Gov. Rick Snyder insists his estimate of a $3.5 billion gap is more accurate."
In fact, however, according to detailed calculations performed by professional actuaries in conformance with both actuarial standards of practice and GAAP, the City's General Retirement System and its Police and Fire Retirement have, respectively, 82.8% and 99.9% of the assets needed to pay benefits to current and future retirees over their lifetimes. Indeed, the separate assessment that suggested that the plans are less well funded describes the data presented as "very rough preliminary guesstimates" based on "rules of thumb and knowledge from general experience" rather than the product of detailed actuarial calculations performed by actuaries with significant experience with public sector retirement systems.
There are at least two reasons to be troubled at Moody's recent actions. First, the cause of enhanced transparency is hardly advanced when Moody's takes it upon itself to act as though it were a standard-setting body and introduce its own measures that depart from generally accepted accounting principles.
Second, inappropriate conservatism in financial analysis is no virtue, as the Financial Accounting Standards Board, which sets authoritative standards of accounting and financial reporting for business enterprises, explains in FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information, paragraph 92:
Since a preference "that possible errors in measurement be in the direction of understatement rather than overstatement of net income and net assets" introduces a bias into financial reporting, conservatism tends to conflict with significant qualitative characteristics, such as representational faithfulness, neutrality, and comparability (including consistency).
The credit rating agencies were accused by the Financial Crisis Inquiry Commission, of being "essential cogs in the wheel of financial destruction" during the 2007-2010 financial crisis." It is sadly understandable that Moody's might be tempted to be overly conservative so as to not be accused of being asleep at the wheel yet again. Sometimes when the pendulum swings too far in one direction it ends up swinging too far in the other direction before righting itself in the middle. This may the case with the rating agencies today. It is our hope that Moody's will resist the temptation to overact by ignoring generally accepted accounting principles and standards of actuarial practice and adhere to its proper role as an unbiased analyst of state and local government finances.
Jeffrey L. Esser is executive director and chief executive officer
of the Government Finance Officers Association.