Military employees earn pensions, post-retirement health and other benefits over the course of their working years, but these benefits are not paid until the employee retires. The federal government accrues a liability for the amounts earned but not yet paid. Currently, pensions represent the largest military employee benefit liability, followed by the post-retirement health benefit liability.

The cash measure reflects the payments made to retired military in the current year but not the estimated long-term costs. While the Department of Defense (DOD) records outlays for the accrued costs in the year the benefits are earned, these are receipts of the military retirement-related trust funds—as such, they are intra-governmental transactions and therefore not reflected in the cash deficit.

The accrual deficit reflects an annual expense for the estimated long-term cost of these benefits each year as the service member renders his or her services. The annual expense also includes accrued interest on the outstanding liability, adjustments for any changes to the plan’s benefits or assumptions, and any deviations between actual experience and assumptions.

The table below shows the accrued liability, which is the present value at the end of the reporting year, of the expected cost of military employee benefits that will be paid in the future, and the year-to-year change in liabilities from 2007 to 2011. The change in liability from the previous year represents the primary difference between accrual and cash measures of military employee benefits. The change in liability is generally equal to the accrued expense for payments that will be made in the future less cash outlays to pay current retirees' benefits, which were expensed in the past. An increase, or positive change, in the liability represents accrued expenses in excess of cash outlays, which increases the accrual deficit relative to the cash deficit.

What drives changes in military employee benefit liabilities?

The accrued benefit expense depends on assumptions and projections for salaries, life expectancy, interest rates, inflation, and other economic and demographic variables. As such, changes in these assumptions or deviations between actual experience and these assumptions can lead to large changes in the military employee benefit liability and the accrual deficit itself. For example, in 2008, military pension liabilities increased by $125.3 billion from the prior year. A large portion of that increase was due to a reduction in the interest rate assumption and a decrease in the mortality rate—an increase in the average life expectancy of military employees.

In fiscal year 2010, agencies implemented a new accounting standard, which required they select discount rates based on average historical rates on Treasury securities over a minimum five-year period as of the reporting date (www.fasab.gov). This was one factor in causing pension liabilities to rise by $85.6 billion in 2010, which was more than triple the size of the increase in liability from the previous year. Post-retirement health liabilities increased considerably, raising total military benefit liabilities by over $164 billion. In 2011, pension liabilities continued to rise, while health liabilities decreased for the first time in three years due to a sizable actuarial gain. Actuarial gains (losses) arise from changes in the assumptions used to calculate the present value of future benefits or from experience different from that originally incorporated into those assumptions.

It should be noted that DOD could not support a significant amount of the estimated military post-retirement health liability related to the cost of direct health care provided by DOD-managed military treatment facilities.

Civilian employees earn pension and other retirement benefits over the course of their working years, but these benefits are not paid until the employee retires. Currently, pensions represent the largest civilian employee retirement benefit followed by the post-retirement health benefits liability.

In the cash budget, the payments made to retired employees are recorded as outlays and reflected in the cash deficit. Any contributions made by employees to their retirement plans are recorded as receipts and offset part of the cash outlays. Contributions made by agencies for employee benefits do not affect the cash deficit as they are intra-governmental transactions where no cash actually leaves the federal government.

The accrual deficit reflects an annual expense for the estimated long-term cost of these benefits each year as the employee renders his or her services. The annual expense also includes accrued interest on the outstanding liability, adjustments for any changes to the plan’s benefits or assumptions, and any deviations between actual experience and assumptions. Contributions made by employees towards pension, health, or other benefits are recorded as earned revenue, which offset part of the expense.

The reported civilian employee benefit liabilities—or the present value of the benefits that have been earned as of the end of the reporting year but are projected to be paid in the future—and the changes in liabilities are shown below. The change in the liability from the previous year is the primary difference between what is recorded in the accrual deficit and the cash deficit for civilian employee benefits. The change in liability is generally equal to the accrued expense less payments made to current retirees during the current year. Therefore a positive change in the liability represents accrued expenses in excess of cash outlays.

What drives changes in civilian employee benefit liabilities?

Changes in civilian employee benefit liabilities can affect the accrual deficit without a corresponding change to the cash deficit. The accrued benefit expense depends on assumptions and projections for salaries, years of service, interest rates, inflation, and other economic and demographic variables. As such, changes in these assumptions and deviations between actual experience and these assumptions can lead to large differences between the changes in the civilian employee benefit liability from year to year and the accrual deficit itself.

Differences between actual experience and assumptions about both pensions and health care costs drove the changes in civilian benefit liabilities. First, for pension liabilities, in 2008 and 2009, pension liabilities increased by $68.5 billion and $74.6 billion respectively, with the biggest factor being interest on the liabilities. Then, in 2010, agencies implemented a new accounting standard, which required agencies to select discount rates based on average historical rates on Treasury securities over a minimum five-year period (www.fasab.gov). A lower real interest rate contributed to a $103.5 billion increase in pension liabilities. The following year pension liabilities fell by $13.2 billion despite slightly lower real interest rates, largely due to actual experience being more favorable than assumptions. The roughly $117 billion swing in the change in liabilities between 2010 and 2011—from an increase of $103.5 billion to a decrease of $13.2 billion—stemmed from an almost $75 billion decrease in losses from changes in actuarial assumptions, a $31 billion increase in gains due to actuarial experience, and a $15 billion decline in interest on the liabilities.

Second, post-retirement health benefit liabilities fell by $13 billion in 2011 after a $3.3 billion increase in 2010. The key difference explaining the drop in 2011, compared to the minimal change in 2010, was a $13.8 billion gain in 2011 due to changes in assumptions. This swing did not reflect changes to the program or structure of benefits, but rather illustrates the effect of changes in assumptions.

The veterans compensation program provides eligible veterans and their survivors with benefits to compensate for the loss of potential earnings due to service-connected disability or death. The cash deficit reflects compensation payments made in the current year to current veterans but not the estimated costs of future benefits. The accrual deficit reflects an expense for future payments to current veterans already receiving benefits, veterans who are not currently receiving benefits but are projected to in the future, and a portion of those in active military service projected by the Department of Veterans Affairs (VA) to become eligible for benefits in the future.

The table below shows the reported veterans compensation liability—or the present value of the estimated cost of future benefit payments earned as of the end of the year and payable in the future—and the corresponding change in each year from 2007 to 2011. The difference between the cash and accrual measures of veterans compensation is the change in the liability from year to year. The change in the liability is generally equal to accrued compensation expense plus accrued interest on the outstanding liability less benefits paid to current beneficiaries. As such, a positive change in the liability represents accrued expenses in excess of cash payments.

What drives changes in veterans compensation liabilities?

Changes in the veterans compensation liability can affect the accrual deficit without a corresponding change to the cash deficit. The change, however, may not necessarily reflect changes in the structure of the program or the benefit formula. VA estimates the compensation liability using assumptions for the number of beneficiaries, life expectancy, future cost of living adjustments, and interest rates, among other things; the liability is sensitive to changes in these assumptions. The liability would also be affected by changes in the veterans benefit package. For example, in 2010, the veterans compensation liability increased to reflect newly recognized payments to veterans suffering from exposure to Agent Orange during the Vietnam conflict.

The veterans compensation liability experienced wide fluctuations in recent years driven by changes in assumptions. From 2004 to 2009, VA used a single-day current market-based interest rate, rather than a historical average, on Treasury securities to discount future payments into present value terms for presentation in the financial statements. Interest rates were quite volatile, which led to volatility in the reported liability. The liability decreased by $26 billion in 2007, increased by $339.0 billion in 2008, and decreased by $149.2 billion in 2009. These large swings resulted not from changes to benefit provisions, laws, or regulations, but from changes in the assumptions used (primarily for interest rates) to estimate the value of future benefits. However, a new accounting standard implemented in 2010 may reduce the large swings in the liability driven by changes in the discount rate. The new accounting standard requires federal agencies to develop discount rates based on average historical rates on Treasury securities over a minimum five-year period as of the reporting date (www.fasab.gov). However, it may be too early to see whether this accounting change helps to lessen the large swings that have otherwise been observed. In 2011, the real interest rate assumption was decreased slightly, which contributed to a $58.9 billion increase in the liability.

Federal, state, and local laws and regulations require the federal government to clean up hazardous and radioactive waste resulting from its ongoing operations (e.g., nuclear submarines and nuclear weapons). While the cash deficit reflects cleanup costs when they are paid, the accrual deficit reflects a portion of the estimated probable and measurable environmental cleanup costs associated with assets as they are used, even though cleanup will not actually occur for many years. In addition, the accrual deficit reflects estimates of the costs of cleaning up and disposing of existing contamination and waste resulting from nuclear weapon production during World War II and the Cold War (also called “legacy waste”). Most of these activities are managed by the Department of Energy (DOE) and the Department of Defense (DOD).

Each year a portion of the estimated total cleanup costs for operating assets is to be recognized as an expense. Accounting standards require that this allocation be based on a systematic and rational method, such as the expected life of the asset and the amount of capacity used each period. For example, a nuclear submarine may have an estimated useful life of 10 years and estimated cleanup costs of $80 million. Under a straight-line allocation method, the expense and liability accrued in each year of its life would be $8 million. This $8 million would be reflected in the accrual deficit for that year but not the cash deficit. In contrast, any increase to the estimated cost of cleaning up legacy waste must be recognized in full in the period it is identified.

The table below shows reported environmental liabilities from 2007 to 2011 and the change in the liability each year. The change in the liability from the previous year represents accrued expenses in the current year less payments for current year cleanup activities, which were expensed in the past.

What drives changes in environmental liability estimates?

Estimates of cleanup costs are inherently uncertain. Estimates must assume the use of current technology and make a number of assumptions about the scope of restoration of the site; detailed projections about the schedule of funding and cleanup activities; and inflation. Costs (and hence the liability) may also change if there is a change in the laws or regulations determining the level of restoration. For example, restoration to “pristine condition” would have a higher cost than restoration to a point deemed to “pose no near-term health risks.”

There was little change in DOE’s reported liability with the exception of 2007 and 2010. In 2007, DOE reported that the $33.3 billion increase in environmental liabilities resulted from a variety of factors such as regulatory changes and changes in the assumptions it uses about the timing, scope, and technical approach used to clean up or dispose of hazardous waste. In addition, this increase resulted from inflation adjustments to reflect constant dollars for the current year. In 2010, the liability declined by $17.4 billion due to adjustments to DOE’s inflation estimates and several other technical and programmatic aspects.

While the accrual deficit reflects more of the long-term cost of environmental cleanup than does the cash deficit, it does not include all long-term cleanup costs. For example, if project costs cannot be estimated (e.g., the technology does not exist), federal accounting standards do not require agencies to record the liability, though it must be disclosed in the notes to the financial statements. Also, DOD remains unable to estimate with assurance key components of its environmental and disposal liabilities.

The federal government insures individuals and firms against a variety of risks, such as loss of deposits from bank failures, crop failures, property damages from flood, and loss of pension benefits. Budget reporting for insurance programs focuses on annual cash flows. Outlays are recorded when claims are paid and collections for insurance programs (such as premiums) are recorded in the budget when received.

In contrast, the Financial Report records expenses or losses for estimated insurance claims when events have occurred and the probable effects can be reasonably estimated. Accordingly, losses are recognized as a liability on the balance sheet when claims have not been paid. The change in the liability generally represents a difference between the cash and accrual deficits.

The table below shows the reported liabilities for 2007 through 2011. The Pension Benefit Guaranty Corporation (PBGC) and the Federal Deposit Insurance Corporation (FDIC) contributed most to differences between the cash and accrual deficits in recent years.

For FDIC, the difference between the accrual and cash deficit is the change in contingent liabilities, liabilities due to resolution of failed or failing institutions and pending depositor claims and debt guarantees. For example, in 2011, the budget recorded net cash outlays (claims paid less any receipts) for FDIC of $1.3 billion. However, the accrual deficit showed a $25.2 billion decrease in accrued liability. While actual bank failures for calendar 2007 and 2008 were 3 and 25 respectively, by September 30, 2009, 95 more banks failed. In 2008, 2009, and 2010, FDIC's insurance liabilities increased (in comparison to pre-banking crisis levels) primarily due to actual and anticipated failures and the implementation of systemic risk programs.

For PBGC, the difference between the cash and accrual deficits relates to the change in liability for retiree benefits of terminated pension plans, which is composed primarily of

• losses (i.e., the difference between the present value of estimated future benefits and plan assets) for pension plan terminations occurring or incurred during the year (both completed and probable),
• net changes in the value of assets and the present value of estimated future benefits for pension plans that terminated in prior years due to factors such as returns in the stock and bond markets, changes in interest rates, and changes in other actuarial assumptions used to measure the value of future benefits, and
• cash benefit payments that are recognized in the budget.

The loss included in the accrual deficit represents the changes in the amount for which PBGC estimates it will ultimately be responsible. For example, in 2011, the accrual deficit reflected a $3 billion loss for PBGC suggesting some combination of declines in plan assets and/or increases in plan liabilities and/or plans have failed. However, the cash deficit reflected approximately $1.2 billion in net cash receipts for PBGC.

What drives changes in insurance and guarantee programs?

Catastrophic events in the economy (e.g., the financial crisis and subsequent economic downturn) and in the environment (e.g., natural disasters) can lead to changes in insurance liabilities from year to year. The $58.4 billion increase in FDIC liability in 2009 was primarily due to anticipated failure of insured institutions. FDIC liability increased slightly in 2010 followed by a notable decrease in 2011. The main drivers behind the decrease in 2011 were the resolution of failed banks and a decline in the estimated number and losses of future bank failures.

The primary drivers of accrued losses recognized by PBGC are the economic health and benefit obligations of companies that sponsor defined-benefit pension plans. PBGC estimates the loss for pension plans that are probable to be terminated in the near future by assessing macroeconomic conditions that can influence firms and investments and the specific performance of particular companies. In 2009 PBGC recognized an increase in liability of $23.1 billion. This increase was due primarily to plan terminations of $15.4 billion and losses on prior terminations (present value of benefits growing faster than assets) of $13.9 billion. These changes were due primarily to the economic downturn. The amount of the liability related to PBGC continued to increase at a more modest rate in 2010 and 2011 and reflected changes in interest and mortality assumptions, the passage of time, and the effect of experience.

The federal government acquires a wide variety of capital assets for its own use including land, structures, equipment, vehicles, and information technology. To directly acquire a capital asset, agencies generally are required to have full up-front budget authority for the total cost of the asset. This allows Congress to recognize the full budgetary effect of capital spending at the time a commitment is made. It also means that the full cost of the asset must be recognized in the annual budget despite the fact that benefits may accrue over many years. Outlays are only recorded as funds are disbursed, which may occur over a number of years. These cash disbursements increase the cash deficit in the years those outlays are made.

In contrast, the Financial Report recognizes the expense for a capital asset by spreading its cost over its expected useful life. This is known as depreciation expense and increases the accrual deficit each year of the asset's life. Depreciation is not recognized in the cash deficit.

In addition, capital assets may be sold or destroyed or revalued to reflect the true value of the asset. When an asset is sold, the budget deficit reflects a cash receipt for the full amount of the sale. The accrual deficit however recognizes the difference between the amount that is received for the asset upon disposal and the book value of the asset (the amount paid less depreciation already recognized). If an asset is destroyed or revalued to reflect a better estimate of its value, this is recognized in the accrual deficit but not the cash deficit.

What contributes to changes in capitalized assets and depreciation?

Changes in the amount of outlays for capital assets, and subsequently to depreciation, are determined in part by the budget authority provided by Congress each year and agency decisions on how to allocate budget resources to capital. Approximately 72 percent of the government’s reported property, plant, and equipment net in 2011 is attributed to the Department of Defense (DOD). However, too much focus should not be placed on the exact size of the increases or decreases in capitalized assets. As we have reported in the past, the federal government cannot satisfactorily determine that capital assets are properly reported in the Financial Report. A majority of capital assets are the responsibility of the DOD and it has not maintained adequate systems or sufficient records to support the reliability of information on these assets.

The federal government's actions to stabilize financial markets and to promote economic recovery resulted in significant amounts of reported assets and liabilities. Financial assets and liabilities resulting from actions involving the Troubled Asset Relief Program (TARP) and government-sponsored enterprises (GSEs) have contributed to the difference between accrual and cash deficits in recent years.

Transactions Related to Fannie Mae and Freddie Mac

When the federal government placed Fannie Mae and Freddie Mac into conservatorship in September 2008, the Treasury received $7.0 billion worth of shares in the two housing GSEs and agreed to provide ongoing liquidity guarantees, in the form of quarterly cash payments, to cover the GSEs' losses. The government's investments in and liabilities to the GSEs affect the cash and accrual deficits differently. Fannie Mae and Freddie Mac are considered by the Administration to be outside of the budget, and therefore the budget records Treasury’s direct cash infusions to Fannie and Freddie as outlays, which increases the cash deficit. Conversely, the accrual deficit reflects the expenses for the estimated long-term cost of the purchase agreements but not the cash infusions. The long-term cost estimate captures both the change in the fair value of the stock received from GSEs and the liability generated by the government's commitment to provide future cash infusions. This liability is equivalent to the estimated future quarterly payments to cover the GSEs' net worth deficit for the life of the agreements with the GSEs.

Changes in the GSEs’ financial positions contribute to the changes in the cash and accrual deficits. Treasury’s estimate of the total future payments to GSEs in 2010 was $359.9 billion, an increase of $268 billion over fiscal year 2009. This amount is reflected in the accrual deficit, but would not be reflected in the cash deficit until a payment is made. This is more than triple the increase reported for 2009. Subsequently, the liability decreased by $43.7 billion bringing the liability down to $316.2 billion.

Based on Fannie Mae’s and Freddie Mac’s reported net worth deficit, Treasury invested $95.6 billion to help maintain each GSE’s solvency in fiscal year 2009. Treasury invested an additional $52.6 billion and $20.8 billion in 2010 and 2011, respectively to help maintain each GSE's solvency bringing the cumulative investment to approximately $176 billion. Nearly two thirds of the $176 billion ($107.6 billion) is support for Fannie Mae and the remaining third ($68.3 billion) for Freddie Mac. These amounts were reflected in the cash deficit for 2010 and 2011, but not the accrual deficit. Instead, with regard to these investments in the GSEs, the accrual deficits reflected the change in value of such investments. The federal government’s shares of GSEs were originally valued at $7.0 billion when they were received in fiscal year 2008 and the government increased the amount of its investment to approximately $176 billion by the end of fiscal year 2011. However, at the end of 2011, the investment had a fair value of only $133 billion. Much of the valuation loss occurred in 2009 ($37.9 billion), while subsequent changes to the valuation loss in 2010 and 2011 were less dramatic. The loss increased by $8.1 billion in 2010 and then decreased by $3 billion in 2011. These changes in valuation loss were reflected in the applicable years’ accrual deficit, but not the cash deficit.

Troubled Asset Relief Program (TARP)

In October 2008, the federal government began a new program—the Troubled Asset Relief Program (TARP)—to help reestablish stability and liquidity in the financial markets. Through the TARP program, the Treasury Secretary is authorized to purchase and guarantee troubled assets, including mortgages and securities.

As economic conditions change and actual asset performance differs from expectations, the expected cost of the financial assets acquired under TARP may change. The subsidy costs of TARP's direct loans and equity investments must be periodically re-estimated to capture actual asset performance and changes in expected future performance. Re-estimates account for any additional costs or savings to the federal government on TARP’s direct loans and equity investments. The downward re-estimated costsFor budgetary purposes, the effect of the year end downward re-estimates (reduction of net outlays) and upward re-estimates (increase in net outlays) is not recognized until the subsequent fiscal year. are reflected in the Financial Report at fiscal year-end but are not reflected in the budget until the following fiscal year. As such, timing causes a difference between the accrual and cash deficits as related to the TARP re-estimates.

The $110.0 billion downward reestimate of the net cost in 2009 is one reason the fiscal year 2009 cash deficit exceeded the accrual deficit. The effect of this reestimate was reflected in the cash deficit for fiscal year 2010. From inception through September 30, 2011, the Treasury disbursed $413.4 billion in direct loans and investments and for the Treasury Housing programs under TARP. The estimated net cost of TARP transactions for this period was $28 billion. As of September 30, 2011, the Treasury estimated a lifetime cost for TARP of $70.2 billion based on utilizing $470 billion of TARP authority. This budget estimate includes committed but undisbursed amounts of funds for housing and other related programs, whereas the costs reported in the financial statements are based on transactions through September 30, 2011. Market conditions and the performance of specific financial institutions will be critical determinants of TARP’s ultimate cost.