Officials Hid Size Of Pension Crisis

SEPT. 22, 2010

By DAVE ROBERTS

Due to “Alice in Wonderland” accounting methods, the amount that taxpayers owe to provide pensions for local and state government employees is much larger – perhaps an extra $2.5 trillion – than government officials have let on, according to an economic advisor to Gov. Arnold Schwarzenegger speaking at a Securities and Exchange Commission (SEC) hearing in San Francisco on Tuesday.

“State and local governments utilize a misleading method for reporting the size of public pension obligations,” said David Crane. For example, an annual obligation of $30,000 for 25 years for a government employee’s pension is projected to cost the government $320,000, while the same $30,000/year, 25-year obligation in the form of a bond is projected to be $425,000. “Two identical and unconditional obligations owed by the same government are valued at different amounts. The answer lies in the Alice in Wonderland world of government pension accounting that allows governments to hide liabilities.”

Government officials justify the lower obligation for the pension based on the earnings they hope to receive by investing the money.

“That might be a legitimate outcome if the government and its taxpayers were no longer on the hook for the pension promises once money is deposited in the pension fund,” said Crane. “But that’s not the way it works. The government and the taxpayer stay on the hook. To put this in perspective, consider this: If Alice’s accounting could be applied to your mortgage obligation, then just setting up a trust account and projecting that account to earn a high rate of return on any deposit you make to that account would allow you to reduce the reported size of your mortgage. Now wouldn’t that be nice – at least until you had to make the payments on that mortgage. Which, of course, remain the same.

“As a result of Alice in Wonderland accounting, state and local governments are understating pension liabilities by $2.5 trillion, according to the Center for Retirement Research at Boston College. Note that these are not like Social Security and Medicare liabilities. These are contractual liabilities that cannot be changed, even by state legislatures or Congress.”

Because government officials are able to hide their future debt obligations in this way, they “are perversely incentivized to assume the highest rates of return in order to minimize reported liabilities, and then to swing for the fences in investing the capital of those funds in the hopes of actually achieving those returns, producing even more risk for the taxpayers who must make up for any pension fund shortfalls,” he said.

The chief investment officer of a large state pension fund recently said that investment returns in the 7.5-8 percent range are not unrealistic, according to Crane, adding, “Given that the capital in state and local pension funds is there to protect governments and taxpayers from having to dig further into their pockets to make pension payments for which they are on the hook, that official is effectively characterizing government and taxpayer capital as being in search of riskier investments.”

This fiscal fudging has led to the growth in the ticking pension time bomb in California. In 1999 the California Public Employees Retirement System (CalPERS) reported that its assets equaled 128 percent of its liabilities when in reality its assets totaled only 88 percent of liabilities, according to Alicia Minell, an economist in the Clinton administration.

“In other words, in 1999 using Alice in Wonderland accounting, CalPERS reported that assets exceeded liabilities when in reality liabilities exceeded assets,” said Crane. “Encouraged by that accounting, the state Legislature enacted a law that year boosting pension promises. The hidden cost from that boost has already hit $15 billion and will reach at least $150 billion for the state budget. More generally, after having reported that liabilities were a fraction of assets and projecting that the state’s pension costs would total $5 billion over the succeeding 10 years, the state actually incurred $25 billion over that period.

“California wasn’t alone in this regard. Unrealistic reporting of pension promises is a systemic problem. That’s why the SEC must require realistic accounting of public pension promises. For that to happen it must insist upon a realistic discount rate when reporting pension liabilities. In addition, the SEC cannot rely upon the Governmental Accounting Standards Board (GASB) to correct its ways and adopt realistic accounting. GASB is funded and governed by the very governments who would be forced to revise upwards their pension should a realistic discount rate be required.”

It remains to be seen whether GASB will restore fiscal sanity to pension accounting, but the board is looking into the matter, according to James Lanzarotta with the Moss Adams accounting firm. “Pension liabilities is one of the big topics of the day,” he said. “So they are currently deliberating on an improvement that would put the liability on the financial statements at amounts that are a lot closer to the expected future payout, the discounted present value of the expected valuation. That’s in contrast to what’s done today. Today the liability is measured based on what the actuary said the annual requirement would be for funding versus what the government actually contributed. So it would be quite a change from current practice.”

The SEC will also be looking further into government pension accounting practices, according to SEC Commissioner Elisse Walter. Noting that the issue “is quite complex,” she said that future SEC hearings “will continue to explore these topics.”

The all-day SEC hearing in San Francisco was the first of five that will be held around the country in the coming months to find solutions for problems in the $2.8 trillion municipal bond market. Other issues raised at the hearing include clarifying the differences in regulation of the municipal and corporate bond markets, and the need to level the playing field for individual investors, who have less access to information on municipal securities than institutional investors.