SEC Hits Out at Underfunded Public Pensions

(May 30, 2014) – The Securities and Exchange Commission (SEC) has accused municipal pension funds of “playing numbers games” to understate unfunded liabilities and likened the practice to “fraud”.

While official estimates place the funding gap across state and local pension plans to be in the region of $1 trillion, SEC Commissioner Daniel Gallagher said the true figure was believed to be more than $4 trillion.

“To fully fund these public pension shortfalls, every household in the US would need to pay $1,400 per year for the next 30 years,” he added, speaking to a meeting of the Municipal Securities Rulemaking Board yesterday.

The commissioner blamed “lax accounting standards” for the discrepancy, which he said was “seriously misleading” to investors in bonds issued by states and local government.

 “This lack of transparency can amount to a fraud on municipal bond investors, and it does a disservice to state and local government workers and retirees by saving elected officials from making the hard choices either to fully fund the pension promises that were made to public employees, or not to make the promises in the first place,” he said.

“In the private sector, the SEC would quickly bring fraud charges against any corporate issuer and its officers for playing such numbers games. And we would also pursue and punish the so-called fiduciaries who recklessly seek yield to meet unrealistic accounting assumptions.

“We should not treat municipalities any differently.”

Gallagher said plan sponsors had been calculating future inflows and outflows based on “over-optimistic” return assumptions, leading the funds to take on too much risk in a search for high yielding investments.

Funds have been assuming future annualised returns of 7.5-8% instead of a “more realistic” 6% range, he said, “contrary to fundamental tenets of financial economics”. “Liabilities should be valued at a rate that reflects their risk, not the risk of the assets that are expected to cover the liabilities,” Gallagher explained.

The commissioner cited ongoing bankruptcy proceedings for the city of Detroit—where the underfunded pension scheme is set to be ranked above bondholders to receive cash when assets are sold off—as an example of why bond investors must know the size of pension liabilities.

Rating agency Moody’s last year adjusted its assessment process for public credit ratings to place more scrutiny on pension liabilities and subject government and government-related bonds to tougher standards.

New accounting standards are set to be introduced next month by the Governmental Accounting Standards Board (GASB), but Gallagher said while this was “a step in the right direction”, more needed to be done to improve transparency on liabilities. In particular he urged schemes to retain the annual required contribution (ARC) disclosure, which has been removed from schemes’ required disclosures by the GASB.

Gallagher said removal of the ARC—which was designed to illustrate how much had to be paid in to a plan to address funding gaps—would “diminish transparency”, and emphasised that “nothing is preventing entities from recreating and using the ARC”.

Gallagher’s full speech can be accessed on the SEC’s website.

Last year the SEC took action against the state of Illinois after finding that it failed to inform investors about the magnitude of problems with its funding schedule when issuing more than $2.2 billion in municipal bonds.

Related links: US Public Pensions Subject to Accounting Changes & Moody’s Targeting Pension ‘Outliers’ With Ratings Overhaul