Pension Liabilities No Longer Hidden
Board: Macro Economics
At the Bond Buyer website, I ran across a short, heads up interview with Brian Whitworth, Sr. VP, First Southwest Co. (a diversified investment bank specializing in public finance, capital markets and asset management) who identifies major changes in pension accounting standards that will significantly impact how issuers manage and report their finances.
Moody’s new pension adjustments include using corporate discount rates instead of the 7% to 8.25% discount rates that most public retirement systems assume. Moody’s new methodology yields much larger unfunded pension liabilities, often about 3 times more than what the retirement systems are receiving. Explaining this to politicians, investors, municipal leaders, employees, retirees and other interest groups has been a difficult task and something very uncomfortable for them to hear. In another recent post here, I mentioned that under Moody’s new methodology, Chicago taxpayers now face $86.9 billion in debt and unfunded liabilities instead of the $63.2 billion total reported by major government units in Chicago. Here’s the kicker. Moody’s based its recent triple-notch downgrade of the city’s debt on the agency’s new methodology for valuing pension shortfalls. The downgrade has led to a collapse in Chicago’s bond prices and a significant increase in its borrowing rates.
Under new Governmental Accounting Standard Board GASB) accounting rules that become fully effective over the next 2 year period, state and local governments will need to input pension numbers into their balance sheets and report net pension liability on their financial statements, not in the notes. These changes will dramatically alter the accounting value of liabilities that in many cases will cause states and municipalities to acknowledge that pensions for police, firefighters, teachers or other municipal workers are woefully underfunded. Although GASB is not a government entity (has no regulatory powers), it is recognized by governments, the accounting industry, and the capital markets as the official source of generally accepted accounting principles (GAAP) for state and local governments.
The U.S. Securities and Exchange Commission (SEC) has been stepping up enforcement activities against municipal bond issuers. Two State cases involved misleading disclosures about pension underfunding. Instead of imposing a heavy fine, on 3/11/2013, the SEC fired a warning salvo across the bow of Illinois, charging the State with securities fraud for misleading municipal bond investors about the state’s approach to funding its pension obligations. An SEC investigation revealed that Illinois failed to inform investors about the impact of problems with its pension funding schedule as the state offered and sold more than $2.2 billion worth of municipal bonds from 2005 to early 2009. Illinois failed to disclose that its statutory plan significantly underfunded the state’s pension obligations and increased the risk to its overall financial condition. The state also misled investors about the effect of changes to its statutory plan.
This was the second time that the SEC has charged a state with violating federal securities laws in their public pension disclosures. The SEC charged New Jersey in 2010 with misleading municipal bond investors about its underfunding of the state’s two largest pension plans. No fine was imposed.
The new pension adjustments and accounting rules are sending a different kind of disturbing tremors in my earthquake prone home state of California. For example, the aforementioned net pension liability posting on financial statements is a hot potato that nobody wants to be the one holding on to at the California State Teachers’ Retirement System (CalSTRS), established by law in 1913, and presently a part of the State’s Government Operations Agency. CalSTRS is the largest teacher’s retirement fund in the U.S. and currently the 8th largest public pension fund in the world. The new accounting rules are expected to more than double the pension debt reported by CalSTRS and boost the current $71 billion unfunded liability to a newly calculated $166.9 billion Net Pension Liability. The new accounting rules call for pension debt to be added to employer balance sheets. To date, neither the State of California nor the school districts have included CalSTRS debt in their financial statements. Here’s the big rub. It’s unclear whether the new liability amount will be reported by the State or spread among the school districts where substantial increases to current debt might lower credit ratings and increase borrowing costs. The big question is, “Who decides?” The State legislature, governor, or state auditor? Now picture every single state, local government and public employee retirement system in the nation dealing with the same issue among others.
Moody’s pension adjustments and GASB new pension accounting rules are pressuring state and local governments to immediately address their underfunded retirement systems and pension liabilities. No longer can they kick the can down the road, stick their heads in the sand, hide their pension liabilities or mislead municipal bond investors about the funding of pension obligations without incurring serious consequences.
David Vaudt, the new GASB Chairman, said it best on a positive note about the new pension standards influencing government budgeting decisions:
I think when you look at any particular government out there, there are a lot of factors that go into what their situation looks like, and obviously a lot of different issues that can impact them. But on the pension side, the really positive side of the pension standards is it has elevated the discussion about the promises that have been made to employees and how we make sure that we’re funding those promises. I think that discussion is very, very important because it’s really getting governments to think longer term rather than just looking one year at a time. It’s required them to say, ‘How are we going to make sure that we have sufficient assets set aside to cover those promises going forward?’ I think it will definitely elevate the discussions on longer-term planning. I’ve seen it happen in the state of Iowa, where I came from. Rather than just looking at a one-year budget, they’re looking at two-year budgets and also looking at five-year financial plans to project out where they see they’re going and how they’re going to sustain those levels of services. So I think that’s the real positive that’s come out of the pension standards.