Monday, January 10, 2011

Testimony for Securities and Exchange Commission Field Hearing: CalPERS Alice in Wonderland Accounting

Following up on Saturday's "New York Times: S.E.C. Investigating California Public Employees' Retirement System (CalPERS)".
We'll have Mr. Crane's testimony to the California legislature tomorrow
From the S.E.C.:

David Crane, Special Advisor to Governor Schwarzenegger

September 21, 2010

Good Afternoon. Thank you for allowing me to be here today. State and local governments utilize a misleading method for reporting the size of public pension obligations. Let me give you an example.
Suppose an individual wears two hats, one as a just-retired government employee entitled to pension payments from a state government, and the other as an investor in a general obligation bond issued by that same state government. Assume the pension payments and the bond payments are unconditionally owed by, and fully recourse to, the government. Suppose further that the pension payments and bond payments have identical profiles. For example, suppose that the bond requires a payment of $30,000 per year for 25 years and likewise the pension requires a payment of $30,000 per year for 25 years. 

Also, with respect to the bond, assume that, at the interest rate at which it was issued to the retiree, the government will record a present value obligation of $425,000. With respect to the pension payments, the very same government will record an obligation of only $320,000.
Now, how can that be? Two identical, fully recourse 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.

In short, that world permits governments to discount pension liabilities at a high rate, resulting in diminished present values. The logic used to justify that outcome is that, because the government has established a fund, called a pension fund, in which it deposits capital in the hope that capital will grow to meet the pension payments, the government should be able to discount its pension liabilities at the rate at which it hopes to earn on that capital.
Now, 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 into the pension fund. But that’s not the way it works. The government and the taxpayer stay on the hook. As a result, the retiree who is due the pension payment is not only due an unconditional payment from the government and its taxpayers but also is secured by whatever assets reside in the pension fund. If anything, an even lower discount rate should be used to discount that senior secured obligation when compared to the unsecured bond. Yet, perversely, current government accounting allows governments to discount those senior secured obligations at a higher rate. 

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 deposits you make to that account would allow you to reduce the reported size of your mortgage. Wouldn’t that be nice - at least, until you actually had to make the payments on the 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. And note that these aren’t like Social Security or Medicare liabilities — these are contractual liabilities that cannot be changed, even by State Legislatures or Congress. It gets worse. Because of Alice-in-Wonderland accounting, state and local government pension funds are perversely incentivized to assume the highest rates of return at those pension funds 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 pension fund shortfalls. Believe it or not, recently, the Chief Investment Officer of a large state pension fund was quoted as saying “Do I think it’s unrealistic to search for returns in the 7.5 to 8 percent range? No, I don’t. It’s really hard to imagine a worldwide market system not providing a return to riskier sources of capital.” (Bloomberg Business Week; italics added.) 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 meet 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.
So what does government pension accounting mean in the real world? As just one example, consider what Alicia Munnell, former member of President Clinton’s Council of Economic Advisors, recently reported:
"In 1999, the California Public Employees' Retirement System (CalPERS) reported that assets equaled 128 percent of liabilities, [after which] the California legislature enhanced the [pension] benefits of both current and future employees. If CalPERS liabilities had been valued at the riskless rate, the plan would have been only 88 percent funded. An accurate reporting of benefits to liabilities would avoid this type of expansion . . .."

In other words, in 1999, using Alice-in-Wonderland accounting, CalPERS reported that its assets exceeded liabilities when in reality liabilities exceeded assets. Encouraged by that accounting, the State Legislature enacted a law that year boosting pension promises as Munnell describes. The hidden cost from that boost has already hit $15 billion and will reach at least another $150 billion. 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 ten years, the state actually incurred costs of $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 S.E.C. must require realistic accounting of public pension liabilities. For that to happen it must insist upon the use of a realistic discount rate when reporting pension liabilities. As Munnell puts it: “The argument is compelling that the liabilities of public pension plans, which are guaranteed under state law, should be discounted by a rate that reflects their riskless nature.” In this sentiment she is joined by academics from Stanford, Northwestern, Wharton and the University of Chicago and other commentators.
In addition, the S.E.C. 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 that would be forced to revise upwards their pension liabilities should a realistic discount rate be required. I am happy to take questions.