Last week, the SEC charged New Jersey with defrauding bond investors by failing to disclose the unsound financing of its public employee pension plans. The case was settled without a fine or actions against individuals -- New Jersey simply promised not to do it again.
New Jersey egregiously misrepresented its financial state to investors. But some of the things it did to make its pensions look better-funded than they really were (and justify sweeter benefits) are not unusual -- indeed, the rules on public pension accounting are so loose that states are often tempted to cook the books to “improve” pension solvency. Other states should be nervous that the SEC will come for them next.
Much of the New Jersey action centers on a law passed about a decade ago that raised pension benefits by 9.09% across the board. Most pension funds use a “smoothing” method to recognize unusual investment gains or losses gradually, so the plans funding ratio (plan assets divided by plan liabilities) does not swing wildly. In New Jerseys case, this meant that the dot-com bubble had swelled the market value of assets held by pension plans, but much of those gains could not be immediately recognized.
To make a pension giveaway look affordable, New Jersey “re-based” its actuarial asset value to equal market value as of June 30, 1999. By temporarily abandoning smoothing, New Jersey was able to immediately recognize stock market gains and create the appearance that pensions were significantly overfunded.
Smoothing is supposed to ensure that lawmakers dont make rash decisions in stock market bubbles, and re-basing undermines that goal. But even worse, New Jersey adopted the June 30, 1999 value base in the spring of 2001 -- by which time the dot-com bubble had already burst.
By the time of adoption, the new “market-based” actuarial value was actually more than 10% higher than the true market value of pension plan assets. New Jerseys benefit sweetening wasnt based on recent gains that might turn into losses, but on recent gains that had already turned into losses. But the state failed to disclose the re-basing to bond investors, which would have undermined the states claim that its pensions were well-funded.
New Jersey was not alone in fiddling with its smoothing practices to artificially boost its pension funding ratios. For example, the New York Employee Retirement System also used a market value reset to take advantage of the tech bubble, and thereby reduce the rates that public employers pay into the system for current employees.
Smoothing tricks work the other way, too: when the stock market falls, states can lengthen the period over which they recognize value declines. The Arizona State Retirement System increased its smoothing period from five years to ten in 2002, to delay recognition of the tech bubble collapse. Gains from strong years like 2000 continued to be recognized at the five-year pace, meaning that the reform intentionally decreased the accuracy of the funds solvency calculations. Funds in South Carolina and West Virginia adopted or extended smoothing to delay recognition of 2008 and 2009 stock market losses for essentially the same reason.
These changes are just an accounting measure, but they have serious policy implications. States that adopt longer smoothing periods in down markets can slow the rise of employer contribution rates -- the percentage of payroll that governments must pay into pension funds. This takes pressure off of taxpayers and government services, but in the long term it allows pension plan assets to dwindle farther and adds implicit liabilities to the states balance sheet.
Pension plan chicanery isnt limited to smoothing. Pension fund managers can also choose from a menu of options to estimate future pension payments that have been accrued to date, some of which arrive at higher figures than others.
In the 1990s, New York State tried to save some money (in the short term) by adopting the Projected Unit Credit method of estimating pension liabilities, which produces a lower liability figure than the Entry-Age Normal Method used by most states. This shift would have cut required employer contributions, but also weakened the plans true funding status over time. A New York court struck down the change, but it was perfectly compliant with Government Accounting Standards Board guidance and the PUC method is used by some other states.
States can also adjust the calculated solvency of their pension plans by changing the “discount rate” assumption used to determine the cost in current dollars of making promises to pay benefits far in the future. Unlike private-sector plans, whose discount rate selection is essentially dictated by the Financial Accounting Standards Board, government plans can choose their own rate, which is typically much higher than in the private sector.
Thus the temptation is to choose a high rate, which cuts the calculated present value of liabilities, and therefore the amount of cash the government must kick into the fund. To justify high rates, plans must invest in higher-return (and therefore riskier) investments -- but the cost of the insurance that taxpayers implicitly provide against market losses is not charged to the plan.
If all of this sounds arcane and dull, it is. The trouble is, legislators use dull, arcane methods to hide pension liabilities, and therefore the true cost of employee retirement benefits. They approve technical accounting changes that shift billions of dollars in costs from today to decades from now. And this only works because they count on your eyes glazing over whenever somebody says the phrase “pension accounting.”
In the case of New Jersey, the valuation reset was used to justify a policy change that immediately added over $4 billion in pension liabilities and then increased annual pension costs by $130 million per year -- a figure that has since nearly doubled, as the cost of sweetened benefits is proportional to state and local government payroll.
Next week, I will write about what the SEC can do to make pension accounting more honest. New Jersey didnt exactly get in trouble for cooking its pension books, but for failing to adequately warn bond investors that the books were cooked. But there is a lot the SEC (and the federal government generally) could do to encourage transparent pension accounting by states. Not only would that help bondholders better evaluate states solvency, it would also help taxpayers understand how much defined benefit pensions really cost.
Original Source: http://www.realclearmarkets.com/articles/2010/08/24/new_jerseys_pension_misdeeds_are_real_but_not_unusual_98637.html