Wednesday, November 20, 2013

Pensions Issues at the SEC – an Update

There are several recent actions involving the Securities and Exchange Commission (SEC) that should be of interest to public pension plans.

New Municipal Securities and Public Pensions Unit Chief Named 

The first item is the announcement, on November 8, 2013, of the appointment of LeeAnn Ghazil Gaunt as chief of the SEC Enforcement Division’s Municipal Securities and Public Pensions Unit. This specialized unit’s purpose is to focus on misconduct in the municipal securities market and in connection with public pension funds including: offering and disclosure fraud; tax or arbitrage-driven fraud; pay-to-play and public corruption violations; public pension accounting and disclosure violations; and valuation and pricing fraud.

Gaunt replaces Elaine Greenberg, who led the unit from the time of its creation in January of 2010 until earlier this year, when Ms. Greenberg left to join the law firm of Orrick, Herrington & Sutcliffe LLP as a partner in its Washington, D.C. office. During her tenure, the SEC brought its first enforcement actions against states, charging New Jersey and Illinois with misleading investors about the funding of their public pensions in the official statements accompanying bond offerings.

Ms. Gaunt worked in this specialized unit since its inception, and supervised the SEC’s first pay-to-play enforcement action for “in-kind” political campaign contributions in September of 2012 when the SEC charged Goldman Sachs and an executive vice president for violations related to contributions to the then-state treasurer of Massachusetts.

Ms. Gaunt has worked in the SEC’s Boston Regional Office for 13 years. Prior to joining the SEC enforcement staff, Ms. Gaunt was in private practice in Boston, first at Skadden, Arps, Slate, Meagher & Flom LLP and later at Goodwin Procter LLP.

John Cross, director of the SEC's Office of Municipal Securities, is reported in the press to have told the National Association of Bond Lawyers' (NABL) annual workshop in September, 2013, that public pension disclosure will be "a continuing and very significant theme of the SEC." He said that "I can't overemphasize the significance and, at least, the need to focus on pension liabilities because of the sheer magnitude of the numbers."

SEC Proposed Rule on CEO Pay Ratio Disclosure 

In other SEC news, the Council of Institutional Investors (CII) has recently expressed support of its membership for the SEC’s proposed CEO pay ratio disclosure rule. This proposal was approved by the SEC in September, and would require publicly-held companies to disclose the ratio of CEO pay to the median of workers' pay.

The rulemaking was mandated as part of the 2010 Dodd-Frank financial markets reform legislation, and is adamantly opposed by the corporate community, including the Chamber of Commerce. The House Financial Services Committee has also approved legislation (H.R. 1135) in June of this year to repeal the requirement.

CII notes in its letter that while its policies recommend that compensation committees consider “the relationship of executive pay to the pay of other employees” as a factor when developing, approving and monitoring their executive pay philosophy, CII’s policies do not advocate for the disclosure of a CEO-to-worker pay ratio. As a result, CII itself has not taken a position on the matter.

However, “in an effort to assist the Commission obtain useful input from investors about the Proposal,” CII staff discussed it with three of its general members from its three main constituencies -- public, corporate and union employee benefit plans. According to CII’s letter, the results of the discussion “revealed broad consensus among the three members in support of the approach” taken in the SEC’s proposal. “The members generally agreed that the Commission has done an admirable job in proposing to implement [the Dodd-Frank provision]in a flexible manner that attempts to strike an appropriate balance between providing potentially useful information to investors and limiting company compliance costs.”

The deadline for public comments on the SEC’s proposed rule is December 2, 2013.

SEC Roundtable on Proxy Advisory Services 

Finally, the SEC has announced a roundtable on December 5, 2013, to discuss the use of proxy advisory firms by institutional investors. CII has previously requested that the SEC "gather empirical data on the proxy voting practices of investment advisers" in order to provide a factual basis for potential consideration of reforms, which the Commission has been contemplating, dealing with potential conflicts of interest and transparency in the proxy advisory industry.

At issue is whether institutional investors routinely “outsource” their proxy voting responsibilities to proxy advisory firms. "Proxy advisory firms have increasingly teamed up with unions, pension funds and other activist shareholders to push a variety of social, political and environmental proposals that are generally immaterial to investors and often reduce shareholder value," House Capital Markets and Government Sponsored Enterprises Subcommittee Chairman Scott Garrett (R-NJ) also claims. However, others would argue that the services of proxy advisory firms are needed by institutional investors because of their large number of holdings.

The Roundtable will be held at the SEC’s headquarters in Washington, DC, and will be webcast on www.sec.gov.

Tuesday, November 5, 2013

"Use-or-Lose” Rule for Health Flexible Spending Arrangements (FSAs) Modified

On October 31, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) issued a notice modifying the longstanding “use-or-lose” rule for health flexible spending arrangements (FSAs).  To make health FSAs “more consumer-friendly and provide added flexibility,” the updated guidance permits employers to allow plan participants to carry over up to $500 of their unused health FSA balances remaining at the end of a plan year.  According to an IRS “Fact Sheet” accompanying the notice, some plan sponsors may be eligible to take advantage of the option to adopt a carryover provision as early as plan year 2013.

Currently, plan sponsors have the option of allowing employees a grace period that allows them to use amounts remaining unused at the end of a year to pay qualified FSA expenses incurred for up to two and a half months following year-end.   Under this new change, an employer, at its option, is permitted to amend its § 125 cafeteria plan document to provide for the carryover to the immediately following plan year of up to $500 of any amount remaining unused as of the end of the plan year in a health FSA.  Furthermore, the carryover of up to $500 does not count against or otherwise affect the indexed $2,500 salary reduction limit applicable to each plan year.

The existing option for plan sponsors to allow employees a grace period after the end of the plan year remains in place.  However, a health FSA cannot have both a carryover and a grace period: it can have one or the other or neither.

Tuesday, September 3, 2013

IRS MOVES TO IMPLEMENT SUPREME COURT’S SAME-SEX MARRIAGE DECISION

The Internal Revenue Service (IRS) has issued a new Revenue Ruling 2013-17 addressing the status of individuals of the same-sex who are lawfully married under the laws of a state that recognizes such marriages.  It states that individuals of the same sex will be considered to be lawfully married under the Internal Revenue Code as long as they were married in a state whose laws authorize the marriage of two individuals of the same sex, even if they are domiciled in a state that does not recognize the validity of same-sex marriages.  The terms of Revenue Ruling 2013-17 will start being applied on September 16, 2013, but taxpayers can file refund claims for prior open years even before that date.

The IRS has also released on-line “Answers to Frequently Asked Questions for Individuals of the Same Sex Who Are Married Under State Law,” which specifically addresses the rules that qualified retirement plans are required to comply with, along with some examples of the consequences of these rules for qualified plans.  It is well to note, however, that while taxpayers can file amended returns that relate to prior periods in reliance on the new rules, the IRS has not yet provided guidance regarding the application of Windsor and these new rules to qualified retirement plans for periods before that date.

The new Revenue Ruling reflects the recent U.S. Supreme Court decision in United States v. Windsor (June 26, 2013), invalidating a key provision of the 1996 Defense of Marriage Act (DOMA) and implements the Federal tax aspects of this decision.  Under the new ruling, same sex couples will be treated as married for all Federal tax purposes, including income and gift and estate taxes.  Interestingly, however, the ruling does not apply to registered domestic partnerships, civil unions, or similar formal relationships recognized under state law.

The Treasury and the IRS said they intend to issue streamlined procedures for employers who wish to file refund claims for payroll taxes paid on previously-taxed health insurance and fringe benefits provided to same-sex spouses. They also plan on issuing further guidance on cafeteria plans and on how qualified retirement plans and other tax-favored arrangements should treat same-sex spouses for periods before the effective date of this Revenue Ruling.

Thursday, June 20, 2013

SOA BLUE-RIBBON PENSION STUDY RAISES CONCERNS

The Society of Actuaries (SOA) has created a “blue ribbon” panel that is charged with determining the causes of underfunding in public pension plans and making recommendations to plan trustees, legislators and plan advisors on how to improve plan management and strengthen plan funding going forward.  The panel is to seek input from public plan actuaries and other key constituencies, and to produce a draft report by the end of 2013.  Many are concerned with the SOA’s characterization of the issue, the make-up of the panel and the nature of the questions contained in a survey associated with the project.  NCTR intends to submit a survey response and is encouraging its members to do likewise; the deadline for responding is June 28th.  NCTR’s Executive Director, Meredith Williams, said “I think we must do everything that we can to prevent the SOA from publishing a report unfairly critical of the management of governmental plans and supportive of methodologies that we know will prove harmful to public plans, their participants, beneficiaries, and, ultimately, their sponsors.”

On April 17, 2013, the SOA announced that it had established a “multidisciplinary blue ribbon panel” to:
  • “Determine the causes, at a high level, of plan underfunding by considering how past decisions about benefit design, funding and investing have led to widespread and persistent underfunding of public sector plans;” and
  • “Develop recommendations for plan trustees, legislators and plan advisors on how to improve plan management and strengthen plan funding going forward.”
As announced, panel members include:
  1. Chair: Bob Stein, FSA, MAAA, Retired, Ernst & Young
  2. Co-Vice Chair: Andrew Biggs, American Enterprise Institute
  3. Co-Vice Chair: Douglas Elliott, Brookings Institution
  4. Bradley Belt, Palisades Capital Management, former executive director of the Pension Benefit Guaranty Corporation
  5. David Crane, Stanford University, former advisor to Gov. Arnold Schwarzenegger, CA
  6. Malcolm Hamilton, FSA, FCIA, Retired, Mercer, senior Fellow, C. D. Howe Institute
  7. Laurence Msall, The Civic Federation (Illinois)
  8. Mike Musuraca, Blue Wolf Capital Partners, former trustee of the NYC Employees Retirement Systems-NYCERS and formerly of American Federation of State, County and Municipal Employees
  9. Bob North, FSA, EA, MAAA, FCA, FSPA, New York City Office of the Actuary
  10. Richard Ravitch, Co-chair, State Budget Crisis Task Force, formerly Lt. Governor of New York
  11. Larry Zimpleman, FSA, MAAA, Principal Financial Group

As part of its effort to seek input from “key constituencies,” the panel has also created an on-line survey made up of 30 questions, most of which are open-ended.

NCTR is very concerned with the SOA’s project for several reasons:
  • Characterizing public sector plans as having “widespread and persistent underfunding” is a gross generalization of the situation.  “I do not agree with this statement, and I think that beginning a project based on this basic premise is very problematic,” says Williams. 
  • To NCTR’s knowledge, no public pension plan director was consulted regarding the panel’s make-up, and, as announced, no public plan director is a member. 
  • Several of the panel members, including its co-vice chair, Andrew Biggs with the American Enterprise Institute, and David Crane, former advisor to Governor Arnold Schwarzenegger of California, are well-known, vocal opponents of public sector defined benefit plans and staunch proponents of the use of the market value of liabilities (MVL) and a so-called “risk-free” rate of return.
  • Many of the panel’s survey questions are “very leading and appear to subsume a response, typically one that is critical of public plan management,” according to Mr. Williams.  In addition, of the 26 substantive questions, at least four deal directly with the discount rate, and several others implicate it.   “While the discount rate is certainly critical to funding issues, there are many other aspects to the funding challenge, and this emphasis on the use of the long-term rate of return on assets suggests to me a predisposition as to where this panel’s real focus lies,” says Williams.

 NCTR has prepared a survey response which stresses several key points:
  1. Judging the adequacy of funding requires more than a snapshot of the ratio of assets to liabilities at a specific moment in time.  The key issue is whether a plan sponsor has a funding plan and is sticking to it.  “Where challenges do exist for certain plans with regard to the adequacy of their funding, the primary cause,” according to NCTR’s survey response, “relates to the lack of funding discipline.”
  2. A pension funding policy should be based on an actuarially determined contribution.  It must include funding discipline to ensure that the funding policy contributions will be made, and it should strive to keep employer costs as a reasonably consistent percentage of payroll, in a manner consistent with the actuarial requirements.
  3. The strongest governance practice that those charged with reviewing or making decisions about plan benefit levels and contributions can establish to support the adequate funding of defined-benefit plans is to have a pension funding policy that is based on an actuarially determined contribution, and to fully and consistently fund this contribution. 
  4. The use of a long-term rate of return on plan assets is an appropriate discount rate to use for funding as well as financial disclosure because it is consistent with both the perpetual nature of governments and the enduring, long-term nature of public pensions.  Using a long-term approach in setting the return assumption also promotes stability and predictability of the cost of a pension system.  Finally, the purpose for measuring public pension liabilities is not to price them, but to fund them, and creating a disconnect between the measurement of a liability and the funding of that same liability would only serve to confuse the general public and elected officials. 
  5. If current taxpayers were charged on the basis of present interest rates, rather than a long-term expected rate, significant disparities in what generations of taxpayers are charged for pension benefits could occur.  This volatility would violate intergenerational equity by overcharging some taxpayers and undercharging others, depending upon the timing and direction of the volatility.   
  6. The Market Value of Liabilities (MVL) approach would produce rapid and erratic changes to a public plan’s normal costs, accrued liabilities, and funded levels, and the serious instabilities in the MVL measures would lead either to erratic demands on government resources or plan terminations.  
  7. All trustees, including elected officials and their appointees, have an undisputed fiduciary obligation to act for the exclusive benefit of the plan and its participants.  Trustees must put the interest of all plan participants and beneficiaries above their own interests or those of any third parties.  Continuing trustee education for all plan trustees, including those elected, appointed, or serving ex officio, should be expanded and consideration should be given to making such trustee education mandatory.
  8. The ability of a plan sponsor to fund a promised benefit is certainly a legitimate consideration, but the time to consider this is at the time the benefit itself is approved, or enhancements to it are adopted, and not when the actuarially determined contribution is being set.  

NCTR is asking its members to consider responding to the survey.  “Unless public pension plans respond, there is a real danger that only the views of proponents of a risk-free rate of return and the abandonment of the DB model will be heard,” according to Mr. Williams.

The Society of Actuaries is the largest professional actuarial organization with 22,000 actuarial members and the public in the United States, Canada and worldwide.  The SOA says its vision is for actuaries to be the leading professionals in the measurement and management of risk.  



Thursday, April 25, 2013

IT’S OFFICIAL: NEW PEPTA LEGISLATION INTRODUCED IN HOUSE AND SENATE


On April 18, 2013, Congressman Devin Nunes (R-CA) introduced the newest version of his Public Employee Pension Transparency Act,” HR 1628, and its companion, S 779, was introduced in the Senate on April 23, 2013, by Senator Richard Burr (R-NC).  The bills are essentially the same as the previous versions from the last Congress, with a few significant exceptions.  Despite a “Dear Colleague” request made to other House members on February 25, 2013, Congressman Nunes only has two original cosponsors, as does Senator Burr.  NCTR, along with nine other national organizations, wrote to all House members on April 3, 2013, urging them not to cosponsor the Nunes legislation, and has recently joined with 20 other national groups representing public employers, public employees and public pension fund administrators in writing to former cosponsors of the legislation telling them PEPTA is unwise and unwarranted and asking for a meeting to discuss public pension plan reforms.  There are some signs that PEPTA may have lost some steam since the last Congress, but NCTR and other public sector organizations still view it as a major legislative threat.

In General
The new PEPTA legislation (HR 1628 and S 779) continues to require that, in order to retain Federal tax-exempt status for their bonds, sponsors of State and local pension plans (other than defined contribution plans) must file an annual report as well as potential supplementary reports with the Secretary of the Treasury related to their pension finances. These reports will be entered into a database that will be accessible to the public.

In effect, PEPTA would require every public pension plan to essentially keep two sets of books.  One would be the set that plans currently produce, which would reflect the reality of balanced investment portfolios -- including stocks and other sensible investment alternatives as well as bonds – that have, over the past 25 years, averaged 8.8 percent returns (based on median returns for periods ended 09/30/2012).  The other set would pretend that all public plan assets were invested in U.S. Treasury bonds (even though this is not the case for any public plan), which currently yield around 3 percent. 

The result would be two substantially different measurements of a plan’s unfunded liabilities maintained by the Treasury Department.  One set of numbers would be a substantially increased, artificial liability measurement that the use of the Treasury yield curve would produce, which, along with the unsmoothed valuation of assets, would significantly understate plan funding levels. This artificial set of numbers will differ substantially from those used to fund a plan or required for accounting and financial reporting purposes under GASB.  The reporting of these two sets of numbers will only serve to confuse the public, failing to provide clarity with regard to public pension accounting.
Details
Specifically, PEPTA would require an annual report that would have to include the following:
  • A schedule of the funding status of the plan, including the net unfunded liability and the funding percentage of the plan;
  • A schedule of contributions by the plan sponsor for the plan year;
  • Alternative projections for each of the next 60 plan years of cash flows associated with the current liability, together with a statement of the assumptions used in connection with such projections;
  • A statement of the actuarial assumptions used for the plan year;
  • A statement of the number of plan participants who are retired or separated from service and are either receiving benefits or are entitled to future benefits and those who are active under the plan;
  • A statement of the plan's investment returns including the rate of return, for the plan year and the 5 preceding plan years;
  • A statement of the degree to which unfunded liabilities are expected to be eliminated;
  • A statement of the current cost of the plan for the plan year; and
  • A statement of the amount of pension obligation bonds outstanding.

The two significant changes from last year’s bill are the requirement for 60 years of plan projections of cash flow instead of 20 years, and the addition of the “current cost” of the plan.
In addition to the annual reports, supplementary reports will be required of plan sponsors in any case in which either the value of plan assets in the annual report is not determined using fair market value, or the interest rate or rates used to determine the value of liabilities or as the discount value for liabilities are not interest rates based on US Treasury obligation yield curve rates.

The supplementary report would be required to include certain information specified in the Annual Report -- specifically, a schedule of the funding status of the plan; a statement of plan investment returns; the degree and manner the plan sponsor expects to eliminate its current unfunded liability; and the plan’s current cost -- but determined by valuing plan assets at fair market value and by using the applicable daily Treasury obligation yield curve rate as the discount rate.  (This is also different from the previous legislation, in that it no longer would require the Treasury yield curve to be based on three different periods.) 

Finally, the legislation would continue to prohibit a Federal bail-out of public pensions.

Public Sector Reaction
On February 25th, Congressman Nunes circulated a “Dear Colleague” request to his fellow House members, asking them to join in cosponsoring his legislation.  NCTR immediately alerted its members, urging them to contact their Congressional delegations, particularly those Members who had cosponsored PEPTA in the last Congress, to ask them to call their public retirement systems before they considered cosponsoring the Nunes PEPTA legislation.   

Next, on April 3, NCTR, along with nine other national organizations, wrote to all House members, asking them not to cosponsor the Nunes legislation, and pointing out that PEPTA “paints an inaccurate and misleading picture of the state of public finance and pensions, and ignores the extensive efforts made at the state and local levels to close short-term budget deficits, as well as address longer-term obligations such as pensions.”  The letter went on to note that “Federal intrusion into areas that are the fiscal responsibility of state and local governments is unwarranted” and that it “makes no sense to impose disruptive and costly federal requirements that only serve to interfere with state and local government economic recovery and pension reform efforts.” 

When Congressman Nunes introduced PEPTA on April 18th, NCTR issued a Press Statement that condemned the legislation as a Federal takeover of public pension accounting.  The statement quoted Meredith Williams, NCTR’s Executive Director, as saying that “I continue to be surprised that Congressman Nunes and his supporters believe that imposing unwarranted, unnecessary, and duplicative Federal regulation on state and local governments is the best way to solve any problem.”

The statement went on to note that when, as now, interest rates are very low, PEPTA will make pension plans appear very underfunded.  This could place pressure on State and local governments to put more monies into these funds than they really need based on their actual funding status.  “But when interest rates are high, it could make plans look even more funded than they actually are, which could exacerbate the underfunding of pensions,” the statement pointed out.

Finally, NCTR has joined with 20 other national groups representing public employers, public employees and public pension fund administrators in writing to former cosponsors of the legislation in both the House and Senate on April 24, 2013, telling them PEPTA is unwise and unwarranted and asking for a meeting to discuss public pension plan reforms.  The letter points out that the Government Accountability Office (GAO) (in a March 2012 report entitled “State and Local Government Pension Plans: Economic Downturn Spurs Efforts to Address Costs and Sustainability”) documented that the exhaustion dates cited in the PEPTA summary materials are “not realistic estimates” of the true financial condition of state and local retirement plans.   “Nevertheless,” the letter continues, “the legislation has been reintroduced in the 113th Congress, along with the same misleading information.”

Outlook
As before, Congressman Nunes was joined in introducing the legislation by Congressman Paul Ryan (R-WI), the Chairman of the House Budget Committee, and Congressman Darrell Issa (R-CA), Chairman of the House Oversight and Government Reform Committee.  These two gentlemen continue to be very powerful members of the overall House Leadership.  However, unlike in the previous Congress, when Mr. Nunes had 36 additional original cosponsors when his bill was dropped and he added another 13 subsequently, he introduced PEPTA in this Congress with only these two additional original cosponsors. And, despite almost two months of seeking other cosponsors, he has only been able to add five more:  Cramer (R-ND); Duncan (R-SC); Jones (R-NC); McClintock (R-CA); and Westmoreland (R-GA). 

Similarly, in the Senate, Senator Burr had only two additional cosponsors when introducing his legislation on April 23rd – Senators Coburn (R-OK) and Thune (R-SD).  In the last Congress, when Burr introduced the Senate PEPTA bill, he had six original cosponsors,  Missing, at least for now, are Senators Grassley (R-IA) and Isakson (R-GA); Senators Ensign (R-NV) and Kyl (R-AZ) are no longer in the Senate.  Also, Senators Kirk (R-IL) and Chambliss (R-GA), who subsequently cosponsored the Burr legislation in the last Congress, are also missing from it so far.
While it is certainly likely that additional cosponsors will be added to both items of legislation, it does suggest that both Senator Burr and Congressman Nunes may have had some difficulty in obtaining comparable numbers for the introduction of this new version of their legislation.  This in turn suggests that the public sector message of unnecessary and unwarranted Federal intrusion is getting across.  Also, unlike the introduction of the PEPTA legislation in 2011, there are no signs of any coordinated media campaign this time around.  Congressman Nunes has not been seen on television talking about “smoking the rats out of their holes,” for example.

However, it is well to note that Congressman Nunes has a new trifold brochure supporting his legislation that includes a litany of supportive quotes and endorsements from newspapers across the country for his earlier bill.  Also, notwithstanding his new role as Chairman of the House Ways and Means Trade Subcommittee, and the demands it places on his time, he has once again championed this legislation.  In short, it cannot be safely assumed that this time he is any less serious about advancing PEPTA.  And as a more senior member and part of the leadership of the Ways and Means Committee, he is now in a much better position to help move it than he was in the last Congress.   

In summary, NCTR and the public pension community in Washington are taking the new PEPTA legislation as a very serious threat.  The risk is not that the legislation will be moved as a free-standing bill, but that it will be added to some other major piece of legislation, such as an extension of the debt ceiling, or tax reform, from which it will be difficult to strip out. 

Hopefully, the efforts of NCTR and its members to keep cosponsors off the bill this time around are working, and Members of Congress are not as quick to jump to blame public pensions for all of State and local governments’ fiscal problems as they have been in the past.  If you have not yet reached out to your Congressional delegation on this matter, please do so as soon as is possible.


Monday, April 1, 2013

NEW STUDY CLAIMS OFFICIAL EDUCATION SPENDING NUMBERS TOO LOW DUE TO UNDERESTIMATES OF TEACHER PENSION COSTS


A new “Backgrounder on Education” was released by the Heritage Foundation on March 25, 2013.   Entitled Official Education Spending Figures Do Not Incorporate Full Cost of Teacher Pensions, the new report claims that the Federal government “dramatically underestimates” teacher pension costs in its official education spending figures, and that correcting the problem could add tens of billions of dollars—about $1,000 per pupil—to official education spending estimates.
The report’s author, Jason Richwine, is the Heritage Foundation’s senior policy analyst in empirical studies, specializing in education policy, public-sector compensation and labor issues.  He also wrote another Heritage Foundation report, along with Andrew Biggs from the American Enterprise Institute (AEI), entitled Assessing the Compensation of Public-School Teachers.  (This report claimed that public-school-teachers’ total compensation (including benefits) was 52 percent greater than fair market levels indicate they should be, given the “relative lack of rigor of education courses” -- meaning that “many teachers have not faced as demanding a college curriculum as other graduates” -- and the “low cognitive ability compared to other college graduates” that active teachers exhibit.)

Richwine’s latest report asserts that the Federal government’s incorrect education spending estimates are due to the fact that the National Center for Education Statistics (NCES), a division of the U.S. Department of Education, permits states to define teacher pension costs as the amount school districts contribute to their pension funds each year. However, Richwine argues that since governments “frequently underfund their pensions,” the reported amount does not really reflect the “true” costs of these pensions, and that the “correct accounting” would measure pension costs based on the present value of future pension benefits that teachers have accrued. 
Of course, Richwine also insists that this “correct accounting” approach would also use a discount rate based on a virtually risk-free rate of return, such as the yield on U.S. Treasury bonds of around 3 percent currently, instead of the pension accounting method that he notes “detractors might call … an accounting trick” that bases the discount rate on the expected rate of return on plan investments.   This latter approach, Richwine say, is “roundly rejected by financial economists, private pension administrators, and public-sector pension regulators in other industrialized nations.” 

Consequently, Richwine argues, government actuaries discount future pension liabilities at a rate that is too high.  If the current numbers used by the NCES were replaced with both the risk-adjusted normal cost and the payments toward unfunded liabilities, the cost of overall benefits would go up by 78.8 percent, according to Richwine, and official total expenditures-per-pupil would rise from $12,309 to $14,054 during the 2009–2010 school year, which is the most recent year for which data are available.
Therefore, Richwine recommends that the NCES should begin measuring the cost of pensions with actual risk-adjusted pension liabilities rather than annual contributions.  He says that this would provide more accurate estimates of teacher pension costs and of education spending in general.

Richwine devotes much time to discussing how many economists agree that the only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate.  He says that this is a “basic principle of financial economics,” and that economists “practically unanimously support” this method. 
He goes so far as to point out that in a 2012 poll, 38 of 39 leading economists agreed with this statement: “By discounting pension liabilities at high interest rates under government accounting standards, many U.S. state and local governments understate their pension liabilities and the costs of providing pensions to public-sector workers.”  Richwine asserts that therefore, “defenders of public pension accounting methods, not their critics in mainstream economics, are the embattled contrarians.”

With all due respect to economists, they are not always right.  Indeed, Paul Krugman, an economist and winner of the 2008 Nobel Memorial Prize in Economic Science, has pointed out that economists can indeed make mistakes.  In a September 2, 2009 article in The New York Times entitled How Did Economists Get It So Wrong? Mr. Krugman discussed how so few economists saw the 2008 economic crisis coming.
Mr. Krugman noted that “During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right.”  “There was nothing in the prevailing models,” he observed, “suggesting the possibility of the kind of collapse that happened” in 2008.  The problem, he went on to say, was that the economics profession “went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.”

So too, perhaps, with the discount rate controversy?  The financial economics model for the discount rate may work beautifully for critics of public sector defined benefit plans when, as now, there is a very long period of very low interest rates.  It can make it appear that plans are discounting future pension liabilities at too high a rate.  Consequently, critics argue, basing the discount rate on the expected return on plan investments systematically understates the costs of funding public pension plans. 
However, what happens when interest rates are very high?  Does the “truth” of Mr. Richwine’s assertions still hold?  For example, 30-year Treasury yields (as of the June valuation date) were almost at 14% in 1982 and 1984.  Between 1978 and 1985 they were consistently above 8%.  During such periods, would financial economists continue to insist that a discount rate based on expected rates of return understates the costs of funding plans?  Would 38 of 39 leading economists still agree that by discounting pension liabilities at the expected rates of return, many U.S. state and local governments were understating their pension liabilities and the costs of providing pensions to public-sector workers?

Basing the discount rate on the risk-free rate of return during periods of high interest rates could make plans look much better funded than they actually are.  Contribution rates could fall below those based on expected rates of return, and could exacerbate underfunding problems when interest rates drop.
I am not an economist, but it seems to me that for a theory to be useful -- in practice and not just in theory -- it should work regardless of whether a risk-free rate is at historic lows, as it has been now for several years, or in the double digits, as it may well be in the future depending upon inflation. 

Just consider me an “embattled contarian.”

    

Friday, March 15, 2013

SEC CHARGES ILLINOIS WITH SECURITIES FRAUD OVER PENSION FUNDING DISCLOSURES


SEC CHARGES ILLINOIS WITH SECURITIES FRAUD OVER PENSION FUNDING DISCLOSURES
On March 11, 2013, the Securities and Exchange Commission (SEC) charged the State of Illinois with securities fraud for misleading municipal bond investors about the State’s approach to funding its pensions – specifically, the Illinois State Employees’ Retirement System; the State Universities Retirement System; the Illinois Teachers’ Retirement System; the Judges’ Retirement System; and the General Assembly Retirement System.  This is only the second time that the SEC has used its anti-fraud statutes against a state in order to underscore what the Commission sees as flawed public pension disclosure by municipal bond issuers; the first involved New Jersey in 2010.
According to the SEC’s investigation, Illinois did not inform investors about the significant impact of problems with its pension funding and failed to disclose that it had “structurally underfunded” the State’s pension obligations and increased the risk to its overall financial condition as a result.  Illinois, without admitting or denying the findings, agreed to settle the SEC’s charges and entered into a “Cease and Desist” Order with the agency.
Elaine Greenberg, Chief of the SEC’s Municipal Securities and Public Pensions Unit, said that the area of public pension disclosures “continues to be a top priority of the unit.”
There are several aspects of the Cease and Desist Order that are worth noting:
·       The SEC provides some insights as to what it views as an acceptable public pension funding policy – or at least what it does not.  Specifically (see Finding 9(a)), the SEC believes that contributions to a plan must be sufficient “to prevent the growth of its unfunded liability” and should cover both the normal cost and a payment to amortize the accumulated amount of pension liabilities that have been deemed earned but are not funded (the unfunded actuarial accrued liability, or ‘UAAL’) for an identified group of plan participants.
(What is an acceptable amortization period?  The SEC does not say.  But the Commission does observe that a 90 percent funding target “allowed the State to amortize the UAAL in a manner that would not eliminate it entirely,” thus increasing the “economic cost” of the pensions and delaying the cash outlays necessary to fulfill the pension obligations.  Also, the SEC noted that Illinois spread costs over fifty years, “in contrast to the thirty-year amortization period adopted by the pension plans of most other states.”) 
If a funding policy does not at least prevent the growth of a plan’s unfunded liability, the SEC found that the result could structurally underfund pension obligations and backload the majority of pension contributions “far into the future,” thereby resulting in “significant stress” on a pension system and on a state’s “ability to meet its competing obligations.”
In short, the SEC found that, at least in the Illinois situation, the “State’s pension contributions were calculated in accordance with State law, not in accordance with the ARC,” and therefore Illinois “deferred funding of the State’s pension obligations and compounded its pension burden.”
Granted, the violation of law was not due to Illinois’ failure to follow some SEC model for funding, but the Commission’s preference for the ARC, as it defines it, over state law, is informative.  Does it mean that if a state has a stautory contribution rate that is less than the ARC, that it is "structurally underfunding" its pension obligations and needs to disclose this in its bond offering statements? 
·       The SEC does not like the projected unit credit (“PUC”) actuarial cost method.  It found that Illinois’ use of it “compounded the risk” of the state’s Statutory Funding Plan and that Illinois “did not inform investors that other aspects of the State’s funding method, such as the State’s use of the PUC method, delayed contributions and increased the unfunded liability.”  (See Findings 9(f) and 13(c).)
·       Beware of consultants.   The SEC was quick to point to a pension consultant retained by the Governor’s Office of Management and Budget who wrote that the Illinois pension system “is now so underfunded that the State likely [would] never be able to afford the level of contributions required to ever reach 90 percent funding.”  The SEC found it problematic that this information was not disclosed to bond investors in bond offering documents.  (See Finding 10(b).)  How broadly, and to whom, does this term “consultant” apply?
·       Policies and procedures related to pension disclosures are important.  In the Illinois situation, the SEC found that the State’s misleading disclosures resulted from, among other things, various institutional failures, including failures to adopt or implement sufficient controls, policies, or procedures designed to ensure that material information was assembled and communicated to individuals responsible for disclosure determinations; to train personnel involved in the disclosure process adequately; and to retain disclosure counsel.  “As a result, the State lacked proper mechanisms to identify and incorporate into its official statements relevant information held by the pension systems and other bodies within the State,” according to the SEC. 
The Commission also found that the State and its advisors “did not scrutinize the institutionalized description of the Plan adequately and made little affirmative effort to collect potentially pertinent information from knowledgeable sources—in particular, actuaries for the pension systems.”
Finally, the SEC refers favorably of the remedial steps taken by Illinois, including, prior to dissemination of official statements, a review by the pension systems, as well as the Office of the Comptroller, the Office of the Treasurer, and the Office of the Illinois Attorney General.  (See, generally, Findings 23 through 26.)
In general, this Cease and Desist order is more focused that the SEC’s action involving the State of New Jersey.  It is shorter (11 pages compared to 17 pages for the New Jersey order, and it makes fewer findings (31)as compared to New Jersey (51).   Perhaps more importantly, it does not get into the pension plans’ preparation of the numbers reported to the state, as it did with New Jersey, but focusses instead on the Illinois’ “structural underfunding” of its pension obligations.   
For example, the New Jersey order found problems with the fact that the State’s bond offering documents “did not disclose the effect of the State’s use of a five-year smoothing method to measure the actuarial value of assets,” which, despite the fact that such smoothing was permissible under applicable GASB standards at the time, the SEC nevertheless found troublesome because New Jersey‘s  contributions to its pension plans  were based on an actuarial value of assets that differed significantly from their market value and thus “reduced the State’s statutory contributions to the pension plans.”
In the New Jersey order, the SEC also found it problematic that the bond offering documents “did not provide asset and funded ratio information on a market value basis.”  The SEC found that “Investors lacked sufficient information to assess the current financial health” of the New Jersey pension plans “as a result of the absence of asset and funded ratio information on a market value basis.’
The Illinois order did not discuss either of these issues.  Perhaps the SEC viewed the Illinois disclosures as being adequate in this area, or that it had sufficient bases for fraudulent action and did not need to discuss these matters.  However, it is worth noting their absence.