More Columns
BENEFITS BEAT
Wisconsin Schools Flunk
‘Investments 101’
Several school districts tried to close their retiree funding gap, but they ended up much worse off than before.
Questions, success stories or anecdotes about benefit issues in government? Girard Miller wants to hear from you.
E-mail him
In a dubious move to solve their retiree medical (OPEB*) funding problem, at least five Wisconsin school districts have reportedly dug themselves into an even deeper hole. They borrowed money and invested it in the most controversial financial instruments of the decade — collateralized debt obligations. At the center of the reported controversy is a broker who appears to have peddled undiversified products generally without the presence and professional assistance of a qualified financial or investment adviser.
As I have reported in previous columns, the issuance of bonds to finance OPEB liabilities for retiree medical promises is a risky trade. The leveraged OPEB bond strategy should be undertaken with extensive due diligence. The Government Finance Officers Association recommends that such transactions be entered into with great caution. Investment returns could fall short of the costs of the bonds and the repayment of principal. That's why OPEB bonds are like borrowing money on a home equity loan to fund your IRA.
OPEB bonds and investment schemes are easy to sell to unaware public officials. There is widespread misunderstanding of the nature of the liability and how it must be reported and financed. Uninformed or unsophisticated officials can be led to believe that they are solving a massive long-term financial problem for once and for all, only to find that the nature of retiree medical costs makes it inherently impossible to achieve that level of finality. Likewise, there is an illusion that virtually risk-free or low-risk transactions can be ginned up that will perform financial alchemy and turn the lead of an OPEB liability into the gold of an investment arbitrage profit. Common sense should suggest that's not likely to happen.
I won't speculate about litigation or fault in the Wisconsin situation. Undoubtedly there are two sides to this story. Actually there will be six sides, since there are five school districts that apparently all independently had the same dream one midsummer's night. What I will say is that the federal securities regulators ought to look into this fiasco. The National Association of Securities Dealers, as the self-regulatory body designated by the Securities and Exchange Commission, is responsible for overseeing the activities of brokers and dealers who sell securities to the public. That includes institutions such as school districts. Generally, many of the SEC and NASD investor protection rules begin with the assumption that large institutional investors are sophisticated and don't need their protection. But the suitability and anti-fraud protections of the federal securities laws can't be swept under that rug. Whether there is actual wrongdoing here is not my job to deduce: Let's leave that to competent authorities.
At issue here is whether a reported pattern of undiversified portfolios of junky debt obligations would be considered unsuitable for investors who borrowed money to fund the portfolio. Generally, a sales representative and a counterparty firm's registered principal have an obligation to ascertain such facts before completing a transaction, regardless of how many CYA documents they required the buyer to sign. A higher standard of duty and ethics is required when leverage is involved, because the losses are magnified when things go sour. Otherwise, this is the institutional equivalent of widows being swindled by peddlers of reverse mortgages pushing exotic investments on them.
The unfunded OPEB liabilities of states and municipalities exceed $1 trillion. This is a huge problem searching for solutions, and some gullible localities will be easy prey if protections are not put in place in the interest of taxpayers. This kind of mischief will continue until the word gets out and safeguards are installed nationwide.
In most states, local governments and school districts don't invest their own pension funds, because the states took over that function decades ago. But OPEB trusts are a new frontier. States should adopt investment laws to govern OPEB trusts with the same caution as pension funds. That means that investment authority should be sufficiently broad to match long-term investment goals, but diversification, prudence and professional management must be required. Investment fiduciaries must be put on the hook and reminded of their solemn obligations.
Local governments also need to adopt OPEB investment policies that require diversification, professional management and fiduciary oversight. Public officials may need to be disciplined, recalled or fired for misguided decisions. Professional associations need to provide training and meticulous guidance. Financial counterparties need to be held responsible and liable for inappropriate sales activity. Brokers, dealers and financial advisers need to clean house, ensure discipline and re-emphasize suitability. Regulators need to investigate and lower the boom on unscrupulous sales practices.
Letting this nonsense continue would be a disservice to taxpayers.
*OPEB stands for "other post-employment benefits" in the parlance of the Governmental Accounting Standards Board, which issued a statement that established financial reporting standards for retiree medical plans and similar benefits.
Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net. His general market observations and institutional investment strategies are his own and should not be construed as investment advice or recommendations concerning specific securities. More biographical information.