Finding Safe Harbor from Pension Fraud

The Governmental Accounting Standards Board's pension disclosures could help CFOs sleep at night.
by | September 9, 2010
 

The recent SEC settlement with the state of New Jersey over its failure to disclose pension funding problems should send chills down the spines of state and local finance officers as well as their pension officials. The state's failure to disclose a hocus-pocus pension funding scheme was deemed a fraudulent artifice by the nation's top securities regulator. Normally, the SEC lacks jurisdiction over issuers of municipal securities, but anti-fraud violations give it full powers to go after government officials. Now, the commission is said to be seeking expanded authority, including a repeal of the historic Tower amendment that limits federal regulatory authority over issuers of municipal bonds.

This is serious stuff. Professional colleagues tell me that we haven't seen the last of this. There are plenty of other state-sponsored subterfuges to avoid paying pension costs, and some of them have never been mentioned in the bond documents. So there is potential liability hanging out there for public finance professionals on both the public and private sides.

For example, California's CalPERS pension system engages in the specious practice of 30-year actuarial smoothing, which probably constitutes an artifice under the SEC's way of thinking. Several states have equally ridiculous practices of amortizing pension liabilities over 40-year periods. This amortization grossly exceeds current GAAP accounting standards and the remaining lifetimes of the employees and retirees. If they aren't properly disclosed to investors, these arrangements could subject both the pension trustees and the CFOs of the participating employers to potential class-action litigation as well as federal antifraud actions.

Any muni bond or mutual fund investor whose securities lose value in the public markets after the truth is revealed can become a plaintiff in what is known in the marketplace as a "stock-drop" class-action lawsuit. It doesn't matter if the bonds get repaid and the interest is paid on a timely basis. It's the short-term market price loss that becomes the foundation of a strong legal claim for damages when fraud is determined.

The problem is that we don't know where this stops. Would an unrealistic or simply over-optimistic investment-return assumption by a pension board subject them and the employer to antifraud liability after the fact? Hindsight is always 20/20 for class-action attorneys. Could California's former public officials now be sued personally for fraud for approving retroactive 50 percent pension increases in 1999 on the now-laughable premise of the Dow Jones Industrial Average reaching 28,000 today and failing to notify bond investors of the inherent risks of their decisions? At least one former legislator and respectable public policy professor is already on that trail. I won't be surprised if there is now a tort team somewhere looking at that one and hunting around for a lead plaintiff.

Fortunately, there is a potential white knight — an unexpected one — that could provide the political and legal cover that muni bond issuers and public pension fund officials need in order to sleep at night. Surprise! It's the much-maligned and oft-criticized Governmental Accounting Standards Board (GASB).

The GASB is midway through a multi-year project on pension accounting, and it has the full authority to set accounting and disclosure standards that can both inform muni bond investors and keep CFOs out of court cases alleging fraud.

For those who've been hibernating this past year, the GASB's pension accounting project has produced "preliminary views" that would (1) record net pension liabilities in the financial statements, perhaps as footnotes if not on the face of the statements, (2) require more conservative amortization of unfunded liabilities and (3) reduce the discount rate and thus increase the liabilities when assets are insufficient to pay the bills in the future. What GASB has yet to deliberate is what it will require as mandatory disclosures in the financial statements. That's where serious professionals now have an opportunity to help craft a disclosure standard that can alert investors to potential cover-ups in the pension plans — and take themselves off the hook for committing fraud.

Instead of whining about pension accounting reforms that move their cheese after years of sometimes slipshod and unsustainable funding practices, finance officers and pension officials should come to realize that GASB is not their problem. It's the plaintiffs' bar and the risk of the SEC unleashed in their backyards.

As one of many respondents to the GASB's preliminary views, I submitted written comments on this specific point two months ago and will testify at their October public hearing. Looking back now, my comments to the board seem prescient. I advocated the mandatory multi-year disclosure of pension funding practices as part of what accountants call "required supplementary information" or RSI. These exhibits typically follow the financial statements and the footnotes in the annual financial report. With the retirement-funding RSI schedule I have proposed to GASB, investors would have all the information they require to make informed judgments about the likelihood that the pension trust will have sufficient assets in future years to avoid impairment of the employers' debt service payments.

For both pensions and OPEB ("other post-employment benefits" — usually retiree medical benefits) plans, GASB simply needs to require that the employers and the pension funds create a three-column RSI schedule with 15-year multi-year projections of:

1. The annual accounting costs per GASB's standards;

2. The pension system's annual actuarially required contributions (ARC) if different from GASB's accounting cost;

3. The employer's (or employers' collective) current funding practices, if different, and;

4. The 15-year projection of the remaining unfunded liability under each column. (Note: I originally proposed to GASB a 20-year schedule, but have since concluded that 15 years is sufficient to highlight the major financial disparities.)

This schedule will flush out any attempt by either the pension fund or the employer to engage in smoke and mirrors to avoid collecting/paying its proper annual costs. If the pension actuaries and the pension trustees succumb to the current voodoo actuarial suggestion that they should separate the funding from the accounting, that will be become blatantly obvious to all readers. If the employer takes a pension holiday or funds less than full cost, that practice must be projected out for 15 years and not dismissed as an extraordinary event: Good intentions don't count for anything in the third column of this schedule. If the employer pays its OPEB obligations on a pay-as-you-go basis and runs up even more debt in the next 15 years, that will become evident to everybody — taxpayers, investors, unions and voters. If the employer wants to add a column to display a multi-year plan to work toward full funding, that should be allowed with (1) appropriate footnote disclaimers that distinguish past practices from intentions and (2) timely subsequent progress reports on compliance with the plan.

If GASB establishes this single exhibit as RSI, it will be almost impossible to play hide-and-seek with pension funding. If the employer engages in practices that fall short of actuarial and accounting standards, it will become quite obvious. Decision-makers can readily see the consequences of financial mismanagement in the 15-year forecast of unfunded liabilities. Pension funds that systematically and habitually cut corners with funding gimmicks will be exposed as emperors without clothes. Under a GASB standard as I propose, this required schedule would be prepared by certified actuaries who would risk their careers and potential litigation if they fudge the projections, so the odds of compliance are very high. In the legalisms of red herrings, it would be "forward-looking financial information" with all the appropriate caveats, but there is not a serious municipal investor or analyst who wouldn't consider this one of their top five data points.

That's all it takes: One schedule for pensions. One for OPEB. Employers who fully fund the accounting costs don't even need to complete the exhibit, as it would apply only when funding practices fail to meet GAAP standards. The Municipal Securities Rulemaking Board can require all muni bond underwriters to include these schedules in the official statements and annual EMMA (Electronic Municipal Market Access) disclosures. SEC should provide a broad safe harbor releasing officials from antifraud liabilities if they truthfully provide this schedule in their bond documents.

Congress doesn't need to repeal the Tower amendment and open that intergovernmental Pandora's box. What investors and stakeholders need is honest, concise, timely and straightforward disclosure. Let GASB do its work, get the market regulators to back up their efforts, and provide clear anti-fraud safe harbors for the good guys who tell it like it is.

Disclosure: Girard Miller was previously a member of the GASB board. His opinions expressed here are entirely his own and do not represent those of any organization with which he is or was previously affiliated.

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