‘Alice in Wonderland’ accounting deceives bond investors

By   /   September 22, 2010  /   News  /   No Comments

By Dave Roberts — Municipal bond investors need more accurate information faster than state and local governments now provide through 'Alice in Wonderland' accounting that underestimates their true long-term fiscal obligations.

SAN FRANCISCO – The first in a series of Securities and Exchange Commission hearings around the country probing impact of state and local government accounting practices on municipal bonds kicked off here with tales of “Alice in Wonderland” methods that deceive taxpayers and investors.

California taxpayers owe state and local government pensions much more – perhaps an extra $2.5 trillion – than officials have let on, according to an economic advisor to Governor Arnold Schwarzenegger testifying at the hearing.

That is debt investors in California municipal bonds did not know about.

Advisor David Crane testified, “For example, an annual obligation of $30,000 for 25 years for a government employee’s pension is projected to cost the government $320,000, while the same $30,000/year, 25-year obligation in the form of a bond is projected to be $425,000.

“Two identical 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.”

California is among the worst in fiscal deception, along with New Jersey, Illinois and New York State, but SEC Chairman Mary Shapiro ordered the hearings because “investors hold about $2.8 trillion of municipal debt,” and “investors must be confident that they are getting the information necessary for knowledgeable decisions, at the time and in a form that they need it.”

 The SEC just settled a fraud case against New Jersey for not telling investors about the true size of unfunded pension liabilities.

Other issues raised at the hearing included clarifying the differences in regulation of the municipal and corporate bond markets, and the need to level the playing field for individual investors, who have less access to information on municipal securities than institutional investors.

The SEC will also be looking further into government pension accounting practices, according to SEC Commissioner Elisse Walter, who was appointed by Shapiro to head the investigation. Noting that the issue “is quite complex,” she said that future SEC hearings “will continue to explore these topics.”

The San Francisco hearing was the first of five around the country. Others will be in Chicago, Washington, Tallahassee, Fla., and Austin, Tex.

Hearings will include testimony from the local region and will examine issues including “investor protection and education; financial reporting and accounting; market stability and liquidity; the Municipal Securities Rulemaking Board; municipalities as conduit borrowers; offering participants, professionals and market intermediaries; Build America Bonds; and 529 plans,” according to the SEC Web site.

Crane said, “The government and the taxpayer stay on the hook,” for pension promises. “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 deposit you make to that account would allow you to reduce the reported size of your mortgage. Now wouldn’t that be nice – at least until you had to make the payments on that mortgage. Which, of course, remain the same.”

Because government officials are able to hide their future debt obligations in this way, they “are perversely incentivized to assume the highest rates of return 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 any pension fund shortfalls,” Crane said.

The chief investment officer of a large state pension fund recently said that investment returns in the 7.5-8 percent range are not unrealistic, according to Crane.

This fiscal fudging has led to the growth in the ticking pension time bomb in California and throughout the nation. In 1999 the California Public Employees Retirement System (CalPERS) reported that its assets equaled 128 percent of its liabilities when in reality its assets totaled only 88 percent of liabilities, according to Alicia Minell, an economist in the Clinton administration.

“In other words, in 1999 using Alice in Wonderland accounting, CalPERS reported that assets exceeded liabilities when in reality liabilities exceeded assets,” said Crane. “Encouraged by that accounting, the state legislature enacted a law that year boosting pension promises. The hidden cost from that boost has already hit $15 billion and will reach at least $150 billion for the state budget.

“California wasn’t alone in this regard. Unrealistic reporting of pension promises is a systemic problem. That’s why the SEC must require realistic accounting of public pension promises.”

Crane said proposed Government Accounting Standards Board regulations do not go far enough.

It remains to be seen whether GASB will restore fiscal sanity to pension accounting, but the board is looking into the matter, according to James Lanzarotta with the Moss Adams accounting firm.

“Pension liabilities is one of the big topics of the day,” he said. “So they are currently deliberating on an improvement that would put the liability on the financial statements at amounts that are a lot closer to the expected future payout, the discounted present value of the expected valuation. That’s in contrast to what’s done today. Today the liability is measured based on what the actuary said the annual requirement would be for funding versus what the government actually contributed. So it would be quite a change from current practice.”

Dave Roberts is a reporter for California Watchdog.