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GASB Loopholes Created Illusions of Solvency

What if most of the public employee compensation enhancements of the past decade or more in California were based on inaccurately optimistic government financial statements? Or to be blunt, what if government decision makers thought they could afford these compensation enhancements, because the information they relied on used accounting gimmicks that would land a person in private industry in jail for fraud?

Back in February the California Public Policy Center (CPPC) published a study entitled “How Lower Earnings Will Impact California’s Unfunded Pension Liability,” where, using various rates of annual investment earnings, the number ranged between $128 billion and $576 billion. This study and others highlighted the fact that starting in 2014, not only will Moody’s Investors Services begin using a much lower investment projection in their credit analysis, but GASB – the Government Accounting Standards Board – will require government entities to recognize this liability on their balance sheets.

Earlier this week, the CPPC published a new study entitled “Unmasking Staggering Pension Debt and Hidden Expense,” that took a look at seven California counties, Alameda, Contra Costa, Marin, Mendocino, Orange, San Mateo, and Sonoma, and restated their balance sheets based on the new GASB financial reporting standards and the new Moody’s credit evaluation criteria. In his analysis of these seven California counties, researcher John Dickerson calculated that the new GASB rules will lower their combined net worth by a factor of ten, from a current reported $10.2 billion to less than $1.0 billion. And all of these losses, in any private enterprise, would have already been recognized.

Starting in 2014, GASB (Government Accounting Standards Board) will require state and local governments to report their unfunded pension obligation as a liability on their balance sheets, eliminating a loophole in their current regulations. It’s about time. The loopholes being plugged by GASB 68 have permitted California’s cities and counties to declare balanced budgets when in fact they were failing to report billions in pension expense.

The study not only calculates the impact of GASB 68, but goes on to estimate the impact of GASB’s new ruling combined with Moody’s new credit evaluation criteria on government financial statements. As Dickerson writes: “These seven counties all together would drop from $10.2 billion of Net Assets down to a negative $8.3 billion hole – $19 billion less. On average, they would have more unfunded pension debt than assets.”

One may argue heatedly as to whether or not Moody’s 5.5% discount rate is too low, but for the moment, let’s forget about the discount rate. Let’s go ahead and accept the long-term earnings projection of 7.5% per year as realistic. This still means that the seven counties analyzed had failed to report over $10.2 billion in liabilities. This still means that across all of California, the state and local governments had failed to report over $128 billion in liabilities. Because $128 billion is the State Controller’s officially acknowledged amount of unfunded pension liabilities.

When financial analysts warn us that the steps GASB and Moody’s are taking will make it harder for cities and counties to acquire credit by erasing most (or all) of their net worth, and will hasten awareness of the need for compensation reform, they’re right. But that’s only half the story: For the last decade or more, as cities and counties were negotiating enhancements to public employee pension plans, and other compensation enhancements – sometimes in council meetings packed with indignant public workers, other times in binding arbitration – they were basing their decisions on financial statements that were inaccurate. Would pension formulas have been enhanced from 2.5% at 55 to 3.0% at 50, for example, if everyone at the negotiating table had been examining city or county financial statements that were correctly recording these billions in losses?

No business can survive for long with bad financial information. Any auditor whose picked apart a few balance sheets, or any general ledger accountant whose closed a few fiscal years, understands how easy it is to commit fraud. If bankers and investors are wary of a company’s financial performance and need to see more profit, an unscrupulous entrepreneur might revalue their inventory to “market value,” and voila, a loss turns into a profit. What GASB 68 is going to prevent might only excite an accountant, but since its consequences affect us all, it’s still a story worth trying to tell.

When many of California’s cities and counties fell behind in their payments to the pension funds, they didn’t record a payable on their balance sheet – because GASB didn’t have a standard in place to force them to. Then when the time came to make the payment, they needed to borrow the money, but they didn’t want to ask voters to approve a pension obligation bond. So they essentially sued themselves, securing a court ruling that documented the fact that they owed the money. This allowed them to characterize the pension obligation bond’s issuance as a refinancing of existing debt, avoiding the need to submit the bond to voters for approval. Then (accounting wonks, pay attention here), when they put the pension obligation bond debt onto their balance sheet as a liability, because they had not recorded a preexisting payable to the pension fund, instead they put the debit onto the top of the balance sheet as an offsetting asset, which they are slowly amortizing. GASB 68 will wipe all of this out, creating billions in extraordinary losses that will mostly be declared in prior period adjustments of past financial statements.

This sort of behavior violates fundamental accounting concepts, most particularly, matching expenses to the time they are incurred. But during the 1990’s and since, it allowed cities and counties to avoid placing billions in losses on their income statements. And that allowed public employee unions, politicians, and arbitrators, to all make decisions based on flawed, overly optimistic financial information. And it enabled what is now a legacy of contracted compensation enhancements that are considered by their supporters to be beyond even the power of a bankruptcy court to amend.

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UnionWatch.org is edited by Ed Ring, who can be reached at editor@unionwatch.org

Municipal Credit Ratings May Crumble Under New Rules

Everyone remembers how thousands of bankers and millions of homeowners were caught by surprise when the real estate bubble collapsed in late 2008. One of the major reasons this prodigious bubble was allowed to inflate in the first place was because credit rating agencies did not properly evaluate the financial risks inherent in collateralized mortgage debt securities.

Once bitten, twice shy. Credit rating agencies these days are loath to make that mistake again. The two biggest credit rating agencies in the world are Moody’s Investors Service and Standard & Poors, with each of them commanding about 40% of the global market for credit analysis. On July 2, 2012, Moody’s, which specializes in bond credit ratings, announced proposed adjustments to how they will evaluate public sector pension data. Using Moody’s new criteria, the credit ratings of municipal bonds will be severely downgraded.

For the past several years, John Dickerson, a financial professional living in Mendocino County who is involved in public sector pension analysis and reform, has been analyzing the impact of unfunded pension debt on the 21 California counties that operate their own independent Pension Funds. He publishes his findings on YourPublicMoney.com, a website he established as a resource for citizens concerned about the solvency of public sector pensions. Earlier this week, he allowed the California Public Policy Center to post his most recent work, “The Impact of Moody’s Proposed Changes in Analyzing Government Pension Data.”

In Dickerson’s remarkably thorough analysis, he calculated the impact of Moody’s adjustments on the size of the unfunded pension liability for six California counties, Alameda, Contra Costa, Marin, Mendocino, San Mateo, and Sonoma. He also calculated how, using Moody’s revised criteria for assessing the solvency of pension funds, how much, for each of the six counties, annual payments into these pension funds would have to increase.

It is challenging to discuss pension finance without delving into jargon and introducing concepts that may seem arcane to anyone not already well familiar with the discipline. Unfortunately, however, it is the obligation of any journalist, activist, policymaker, financial professional, or concerned citizen, to do exactly that. The failure of a critical mass of individuals to intellectually grapple with pension finance, to honestly assess what it all means, and then do something about it, will spell bankruptcy for virtually every public entity in California. So here goes.

Moody’s has proposed three fundamental changes to how they will evaluate the solvency of pension funds:

(1) They will change the assumed rate of return on pension fund investments from the commonly used projection of 7.0% or more to a much lower 5.5%.

(2) They will require a 17 year time horizon for catch-up payments to reduce unfunded pension liabilities to zero, instead of the 20 to 30 year intervals currently used.

(3) They will require catch-up payments to use a “level payment” method, similar to how payments on a typical home mortgage are structured, instead of the commonly used “percent of payroll” method which actually incurs negative amortization – i.e., the amount of unfunded pension debt actually grows – for the first third of the payment period.

Using unassailable logic, Dickerson’s study – which was reviewed by other pension experts and financial professionals before release – comes to some sobering and indisputable conclusions:

  • The annual contribution for ongoing pension funding obligations – not catch-up payments, but normal ongoing payments, will increase for the six counties combined from the current $312 million per year to $550 million per year, a jump of 79%.
  • The annual catch-up payments to eliminate the unfunded pension liability will increase for the six counties combined from the current $327 million per year to $890 million per year, a jump of 192%.
  • The payments necessary to pay off pension obligation bonds – which were incurred when the local governments borrowed money in order to have enough cash to make their normal pension contribution – will add another $177 million to the annual payments necessary to service existing pension debt and maintain pension fund solvency.

If you add this all up, the six counties analyzed by Dickerson – according to Moody’s – are going to need to increase their annual pension payments from today’s $817 million to over $1.6 billion. Put another way, in order to preserve their credit ratings once Moody’s adjustments take effect, the six counties analyzed will need to double the amount of money they spend each year to maintain their pension funds.

To put this in perspective, Dickerson compared the amount that the six counties combined will need to pay each year for their pensions, $1.6 billion, to the total property tax revenues retained by these six counties last year, which is also $1.6 billion. Get it? “My property tax, your pension,” is not mere rhetoric. Literally 100% of the property tax revenue available to these counties will be just enough to fund the pensions for county workers in the coming years.

For anyone so inclined, wading through the entire 10,000 word study produced by Dickerson is well worth the time. Because the counties he evaluated, Alameda, Contra Costa, Marin, Mendocino, San Mateo, and Sonoma, are not unique. Even though all six of them have their own independent pension funds, the differences between how Dickerson’s analysis affected them were too insignificant to mention here. And what they are going to face is unlikely to differ significantly from any of California’s other local government pension funds, or CalPERS or CalSTRS for that matter.

This is the context in which the pension debate rages onwards. Pension reformers are accused of being economic pessimists, afflicted with pension envy, tools of Wall Street bankers (a supreme irony since government employee pension funds and government borrowing are one of the biggest sources of Wall Street profits), right-wing zealots, libertarian whackos, Darwinian brutes, tea-bagging extremists, union bashers, destroyers of the middle class and “working families,” mean spirited, disrespectful – people who deserve to fend for themselves since they obviously don’t appreciate police or firefighters, and on, and on, and on. And all of these accusations are nothing more than well-funded, utterly misleading propaganda.

The arithmetic, fact-based reality is this: We are on track to spend more money each year to pay public sector pensions than we will spend on social security for five times as many citizens. The average government employee retires with benefits that are five times more lucrative than the average social security recipient. Government employee pension funds are employing desperate tactics to achieve the unachievable 7.5% rate of return and in the process they are endangering the stability and liquidity of America’s financial markets, as well as extracting over-market returns that in-turn deny opportunities to small investors who also need to save for retirement. And taxpayers are being tapped to guarantee pension fund solvency – based on unrealistic projections for pension fund returns – yet have no access to remotely comparable risk-free rates of return on their own investments.

Moody’s has fired a shot that will be heard around the world. Accountants, open your spreadsheets and sharpen your pencils. It is up to financially trained citizen volunteers like John Dickerson to cast a bright light on the true state of California’s public employee pension funds, since those officially tasked with this great responsibility continue to downplay the problem.