Several years ago, State Budget Solutions filed a complaint with the Securities and Exchange Commission, or SEC. We reported false and misleading reports by the state of Washington on the status of state pension funds. That complaint fell on deaf ears. Or, maybe not.
Last Monday, the SEC brought charges of fraud against the state of Illinois, alleging it repeatedly misled municipal bond investors about the underfunding of its pensions. Illinois quickly settled those charges, neither admitting nor denying them. The state was not ordered to pay a penalty, and it agreed to change its practices to more fully disclose risks to bond investors.
These charges apply only to representations made from 2005-2009, at which time Illinois issued $2.2 billion in bonds. The SEC said that the state's disclosure of the extent of the state's problems has improved, but Illinois' pension problem has only worsened since then, and dramatically so.
Illinois and other states should immediately end the use of budget gimmicks to "fund" their pension systems. From fiscal year 2002 to 2011, Illinois underfunded its annual required contribution by $5.4 billion and borrowed an additional $17.2 billion in pension obligation bonds.
This is only the second time in history that federal regulators have accused an American state of securities fraud, so it is significant. It puts other states on notice that regulators are not only aware of such practices but prepared to take action against them.
Hopefully, the SEC will continue to take such action when necessary. How are the other 49 states, many of whom also face massive unfunded pension liabilities and their own "fiscal cliffs," addressing disclosure of their pension funding, or lack thereof? In a study for State Budget Solutions, economist Andrew Biggs found total state and local unfunded liabilities to be nearly $4.6 trillion.
Elaine Greenberg, chief of the SEC's Municipal Securities and Public Pensions Unit, said in a statement on the Illinois settlement that pension disclosure "continues to be a top priority." But beyond disclosure, the charges shine a light on the urgent need for reform in how states fund public pensions. Illinois used some complicated gimmicks, including a complicated system that included "ramp-ups" and "pension holidays."
Such "holidays" and other tricks are not unique to the Land of Lincoln, but they are not the only ones upon which states rely. Others include unrealistic assumptions about rates of return on pension investments and accounting tricks like "future payments," borrowed money to pay required pension contributions, and the use of "smoothing," which has allowed the Washington State's treasurer to write off a $16 billion loss over 8 years.
It is clearly time for all states to be transparent about their actual financial situation when issuing bonds. Any false and misleading information previously issued must also be corrected. States also need to switch their employees from defined benefit pension systems to defined contribution systems, in which employer contributions become less subject to political gimmickry. They should adopt responsible accounting rules, in line with Generally Accepted Accounting Principles, or GAAP (market valuation rules). These more accurately reveal the cost of financial manipulation under the Governmental Accounting Standards Board, or GASB, standards that many states currently use.
Illinois lawmakers have done nothing to address the fiscal crisis that their state faces as a result of its public pension system. The SEC charges may help states make clear the extent of the problem, but as Illinois Comptroller Judy Baar Topinka said, "Unfortunately, we will all be paying for the mishandling of the pension funds for many years to come." She is absolutely correct.
The SEC charges signal a need for change, both in the accounting and disclosure of the status of public pension systems, and in pensions themselves. Citizens need to demand that their lawmakers immediately enact the pension reforms necessary to make their state pension system, and states themselves, more financially stable.
Bob Williams, a former official with the General Accountability Office and a former state legislator and gubernatorial candidate from Washington State, is president of the nonpartisan budget and pension reform organization State Budget Solutions.