Regulator hits U.S. public pensions for "misleading" practices

WASHINGTON Thu May 29, 2014 1:40pm EDT

WASHINGTON May 29 (Reuters) - Public pensions are misleading people about their true financial state and need major reforms, a top U.S. financial regulator said on Thursday, launching the latest strike in a long-running political battle.

Since the 2007-2009 recession, political leaders and voters have worried about the ability of public pension funds to cover retirement promises made to government workers that are often protected by law.

Most pensions have made reforms, but a recent report from Fitch Ratings indicated they still have a large funding gap.

"Trillions of dollars in liabilities -- reflecting amounts promised to state and local government workers -- are not appropriately reflected on government books, thereby seriously misleading investors about the riskiness of their investments in municipal securities," said Daniel Gallagher, one of the five members of the Securities and Exchange Commission, which regulates U.S. financial markets.

"In the private sector, the SEC would quickly bring fraud charges against any corporate issuer and its officers for playing such numbers games," he also said in a presentation to the Municipal Securities Rulemaking Board, which writes the rules for public sector debt that the SEC enforces.

At the end of 2013, public pensions were $1.1 trillion short of the $5 trillion in benefits they had promised, according to Federal Reserve data.

During the recession states and cities cut contributions to retirement systems to balance their budgets just as the financial markets wiped out the investment returns that provide the bulk of pensions' revenues.

Gallagher, who warned last year of an impending "Muni Armageddon," hit every area of public pensions, saying that the current system saves "elected officials from making the hard choices."

Many pensions calculate the rate for discounting their future liabilities and then forecast a comparable investment rate of return, typically between 7 and 8 percent. Gallagher said the practice was "contrary to fundamental tenets of financial economics: liabilities should be valued at a rate that reflects their risk, not the risk of the assets."

Pensions should discount liabilities at rates closer to 3 percent or 5 percent, he said, which will make their liabilities appear much larger. At the same time, he said they should expect investment returns closer to 6 percent, which could then swell funding gaps, given investments provide two-thirds of public pension revenues.

Next month, new standards from the Governmental Accounting Standards Board will go into effect on pension accounting. While Gallagher said the board, which sets accounting practices for the public sector, took "a step in the right direction, there is more than needs to be done."

The new standards leave room for state legislatures to hide "the true extent of underfunding," burn cash, and do not eliminate the incentives to chase yield, he said. He also criticized them for not requiring pensions to disclose the contributions that actuaries suggest state and local governments should make each year to the plans. (Reporting by Lisa Lambert; editing by Andrew Hay)