For years, state and local governments have been playing imaginative or patently dishonest games with their pension funds, thinking they could get away with it. But now the chickens are coming home to roost, as federal authorities have begun cracking down on corruption and mismanagement.
The modus operandi was much the same in state after state: government officials underfunding or skimming retiree pension funds to meet other more immediate costs; financial officers papering over or hiding the extent of the funding shortfalls; and private financial managers exaggerating the return they could deliver on pension fund investments while often leaving the fund vulnerable to unexpected market swings.
State pensions, still feeling the pain of the Great Recession, are now underfunded to the tune of more than $4 trillion, according to State Budget Solutions, a non-partisan fiscal watchdog.
In the past week alone, government officials and private investment groups with major government contracts have learned hard lessons about the risks of playing fast and loose with the government retirement systems:
The Securities and Exchange Commission charged Illinois with securities fraud following years in which state officials misled investors and shortchanged the state pension system and stuck future generations of taxpayers with the staggering bill. The suit was part of a larger push by the SEC to bring greater transparency and accountability to the municipal bond market, according to the Wall Street Journal.
• A federal grand jury indicted the former CEO and former board member of the $232 billion California Public Employees’ Retirement System on bribery and influence peddling charges. The indictment accuses them of unduly using their influence to defraud a giant equity firm of millions of dollars.
• The nearly bankrupt city of Detroit was placed under a state financial overseer after years of mismanagement, corruption and obfuscation of major obligations – including billions of dollars in retiree health costs. Federal authorities meanwhile charged two former pension officials with bribery and accepting kickbacks.
These are arguably among the worst cases of state and municipal malfeasance in the handling of public employees' vital pension programs, but experts say they represent the tip of the iceberg. Around the country, state and local governments are cutting corners and taking big chances to meet pension investment goals. Absent reforms or a turnabout in current practices, many state employees will end up with far less than promised when they retire.
“There are a lot of governmental pension plans that have been chronically underfunded, and this is a big problem,” said Chester Spatt, a former chief economist for the SEC and now the director of the Center for Financial Markets at Carnegie Mellon University’s Tepper School of Business.
A big part of the problem has been shoddy accounting practices by state and municipal officials who have operated with fewer restraints than financial officers in the private sector, Spatt said. Moreover, many states and local governments have misled investors by exaggerating the projected return on their bonds and securities.
Nowhere is the problem greater than in Illinois, where Democratic Gov. Patrick Quinn is facing the biggest crisis of his administration. Quinn inherited the budget crisis when he took office back in January 2011, at a time when many state governments were struggling to make ends meet.
Quinn and the Democrat controlled state legislature moved swiftly to pass a major tax increase to offset a budget deficit of at least $12 billion, or about 34 percent of the $35 billion general fund budget – plus another $6 billion of debt carried over from the previous year. That debt consisted of unpaid bills to public universities, schools, social service agencies, druggists and vendors.
On top of that, the state employee pension fund was woefully underfunded to the tune of $80 to $90 billion, and the state’s once shining credit rating was dangerously on the skids, which meant paying high interest rates to borrow money. “It’s the enormity of the deficit,” when compared to the overall budget, that sets Illinois apart from many other states, Richard F. Dye, of the University of Illinois' Institute of Government, said at the time.
Even with the new tax revenue in place, Illinois has struggled to address its long term pension program problems. Standard & Poor’s downgraded Illinois Jan. 25 to A-, six steps below AAA, after lawmakers were unable to whittle down a backlog of $9 billion of unpaid bills or produce a plan to shore up the pensions, which have just 39 percent of assets needed to cover projected obligations, according to Bloomberg. No other U.S. state has a ratio that low.
But the illegal practices that triggered last week’s SEC sanctions date back to 2005 and the administration of disgraced -- and now imprisoned -- Democratic governor Rod Blagojevich. The SEC charged that the state misled investors from 2005 to 2009 about shortfalls in retirement funds. Illinois failed to disclose how much it was underfunding its plans as it sold $2.2 billion in bonds, according to the SEC. The fifth-most-populous state became the second to settle over such charges. New Jersey resolved a similar case in 2010, as did San Diego in 2006.
Illinois neither admitted nor denied the SEC’s findings in the settlement, which didn’t include fines, according to a statement from Quinn’s Office of Management and Budget. However, the state is paying a steep price for its misdeeds in operating the pension fund. Investors demand 1.3 percentage points of extra yield to own 10-year debt of the state and its localities, almost seven times the average in 2005, when the SEC said the inadequate disclosure began.
“I can tell you it’s troubling because we have made promises we can’t keep in Illinois,” said Sen. Richard J. Durbin, D-Ill, the second-ranking Democrat in the U.S. Senate. “And the people who are affected by those promises have done everything they were asked to do. They’ve made all the payments they were expected to make, and many of them are in a vulnerable position personally.”
CalPERS SCANDAL ILLUSTRATED BROADER PROBLEMS
For years, the California Public Employees’ Retirement System (CalPERS) was considered one of the best run in the nation. It was the largest public fund, with nearly $180 billion in assets at the end of 2008. It served 1.6 million workers, and had a reputation for taking a careful, balanced investment approach that provided consistent returns. Also absent were rumors of corruption.
That all changed in 2011, when the Justice Department launched an investigation into how the fund was managed. What followed was a scandal that followed a familiar script: former CalPERS CEO Federico Buenrostro Jr. and former board member Alfred J.R. Villalobos steered money to Wall Street investment houses in exchange for payouts. They also conspired to hide the payments, creating false document trails to mislead investigators.
According to Edward Siedle, a forensic expert who specializes in pension fraud crimes, the crimes committed in the CalPERS scandal are common in cases of pension abuse. He said lack of sufficient regulation allows board members to act without oversight.
“Funds aren’t regulated by any comprehensive federal or state laws. They’re subject to a patchwork or quilt of city, state or county laws that more often than not don’t have the power to oversee fund activities,” he said. “If you want to know if a fund can invest in derivatives, there’s almost certainly no law that requires the board to tell you.”
Siedle also said that the very make up of pension boards invite the prospect of mismanagement. “Pensions boards are composed of firefighters, kindergarten teachers, and garbage collectors,” he said. “There is no requirement that these boards require any kind of financial expertise.”
But mismanagement does not just exist on the public side, Siedle said. Money managers know they aren’t dealing with the most sophisticated investors when they pitch pension boards. They often oversell projected returns, making promises that they are unlikely to keep.
“It is often said that public pension boards are the dumbest investors in the room. If you want to pitch a billion dollar scam, are you better pitching it to a wealthy person or a bunch of schoolteachers or firefighters?” Siedle asked. The burden falls on taxpayers when money managers fail to deliver.
The Pension Benefit Guarantee Corporation guarantees pensions, and in the wake of the Great Recession, has had to dish out billions. In 2010, it covered $5.6 billion in lost pensions. According to a 2012 Inspector General Report, it does not have “the resources to fully satisfy PBGC’s long-term obligations. These funds are backed by taxpayers,” he said. “If the money’s not there, the taxpayers have to put more money in.”
The financial crisis that led Republican Gov. Rick Snyder to installing bankruptcy attorney Kevyn Orr as emergency czar of Detroit last week was decades in the making and had much to do with an economy buffeted by a declining auto industry, white flight to the suburbs, widespread poverty and crime, and government corruption. But a state-appointed review board also found astounding examples of government mismanagement, particularly in the handling of employee pension and retiree health programs.
These included the hiding of $7.2 billion in retiree health costs until it was discovered by an outside consultant in 2005 and the use of tricks to hold down salary costs in the short term by offering employees inflated pension programs down the road without the resources to make good on them.
Last week, Ronald Zajac, the long-time general counsel of Detroit’s two pension funds, and Paul Stewart, a former trustee of Detroit's Police and Fire Retirement System, were indicted on federal charges of taking part in a bribery and kickback scheme involving more than $200 million in Detroit pension fund investments.
A distraught Mayor Dave Bing issued a statement saying Detroiters deserved honest government, and that “when the public trust is betrayed, justice must prevail.”