SEC commissioner Daniel Gallagher attacked municipalities’ accounting practices at the MSRB Municipal Securities Regulator Summit in Washington D.C. yesterday, saying that there is $3 trillion in unfunded liabilities that is being hidden from investors with accounting tricks and that “this lack of transparency can amount to a fraud on municipal bond investors.”

SEC Daniel Gallagher

“In the private sector, the SEC would quickly bring fraud charges against any corporate issuer and its officers for playing such numbers games,” said Gallagher. “We should not treat municipalities any differently.”

It’s no secret that municipal pensions and other post-employment benefits (OPEB) are underfunded – there’s roughly a $1 trillion shortfall according to the plans own accounting, but Gallagher says that the true number is closer to $4 trillion putting it in the same range as Social Security’s $6.5 trillion in unfunded liabilities. Unlike Social Security, these liabilities aren’t even distributed leading to extreme cases like Detroit, where the city is currently going through bankruptcy proceedings, and Chicago where liabilities amount to $88,000 per household compared to a median income of $47,400.

How munis hide their true pension liabilities

Municipalities use two main methods to reduce their apparent unfunded liabilities. First, they assume a rate of return on their investments that they are unlikely to match. Gallagher says that 7.5% to 8% is common even though 6.5% is more realistic, and that pension fund managers are faced with the unenviable choice of either falling short on these goals or chasing returns by taking on unacceptably high amounts of risk.

While these assumptions may be irresponsible, the second common trick is the one that pushes the boundary of fraud. Pension funds calculate the present value of their future outflows using these same rates of return as the discount when they should be using the risk of the liabilities themselves. In other words, the discount rate should be around 5% (or even closer to 3%, Gallagher suggests, since pensions have gotten better treatment than general obligation bonds in the Detroit bankruptcy case so far), not 8%. The difference between these rates distorts a city’s apparent unfunded obligations in a way that investors will have a hard time uncovering.

Gallagher’s two main reform proposals

Gallagher says that the Governmental Accounting Standards Board (GASB) has made some headway with its minimum accounting standards, but that more needs to be done. Specifically, he wants to see entities disclose all of their liabilities using a risk-free discount rate such as the Treasury yield curve. Second, he argues that bond issuers should have to calculate a baseline contribution plan that would fully fund their commitments and disclose it alongside actual contributions so that investors can easily spot the difference.