Tuesday, March 12, 2013

SEC Slams Illinois Over Pensions?

Lisa Lambert of Reuters reports, Illinois settles SEC charges over pensions:
Illinois, which has the worst-funded state pension system in the United States, agreed on Monday to settle federal civil securities fraud charges alleging it repeatedly misled municipal bond investors about the underfunding of its pensions, the U.S. Securities and Exchange Commission said on Monday.

Illinois neither admitted or denied the charges and was not ordered to pay a penalty. It agreed to change its practices to more fully disclose risks to bond investors.

The settlement of charges that Illinois failed from 2005 to early 2009 to fully tell investors the risks of buying $2.2 billion worth of its municipal bonds is the latest blow to the state's reputation as fiscally troubled and crippled by a pension shortfall of $98.6 billion (figure above from WSJ is short a couple of billion dollars).

In official statements accompanying bond offerings Illinois explained that factors such as market performance had contributed to the increase in its unfunded pension liability, but it "misleadingly omitted to disclose the primary driver of the increase - the insufficient contributions," the SEC said.

In order to keep its contributions low, Illinois had developed a complicated system that included "ramp-ups" and "pension holidays," the SEC said.

Instead of paying to pension funds what actuaries had determined to be the annual contributions, Illinois followed a funding plan approved by the legislature that deferred the payment of pension obligations, compounding its pension burden.

The legislature phased in the state's contribution over a fifteen-year "ramp" period, where the amount Illinois put in gradually grew until in 2011 it made the full amount. It then had to put in a level amount so the pension system was funded by 2045.

The state went further, amortizing pension costs over 50 years, instead of the typical 30, which gave it a longer window to pay off the liability. Then, it lowered the contributions in 2006 by 56 percent and in 2007 by 45 percent in "pension holidays."

Illinois "failed to disclose the effect of its unfunded pension systems on the state's ability to manage other obligations, the SEC said. "The state also did not inform investors that rising pension costs could continue to affect its ability to satisfy its commitments in the future."

It also did not explain to investors that its "inability to make its contributions increased the investment risk to bondholders," the SEC said, adding it "did not identify or discuss how this underfunding compromised the state's creditworthiness or increased its financing costs."

The state of Illinois has $19.67 billion pension obligation bonds outstanding, out of a total of about $50.2 billion in outstanding municipal bonds, according to Thomson Reuters data.


There were also institutional failures, according to the regulator. The Illinois government relied on bond underwriters, consultants and lawyers to advise them what to disclose but those same groups were relying on the state for the advice, SEC said.

"The result was a process in which no one person fully accepted responsibility for identifying and analyzing potential pension disclosures," the settlement document said.

Beginning in 2009, the state took steps to address the commission's concerns, the SEC said. Over the last four years, Illinois has improved disclosures in the pension section of its bond offering documents, retained disclosure counsel, and instituted written policies on disclosure.

In 2010, the state also enacted a law that employees hired after Jan. 1, 2011 would have a higher retirement age and lower pension.

Governor Pat Quinn said the commission had acknowledged the "proactive steps" Illinois took improve its pension disclosures, and that "the state began these enhancements prior to being contacted by the SEC."

Quinn and the state legislature are currently locked in a political battle as to how best to fix the funding gap, which is so large that it has led Illinois to have the worst credit rating among U.S. states. All three rating agencies have raised alarms that the swelling pension obligations and problems could eat away at the state's credit quality.

Investors' concerns over credit quality has driven up the amounts the state must pay to borrow - on Friday the spread of yields on Illinois debt to Municipal Market Data's benchmark scale was 140 basis points for a 10-year bond. For the last year, the spread has averaged 149.8 basis points, the second highest after financially troubled Puerto Rico.

Many states had long short-changed their pension funds, and when their revenues collapsed during the 2007-09 recession, they pulled even further back on contributions. At the same time the leading source of revenues for pensions, investments, plummeted in the financial crisis. According to Pew Center on the States, the pension gap for all states is currently $757 billion.

Illinois Comptroller Judy Baar Topinka, a Republican who was not in office when the alleged abuses took place, said the state has done "the right thing."

"Unfortunately we will all be paying for the mishandling of the pension funds for many years to come. At the time I warned that raiding our pension funds and borrowing to make our payments was a 'ticking financial time bomb' and sadly, that has come to pass," Topinka said.

The case marks the second time the SEC has charged a state in connection with public pension disclosure failures. The SEC had previously charged New Jersey in 2010, for not adequately informing investors of the costs of its pensions, saying at the time the charges were a warning to all other issuers in the $3.7 trillion municipal bond market.

Elaine Greenberg, chief of the SEC's Municipal Securities and Public Pensions Unit said in a statement on the settlement, pension disclosure "continues to be a top priority."
None of this shocks me. In August 2010, wrote a comment on whether pensions are the next AIG which elicited this response from Illinois' TRS. Then in December 2011, wrote a comment on whether Illinois' TRS is going for broke, questioning the risks they were taking to attain their ridiculous 8.5% target rate of return.

Last week, I discussed who's addressing their pension shortfall, referring to Illinois, New Jersey and the pathetic state of state pension funds. In that comment, I also referred to the Ontario Teachers' Pension Plan as an example of a plan that is properly addressing its shortfall by sitting down with its stakeholders to hammer out a long-term deal that makes sense for unions, the government and taxpayers.

Underfunded pensions are a huge issue in the United States and pretty much all over the world. It's a slow motion disaster that has been in the making for a long time but it has come to forefront after the 2008 financial crisis.

Unfortunately, in the US, the issue has been blown way out of proportion and politicized by politicians who blatantly ignore the seven truths of public employee pensions. What is the typical response to the "pension calamity"? Raise the retirement age, cut benefits and switch new workers to a defined-contribution plan. That last solution makes no sense whatsoever because instead of bringing everyone up to the gold standard of pensions, switching new workers to DC plans will just exacerbate America's new pension poverty.

Finally, a little note to Elaine Greenberg, chief of the SEC's Municipal Securities and Public Pensions Unit. I was recently contacted by someone in the US who asked me if they should lock up their money for three years in some municipal bond fund that guarantees a yield of 5%. The broker was aggressively peddling this product, which immediately rang alarm bells in my head.

I told the person the same thing I will tell all of you. Even though pension bonds have yet to increase default risk, be very weary of sharks peddling municipal bonds because of their tax-free status. There is no guarantee that your principal will be safe if you lock up your money over the next three years and in my opinion, you're better off investing in good companies that pay out stable dividends.

Below, Meredith Whitney, analyst and founder of Meredith Whitney Advisory Group LLC, talks about the outlook for U.S. municipal bonds and banks. Whitney, speaking with Tom Keene, Sara Eisen and Michael McKee on Bloomberg Television's "Surveillance," also discusses the Justice Department's fraud allegations against Standard & Poor's.

And for a more bullish comment, US Trust CIO Chris Hyzy discusses municipal bonds. He speaks on Bloomberg Television's "Lunch Money."

Finally, Mesa, AZ Mayor Scott Smith discusses how the sequester will impact the municipal bond market and local governments. He speaks with Mark Crunmpton on Bloomberg Television's "Bottom Line."