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Archive for August, 2012

Close relationships: the University of Richmond and the University of Virginia should know something about that.

About a half-dozen coaches on each side have played or coached for the other.  UVA’s head coach Mike London played for the Spiders and coached the team to the FCS Championship in 2008.  Richmond’s first year coach Donny Rocco will see his nephew start at quarterback for Virginina on Saturday.  Richmond’s backup quarterback is a recent transfer from Virginia.

I-64 has become a popular U-Haul route between the two schools and will likely remain so.

I just love this time of year.

The game will be telecast on some Comcast affiliates and will be shown on ESPN3.

Spider defensive standout Cooper Taylor figures to be an NFL pick.

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What was on your summer reading list?

I hope it was not the new pronouncements issued by the Government Accounting Standards Board (GASB) regarding how cities and states account for public union pension plans.  The Generous Accounting Standards Board, as I refer to it, did not make a significant change in local and state government disclosures of their true pension liabilities.

After six years of research and about 400 pages of text, GASB’s statements 67 and 68 do little to provide enough meaningful information about the potential retirement costs faced by the taxpayers.   The statements will force the worst of the worse, such as Illinois, to recognize a much larger liability.  That’s like throwing the zombified Walking Dead under the bus to give the appearance of taking a serious step in providing transparency.  Zombies are already dead.  You can throw them under a bulldozer;  it doesn’t make them more dead.

That was an easy decision for the GASB board members, a majority of whom have or had day jobs with state and city governments and perhaps lack the independence to challenge their employers. Even the most ardent supporters of the status quo public pension accounting admit that Illinois and other crippled government entities are beyond hope.

The new standards still allow most pension funds to choose their discount rates when determining their pension liabilities.  In other words, the sworn and civilian plans of the City of Los Angeles can wantonly throw caution to the wind and assume a 7.75% earnings assumption going forward, avoiding any consideration of risk.  

The Huffington Post summarized the changes in no uncertain terms:

…GASB reforms could reveal several hundred billion more dollars in underfunding. But that small progress is overshadowed by the key reforms GASB omitted.

Currently, public pension funds make their own assumptions about their future investment returns without GASB interference. If public pensions increase the riskiness of their investments, they assume a higher rate of return. Simultaneously, pension funds use that high rate to “discount” their long-term liabilities, which artificially reduces today’s sticker price for the future costs of retiree benefits. This practice has no basis in finance or economics and encourages public pensions to make risky investments and then underestimate the amount they owe. It is the principal reason economists think they are hiding trillions of dollars in liabilities. GASB’s new standards do little to change this.

Instead, new rules effect soft changes, like requiring funds to explain their discount rates, though many already do. In 2010 the chief New York State actuary explained theirs while avoiding any meaningful financial evaluations. He might at least have heeded Warren Buffet: “I think it’s very hard to come up with a persuasive case that equities will over the next 17 years perform anything like … they’ve performed in the past 17. If I had to pick the most probable return … that investors in aggregate … would earn … it would be 6%.” Alas, New York State chose 7.5 percent.

More troubling, GASB implies it is implementing a “blended,” more responsible discount rate for plans that expect to run out of assets before they can pay all the benefits owed to workers. Some call this a “compromise.” But GASB has made sure its compromise will have little practical application.

My hopes for at least better footnote disclosure of the effects of using different discount rate assumptions were dashed by GASB’s allowing pro forma pension liabilities to be shown within  +/- one point of long-term earnings assumptions.  So, LACERS and LAFPP can express the  impact on the pension liabilities at 6.75% or 8.75%.  The former still beyond reason; the latter beyond belief.

Discloure should contrast the city’s measurement of what the liability would be under the current 7.75% assumption with a risk-free rate of return (around 4% today), and a return of 6%.  Analysts and interested citizens could then extrapolate a range of scenarios from this information.

There is nothing preventing the city from providing this disclosure.  GASB does not limit disclosure; it only sets minimum standards.

Don’t expect mayoral candidate Wendy Greuel to go beyond the minimum.  Ditto with wannabe city controller Dennis Zine.  Their mantra when it comes to public pensions is “if the public doesn’t know the risk, it can’t hurt them.”

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President Obama has accused Governor Romney of outsourcing jobs overseas while with Bain Capital.

Romney countered by stating that the President outsourced stimulus spending.

The truth is that neither can stop outsourcing – it is the natural course of the global economy.  We vote with our wallets. That means cheap overseas products and services win most of the time.

But there is a form of outsourcing we can stop. It is occurring in a majority of cities and states, including Los Angeles and California.

I’ll focus on Los Angeles.

Objectivity and judgment are essential components for assuring the existence of transparency. Knowing  the true value of the city’s services and financial condition is essential for voters to assess the effectiveness of our local government.

City Controller Wendy Greuel has outsourced both of these components with the blessings of the mayor and City Council.  She has used the city’s audit firm Simpson and Simpson as a means to that end. Councilman Dennis Zine will likely follow Greuel’s example if he is elected to succeed her.

It is common practice for organizations and auditors to rely on financial statements audited by other CPA firms for related entities, or assessments by outside experts.

Relying on the work of other professionals does not necessarily relieve a CPA from responsibility for material errors and omissions made by others……and the city’s public pension plans are subject to a high degree of risk when it comes to estimating the unfunded pension liabilities.

Simpson and Simpson routinely relies upon the audit reports and actuarial assumptions of other professionals to help form an opinion on the overall financial statements of the city. One of these reports is the actuary’s analysis of the public employee pension plans. The Segal Group is the actuary for the city.

The reports reflect an earnings rate assumption of 7.75% on the plans’ assets.  The civilian plan’s rate was only recently reduced from an 8% assumption.

There has been much debate over what rate assumptions should be. Generally, academia and financial sectors, along with notable leaders, among them Mayor Bloomberg of New York and billionaire Warren Buffett, believe that public plan earnings assumptions are unrealistic. About the only ones supporting the use of high rates are the public unions and the politicians they routinely support – no surprise.

Consider this: the yields of  the 10-year bonds of Spain and Italy are hovering around 6.5%.  We can all agree that these two nations are at some risk of defaulting without a bailout.  Those yields should shed some light on the aggressive strategy implicit in the city’s public pension funds to return 7.75%.

The mainstream media outlets have been significantly increasing their coverage of this issue, too. They have clearly highlighted the risks associated with defined benefit plans, risks that are the result of union employees failing to contribute an adequate share from their paychecks to cover future benefits.

Given the increased publicity and frequency of studies over the last few years about the solvency of public pension funds, you have to be a caveman not to take notice. Ignoring the ramifications a volatile world economy has on earnings potential is the equivalent of burying your head in the sand. Simply trusting published estimates of unfunded liabilities from a single non-independent source, especially estimates  using only a single assumption, is gambling with the future of Los Angeles.

But that is what Greuel is doing, and she has the perfect partner in Simpson and Simpson to support her.

The Government Accounting Standards Board (GASB), which sets generally accepted accounting principles (GAAP) for state and local governments, has been soft in its policy regarding the recognition of pension liabilities.  Another name for GASB could be the Generous Accounting Standards Board.

GASB forms a convenient shield for firms, such as Simpson and Simpson, and Controller Greuel to hide behind.

Greuel has an obligation to disclose potential financial risks to the city, its residents and stakeholders, both long- and short-term. Instead, she focuses on the headline grabbers – generally those stemming from waste, fraud and abuse (the values are estimates) that she claims are the reasons for the city’s dire financial situation.

In reality, her findings are small potatoes that have nothing to do with the structural deficit dragging the city down.

And the structural deficit is driven by ever-increasing pension and health benefit contributions by the city to employee retirement plans.

Simpson and Simpson, too, has an obligation to inform the public of the risks facing the city. Lest they forget, the “P” in CPA stands for “public.”  That’s us.

The attestation of third-parties does not relieve a CPA firm from questioning the results when contrary evidence from reputable sources is available and widespread. Just because the unions do not agree with alternative views does not mean they are wrong or any less reliable than the in-house assumptions used by the LACERS and LAFPP boards. Alternatives must be seriously considered in evaluating the unfunded liability in order to serve the needs of those who rely on the audited financial statements of the city. If anything, the unfunded liabilities could be construed as contingent liabilities which require full disclosure in the footnotes to the statements, if not actually recorded.

As more cities across the state and the nation declare bankruptcy, the more likely CPA firms will be sued for negligence due to their failure to adequately disclose pension fund risks.

Unfortunately, self-serving politicians such as Greuel will be virtually immune to such lawsuits.

So what should be disclosed if the city and its auditors want to fulfill the public’s need for transparency concerning pension funds?

A comparative analysis of the unfunded liability using different earnings rate assumptions would be a good start. I do not expect anyone, including the pension boards, Simpson and Simpson and Greuel, to have a crystal ball that predicts future returns – quite frankly, I expect very little from Greuel about anything.

All the more reason why alternative projections must be disclosed for stakeholders to draw their own conclusions.

I would go one step further – a presentation of the unfunded liabilities without the effect of smoothing.

Smoothing is used to spread the impact of investment gains and losses to future periods in order to reduce what are considered short-term distortions to pension portfolios. While the technique serves the needs of actuaries, they tend to obfuscate the true results.

Smoothing assumptions are very subjective and have been used as excuses to reduce the city’s annual pension contribution in order to close a budget gap.  In effect, smoothing has become a source of back door financing of the annual budget deficits – undisclosed loans against the future.

We can stop this legerdemain by insisting on enhanced disclosure as I have outlined above.

We should also insist on rotation of CPA firms, a practice followed in Europe to foster independence and objectivity in audits.

It would also help if we end Wendy Greuel’s and wannabe controller Dennis Zine’s political career in the 2013 elections.

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