Last month, the U.S. Securities and Exchange Commission charged the state of Kansas with securities fraud for failing to disclose shortcomings in its public pension program to potential investors. A four-year investigation found that the state did not inform investors about funding shortfalls that made the pension system a repayment risk for bondholders before holding bond offerings totaling US$273 million in 2009 and 2010,
Reuters reports. Moreover, the state did not disclose that the legislature might have to use state funds to cover the shortfall, which was US$10.3 billion at the end of 2012. These failures left "investors with an incomplete picture of the state's finances and its ability to repay the bonds amid competing strains on the state budget," said LeeAnn Ghazil Gaunt, chief of the SEC's enforcement unit on municipal securities and public pensions. The SEC and Kansas have agreed to settle the charges, although the state did not have to admit wrongdoing.
At the heart of this story are two key elements: 1) the disclosure rules for public pensions and related employee benefit plans, and 2) the need to thoroughly audit their financial statements.
Kansas, along with many other states and cities, is still bearing the impact of the subprime mortgage crisis. During that crisis, insurers of municipal bonds incurred heavy losses on the collateralized debt obligations (CDOs) and other structured financial products that they also insured. Consequently, the credit ratings of these insurers were called into question, and the prices of municipal bonds fell. Many pension plans are still dealing with the consequences of the 2007-2009 recession and their shaky finances, and the continuing pressure for governments to reduce costs, including employee benefits, highlights a greater need for better management and disclosure of employee benefit plans.
The U.S. Municipal Securities Rulemaking Board reinforces the SEC regulation that requires most new offerings of municipal securities to be supported by disclosures of annual financial information and operating data, plus audited financial statements. And, the U.S. Financial Accounting Standards Board has a wealth of standards and guidance, such as Statement Number 158, that govern how accounting for pension plans must be conducted. Still, given the uncertain finances of many municipal pension programs, regulators and accounting standard-setters may need to address whether those requirements are sufficiently explicit regarding disclosure and the use of assumptions that recognize the funded status of a benefit plan — measured as the difference between plan assets at fair value and the benefit obligation — in its statement of financial position.
For a pension plan, the benefit obligation is the projected benefit obligation. For any other post-retirement benefit plan, such as a retiree health-care plan, the benefit obligation is the accumulated post-retirement benefit obligation. If these plans are subject to greater and ongoing risk — including to investors thinking about buying into the related municipal bonds — then that may require greater attention in the regulatory framework. Certainly, investors should educate themselves on how these numbers are produced and reported.
Audits of Financials
The second key element, more directly relevant to the work of internal auditors, is the importance and quality of planning and executing thorough audits of annual and other financial statements and pension fund accounting. The pension fund is one kind of special long-term liability, and for many organizations, a large liability that frequently is not captured on the balance sheet. Pension fund accounting is complicated, but auditors can focus on a few of the most important issues to address, whether it be a defined benefit pension plan (essentially a promise to pay a benefit based on years of service plus salary at retirement) or a defined contribution plan, such as a 401k plan.
In the Kansas pension system case, the state got into trouble over the completeness of its disclosure of the funded status of its plan — particularly its projected benefit obligations. Three kinds of ambiguities have a major influence on the latter. First, actuaries do their best to use estimates about the retiree population, salary increases, and other factors in order to discount the future stream of estimated payments into a single present value.
Second, accrual accounting rules mean that actual cash flows are not counted each year. Instead, these rules attempt to capture changing assumptions about the future, such as for the depreciation of assets, and these cash flow amounts are modified accordingly when they are disclosed.
Finally, and perhaps most significantly, pension accounting rules require a smoothing of year-to-year fluctuations in investment returns and actuarial assumptions so that pension fund accounts are not dramatically overstated or understated when their investments produce a single year of above- or below-average performance. Although well-intentioned, smoothing makes it more difficult to see the true economic position of a pension fund at any given point in time.
Internal auditors examining financial statements or accounting for pension funds should ask questions about trends and levels of these four key assumptions and how they are used in financial documents:
- Discount rate (the value of a future financial obligation in today's terms). Make sure it is conservative (low) enough. If it's going up, why?
- Expected return on plan assets. Is it conservative (low) enough? If it is significantly higher than the discount rate, be skeptical of the pension expense.
- Salary increase rates. Are they high enough?
- Target vs. actual allocation of pension plan funds. Is the organization making appropriate use of bonds or other investment mechanisms to fund the pension liability? Are other factors, such as contribution rates, realistic in light of future plan obligations and returns?