Due to "Alice in Wonderland" accounting methods, the amount that
taxpayers owe to provide pensions for local and state government
employees is much larger – perhaps an extra $2.5 trillion – than
government officials have let on, according to an economic advisor to
Gov. Arnold Schwarzenegger speaking at a Securities and Exchange
Commission (SEC) hearing in San Francisco on Tuesday.

"State and local governments utilize a misleading method for
reporting the size of public pension obligations," said David Crane.
For example, an annual obligation of $30,000 for 25 years for a
government employee’s pension is projected to cost the government
$320,000, while the same $30,000/year, 25-year obligation in the form
of a bond is projected to be $425,000. "Two identical and unconditional
obligations owed by the same government are valued at different
amounts. The answer lies in the Alice in Wonderland world of government
pension accounting that allows governments to hide liabilities."

Government officials justify the lower obligation for the pension
based on the earnings they hope to receive by investing the money.

"That might be a legitimate outcome if the government and its
taxpayers were no longer on the hook for the pension promises once
money is deposited in the pension fund," said Crane. "But that’s not
the way it works. The government and the taxpayer stay on the hook. To
put this in perspective, consider this: If Alice’s accounting could be
applied to your mortgage obligation, then just setting up a trust
account and projecting that account to earn a high rate of return on
any deposit you make to that account would allow you to reduce the
reported size of your mortgage. Now wouldn’t that be nice – at least
until you had to make the payments on that mortgage. Which, of course,
remain the same.

"As a result of Alice in Wonderland accounting, state and local
governments are understating pension liabilities by $2.5 trillion,
according to the Center for Retirement Research at Boston College. Note
that these are not like Social Security and Medicare liabilities. These
are contractual liabilities that cannot be changed, even by state
legislatures or Congress."

Because government officials are able to hide their future debt
obligations in this way, they "are perversely incentivized to assume
the highest rates of return in order to minimize reported liabilities,
and then to swing for the fences in investing the capital of those
funds in the hopes of actually achieving those returns, producing even
more risk for the taxpayers who must make up for any pension fund
shortfalls," he said.

The chief investment officer of a large state pension fund recently
said that investment returns in the 7.5-8 percent range are not
unrealistic, according to Crane, adding, "Given that the capital in
state and local pension funds is there to protect governments and
taxpayers from having to dig further into their pockets to make pension
payments for which they are on the hook, that official is effectively
characterizing government and taxpayer capital as being in search of
riskier investments."

This fiscal fudging has led to the growth in the ticking pension
time bomb in California. In 1999 the California Public Employees
Retirement System (CalPERS) reported that its assets equaled 128
percent of its liabilities when in reality its assets totaled only 88
percent of liabilities, according to Alicia Minell, an economist in the
Clinton administration.

"In other words, in 1999 using Alice in Wonderland accounting,
CalPERS reported that assets exceeded liabilities when in reality
liabilities exceeded assets," said Crane. "Encouraged by that
accounting, the state Legislature enacted a law that year boosting
pension promises. The hidden cost from that boost has already hit $15
billion and will reach at least $150 billion for the state budget. More
generally, after having reported that liabilities were a fraction of
assets and projecting that the state’s pension costs would total $5
billion over the succeeding 10 years, the state actually incurred $25
billion over that period.

"California wasn’t alone in this regard. Unrealistic reporting of
pension promises is a systemic problem. That’s why the SEC must require
realistic accounting of public pension promises. For that to happen it
must insist upon a realistic discount rate when reporting pension
liabilities. In addition, the SEC cannot rely upon the Governmental
Accounting Standards Board (GASB) to correct its ways and adopt
realistic accounting. GASB is funded and governed by the very
governments who would be forced to revise upwards their pension should
a realistic discount rate be required."

It remains to be seen whether GASB will restore fiscal sanity to
pension accounting, but the board is looking into the matter, according
to James Lanzarotta with the Moss Adams accounting firm. "Pension
liabilities is one of the big topics of the day," he said. "So they are
currently deliberating on an improvement that would put the liability
on the financial statements at amounts that are a lot closer to the
expected future payout, the discounted present value of the expected
valuation. That’s in contrast to what’s done today. Today the liability
is measured based on what the actuary said the annual requirement would
be for funding versus what the government actually contributed. So it
would be quite a change from current practice."

The SEC will also be looking further into government pension
accounting practices, according to SEC Commissioner Elisse Walter.
Noting that the issue "is quite complex," she said that future SEC
hearings "will continue to explore these topics."

The all-day SEC hearing in San Francisco was the first of five that
will be held around the country in the coming months to find solutions
for problems in the $2.8 trillion municipal bond market. Other issues
raised at the hearing include clarifying the differences in regulation
of the municipal and corporate bond markets, and the need to level the
playing field for individual investors, who have less access to
information on municipal securities than institutional investors.