In a speech given late last month, SEC Commissioner Daniel M. Gallagher warned that “for years, state and local governments have used lax governmental accounting standards to hide the yawning chasm in their balance sheets.”  According to Commissioner Gallagher, pension funds have been committing two fundamental errors.  First they are overstating investment returns.  He noted that many funds assume a return of 7.5% and 8% when a 6% return would be more realistic.

Returns can be affected by many exogenous circumstances beyond the control of the fund, such as the over-all economy and securities markets.  For example, CalPERS reported a negative return for the year ended June 30, 2009 of 23.4% (gross of fees) and a positive return of 13.1% for the year ended June 30, 2013 (net of fees).  For the five year period ended June 30, 2013, CalPERS reported a return of 3.5% (It’s unclear how CalPERS calculated this return as it only began reporting returns net of fees in 2011).  I obtained these returns from CalPERS’ website; Commissioner Gallagher did not refer to CalPERS specifically.

According to Commissioner Gallagher, public pension funds also commit a far more serious error by assuming outflows (i.e., pension payments) equal their inflows: “This is contrary to fundamental tenets of financial economics:  liabilities should be valued at a rate that reflects their risk, not the risk of the assets that are expected to cover the liabilities” (emphasis in original).

Perhaps the most disheartening aspect of the Commissioner’s remarks was his frank acknowledgment that government pension funds are not as accountable as the private sector:

In the private sector, the SEC would quickly bring fraud charges against any corporate issuer and its officers for playing such numbers games.  And, we would also pursue and punish the so-called fiduciaries who recklessly seek yield to meet unrealistic accounting assumptions.  We should not treat municipalities any differently.

My modest appeal in response to this tocsin is that the governing and the governed be bound by the same rules.