Yesterday, the Securities and Exchange Commission (SEC) charged the State of Illinois with misleading municipal bond investors by making inaccurate or incomplete statements concerning their statutory plan to fund the state's pension obligations. In particular, the "SEC investigation revealed that Illinois failed to inform investors about the impact of problems with its pension funding schedule as the state offered and sold more than $2.2 billion worth of municipal bonds from 2005 to early 2009."
The statutory plan, established by the state in 1994, aimed for a 90% funding level by 2045 and had a ramp-up period in which state contributions to the plans would increase to the required annual level by 2010. By "backload[ing] the majority of pension contributions far into the future," the schedule has left the state's pension obligations significantly underfunded. Although the plan was meant to address the funding problems, the plan actually exasperated the situation leading to a $57 billion increase in liabilities according to the SEC order (PDF).
In addition, the SEC found that Illinois did not sufficiently disclose the effect of the "Pension Holidays" in 2006 and 2007 on the state's ability to fund the pension obligations and the state's creditworthiness.
The SEC has found that the state of Illinois did not make sufficient efforts to disclose their ability to meet the pension obligations to municipal bond investors and as a result investors did not have a clear picture of the financial condition of the state of Illinois. As evidence that these obligations were significant, the SEC cites the ratings downgrades in between 2010 and 2012 over Illinois' pension financing.
In 2010, the SEC charged the state of New Jersey for failing to disclose to municipal bond investors that the state's two largest pension plans--the Teacher's Pension and Annuity Fund (TPAF) and the Public Employee's Retirement System (PERS)--were inadequately funded. Following this action, Illinois "began to implement a series of remedial measures" including retention of disclosure counsel and required review of disclosure documents by several state commission and offices as well as the pension systems themselves.
For example, while the official statements for general obligation bonds in 2006 (see for example this offering) devoted roughly 10 pages to a discussion of the pension system similar documents for 2011 general obligation bonds (see here for example) devoted over twenty. In fact, the presence of the disclosure counsel responsible solely for this section is now prominently placed on the front page of the disclosure.
Interestingly, the adoption of the Asset Smoothing Method in 2009 masked the precipitous decline in asset value resulting from the financial crisis. This resulted in reported funding ratios of 50.6% and 45.4% for fiscal years 2009 and 2010 while the fair value method, used in previous years, resulted in funding ratios of 38.5% and 38.3% respectively.
For more on this story, see Michael Corkery and Jeannette Neumann's article in the WSJ, Edward Siedle's article in Forbes or coverage by the Associated Press's John O'Connor.