Kansas Bannder

Pension-Gate and Muni Bonds—an Enforcement Action against Kansas by the SEC

Kansas Bannder

While we at Index Fund Advisors have coined the term “pension-gate” to describe the overall mismanagement of public pension investments through active management, the real pension-gate is the massive underfunding of liabilities which will lead to one or a combination of the following four unpleasant alternatives (short of a federal bailout which would bring baggage of its own):

1)      An increase in taxes, perhaps to a level that could be considered confiscatory.

2)      A reduction in benefits promised to retirees which would cause massive protests and perhaps strikes by employees.

3)      A default or a “re-structuring” of state and municipal debt which would essentially cripple their ability to borrow in the future.

4)      A reduction in vital services or a sale of public assets such as art held in museums, which would lower the quality of life for residents.

Essentially, this is what the city of Detroit is experiencing right now, with a bankruptcy trial set to start on August 21. Sycora Guarantee, an insurer of Detroit’s municipal bonds, stands to lose $400 million, according to this article in USNews.

Underfunding of pensions is a risk that many investors in municipal bonds undertake, whether they are aware of it or not. IFA has long maintained that municipal bonds carry risks which fully explain their higher after-tax returns than Treasury Bonds of equivalent duration, and potential investors should be apprised of these risks before plunging in. Towards this end, the Securities and Exchange Commission announced securities fraud charges against the state of Kansas stemming from a nationwide review of bond offering documents to determine whether municipalities were properly disclosing material pension liabilities and other risks to investors.  According to the SEC’s cease-and-desist order, the state’s bond offering documents failed to disclose that the state’s pension system was significantly underfunded, and the unfunded pension liability created a repayment risk for investors in those bonds.

The charges against Kansas come on the heels of similar charges against New Jersey and Illinois. Both of these states implemented remedial actions to disclose their underfunding of pensions to prospective bond purchasers, and Kansas has agreed to do the same. While we are very pleased with this development, we know that many investors will continue to buy muni bonds simply because their broker tells them they are safe and tax-free. The number of bond investors who actually read a bond offering document is probably similar to the number of kosher butchers that offer pork. Nevertheless, states and municipalities that carry underfunded pension liabilities should experience higher borrowing costs (interest rates) which may spur them to refrain from making politically-motivated promises whose burden will fall upon future generations of taxpayers.