Despite the influx of fiscal stimulus money, the governor of Arizona is appearing this afternoon before a joint session of the legislature to lay out the sobering facts about the fiscal condition of the state. The stimulus money only plugged the current hole. It does nothing to address the systemic hole that Arizona has dug for itself.

According to the Goldwater Institute, the state faces a $4 billion funding shortfall for its proposed $10.5 billion fiscal year 2010 budget. To put that another way, in fiscal year 2004 the state’s spending was $6.5 billion and the budget was largely in balance. Arizona is now generating revenues at 2004 levels thus the challenge is to get expenditures right-sized.

Not an easy task and one that most likely is not going to be accomplished by cutting programs exclusively. A tax increase is sure to be on the table. A dire situation but there is probably one item that won’t be discussed this evening even though it may represent the biggest time bomb of all. The state’s pension funds.

The dirtiest little secret in government finance has to be the sorry state of the state and municipal pension plans. Leaving aside the promises of rich retirement benefits that were from inception mathematically impossible to deliver the schemes and deception that the various governments are employing to delay the day of reckoning are stunning.

An article in Bloomberg a couple of days ago shined a much needed light on them.

The author, David Evans, writes extensively about how pension funds are using the municipal bond market to generate money to pay retirees.

The Chicago Transit Authority retirement plan had a $1.5 billion hole in its stash of assets in 2007. At the height of a four-year bull market, it didn’t have enough cash on hand to pay its retirees through 2013, meaning it was underfunded to the tune of 62 percent.

The CTA, which manages the second-largest public transit system in the U.S., had to hope for a huge contribution from the Illinois state legislature. That wasn’t going to happen.

Then the authority found an answer.

“We’ve identified the problem and a solution,” said CTA Chairman Carole Brown on April 16, 2007. The agency decided to raise money from a bond sale.

A year later, it asked Illinois Auditor General William Holland to research its plan. The state hired an actuary, did a study and, on July 17, concluded that the sale of bonds would most likely result in a loss of taxpayers’ money.

Thirteen days after that, the CTA ignored the warning and issued $1.9 billion in bonds. Before the year ended, the pension fund was paying out more to bondholders than it was earning on its new influx of money. Instead of closing its funding gap, the CTA was falling further behind.

Mr. Evans notes that there is $50 billion of these pension bonds outstanding. They are easy to float as the state is required by law to stand behind the pensions, hence they generally receive credit ratings in line with those of the state. They aren’t however exempt from federal taxes so the coupon is higher than, say, general obligation bonds. In the end they have tended to simply dig a deeper hole for pension funds as the returns on the capital that was raised has tended to lag well behind the interest expense.

Bloomberg also highlights the accounting games that the states use to inflate the value of plan assets.

Fund accountants resort to a grab bag of tricks to get by. They set unrealistically high expected rates of return to reduce governments’ annual contributions. And they use smoothing techniques to paper over investment reverses so they make losing years look like winners.

Accountants do that by averaging gains and losses, usually over a five-year period — sometimes for as long as 15 years of investment returns.

That means actual results of any one year aren’t used to calculate how much a state legislature contributes, which can delay governments catching up with losses for more than a decade.

This ruse can pass the buck to future taxpayers, who will pay for the retirement benefits of today’s government workers.

“There are accounting gimmicks in pension land which create economic fictions and which disguise the severity of the real problem,” Kramer says. “Unfortunately, pension board members don’t have much of an appetite for disclosing inconvenient truths.”

If you’re starting to think Ponzi then you and I are on the same wavelength. This all begins to sound like something that Madoff would have cooked up one evening. Inflated asset values, borrowing money to pay fund withdrawals, fraudulent investment returns – sounds like something that would get you and I thrown in jail.

Bloomberg estimates that the current unfunded liabilities of the public pension funds at around $1 trillion. That’s based of course on the reported assets of the funds and we know that’s probably a fiction. Add to the underfunding problem the reality of millions of boomers racing toward retirement age and you can see the magnitude of the problem.

Sooner rather than later government is going to have to own up to this deception. Doing that in an era of strained finances will be painful.

more: here