In early 2012, as he prepared to enter a meeting with the board of trustees of a state pension fund, Harry Markham,¹ CFA, couldn't help but feel professionally conflicted. Since earning his Master of Finance in 2004 at one of the top business schools in the United States, Markham had worked for Investment Consulting Associates (ICA), a firm that gave investment advice to pension funds. Since joining the firm, Markham had grown increasingly concerned over how public sector pension fund liabilities were being valued. If he valued the liabilities using the valuation and financial analysis principles he learned in his Master of Finance and CFA programs, he would get numbers almost twice as high as those reported by the funds. This wouldn't be such a problem if he were allowed to make adjustments to the official numbers, but neither his clients nor his firm were interested in questioning them. The board didn't want to hear that the fund's liabilities were much larger than the number being captured by the Government Accounting Standards Board (GASB) rules and his firm wanted to keep the board of trustees happy. How, Markham wondered, was he supposed to give sound investment advice to state treasurers and boards of trustees working from financials that he knew were grossly misleading?

Markham's dilemma came down to conflicting loyalties: loyalty to his firm, loyalty to the boards of trustees and others who made investment decisions for public pensions and who, by turn, hired his firm to provide investment expertise, and loyalty to the pensioners themselves, as Markham believed was called for by the CFA Code of Ethics and Standards of Professional Conduct.

Like their private sector counterparts, public sector pensions provided retirement income and benefits for public sector employees. While the goal was the same, the way in which the two sectors reached that goal was often quite different. The private sector increasingly relied on defined contribution plans (e.g., 401Ks) whereby the employee decided where and how much money to invest in a retirement account. In a defined contribution plan, the employee bore all responsibility. (See Figure 1.)

Figure 1 Traditional Defined Benefit Plan and Traditional Defined Contribution Plan

Strategic Considerations	Defined Benefit Plan	Defined Contribution Plan
Employee retention	Attracts longer tenured/older employees	Attracts shorter tenured/younger employees
Financial liabilities	Placed on the corporate sponsor	Placed on the participant
Responsibility placed on employee	Very little	Significant-voluntary contributions, necessary investment decisions
Responsibility placed on employer	Significant-investment decisions, financial liability	Less significant
Employer fiduciary responsibility	Significant	Significant
Investment results	Average returns are higher/narrower distribution of returns	Average returns are lower/broader distribution of returns
Economic savings	Significantly increases savings rate and the available pool of national savings	Less significantly increases savings rate and the available pool of national savings
Personal retirement savings	Maximizes savings for retirement	Allows withdrawals and loans before retirement, depleting retirement savings
Fees	Lower overall fees	Higher overall fees
Administrative complexity	Generally high	Generally high
Portability	Not typical	Yes

Source: Stephen P. McCourt, "Defined Benefit and Defined Contribution Plans: A History, Market Overview and Comparative Analysis," Benefits & Compensation Digest, February 2006.

In contrast, nearly 80% of state and local government workers had defined benefit pension plans.² In a defined benefit plan, an employer commits to paying its employee a specific benefit for life upon their retirement. The amount of the predetermined benefit was usually based on factors such as age, earnings, and years of service. Actuaries determined the contributions by using statistical analysis to calculate the costs of future risks.³ Under a defined benefit plan, employers bore the financial risk. When payouts fell short, say, for example, if funds' return on investments failed to meet expectations as they did during the financial crisis of 2008, governments would be forced to dip into other areas of the budget and/or raise taxes to fill the gap.

In their 2009 article, "The Liabilities and Risks of State-Sponsored Pension Plans," Joshua Rauh of Northwestern's Kellogg School of Management and Robert Novy-Marx of the University of Chicago, had some sobering words for the future of public pensions. While it was well known that public pension funds were facing a funding crisis, Rauh and Novy-Marx believed the problem was much worse than what was being reported in government financial statements. It was their view that state pension funds were underfunded not by $1.04 trillion, the official figure, but rather $3.23 trillion (Exhibit 1).⁴

What accounted for the discrepancy? In valuing the liabilities of pensions, actuaries followed the rules set forth by the Government Accounting Standards Board (GASB), which called for discounting the cash flow of pension liabilities at the expected return on assets that had been set aside to fund the liabilities. With support from GASB, actuaries argued that, due to the long-term horizon of public pension funds, a discount rate of about 8% was appropriate, and that this rate was supported by investment return history.⁵ However, economists argued that it was inappropriate to discount liabilities at the expected return on assets 8% was too high a discount rate not only because it reflected possibly over-optimistic expectations about future returns, but more importantly, because it was inappropriate to discount liabilities at the expected return on assets in the first place.⁶ The use of an 8% discount rate resulted in "nonsense valuations," economists argued, valuations that were nonetheless taken seriously by actuaries and plan sponsors.

In contrast, economists and financial analysts, like Rauh, Novy-Marx, and Harry Markham, did not take accounting at face value. According to Markham, "Some actuaries and plan sponsors act and speak as if accounting measures are unambiguous, unbiased measures of reality, or perhaps are reality itself. Economists and financial analysts have a term for this: accounting illusion." Like Rauh and Novy Marx, Markham believed the discount rate should reflect the fact that public pensions were secure promises. In his view, a 3% to 4% rate was more appropriate. He explained:

If you knew for sure you were going to earn 8%, then it would be appropriate to discount the liabilities at 8%. But the highest rate you can earn with any degree of certainty is about 3% in the current environment, so this is the appropriate discount rate for a promise, which is intended to be low-risk. The plan sponsor may decide to invest in assets more risky than the liabilities in the hope of earning 8%, but so long as the pensions remain secure, employing a risky investment strategy to juice expected returns doesn't change the value of the pensions, or the appropriateness of a low-risk discount rate.

But Markham was well aware that this wasn't the mindset of a majority of those responsible for managing state pension funds or, for that matter, Investment Consulting Associates.

in his

role as investment advisor, the differing views on how to value pension liabilities challenged Markham on both a practical and an ethical level. "My role is not to decide the value of liabilities," he explained.

That's the actuary's job. My role is to give investment advice. But as an investment adviser, the first thing you want to understand is the client's circumstances. That's a basic ethical precept. The CFA professional standards say you should never give advice without knowing what your client's circumstances are. And so what happens is that we have these funds that are grossly short of money, but the accounting doesn't show them as being grossly short of money. I make the case within my firm that we need to know where we're starting before we give advice. And perhaps our advice would be different if the client knew they were starting from a multi-billion dollar hole that they're seemingly not aware of.

In addition to the fact that Markham was constrained by not having what he believed were accurate accounting figures to work with, he was also well aware that his clients didn't like bad news. He feared that if he was to raise the liability issue, he and his firm could very well be fired:

Most plan sponsors want to minimize near-term contributions to their pension fund, and this makes them predisposed to points of view that justify higher discount rates. Furthermore, investment committees and staffs consider their mandate to be to earn, at least, the discount rate assumed by actuaries. The social pressure to embrace overly optimistic return expectations can be enormous. As one plan sponsor told me, It wouldn't be in plan members' interest to lower the discount rate because the increase in liabilities would so shock the taxpayers and the state legislature that it would undermine political support for the plan.' Given this context, plan sponsors don't want to hear the news that they are less well funded than the numbers show and may blame the messenger. And if it's an elected official you're dealing with, they don't want a crisis on their watch.

But an investment advisor has a professional responsibility to help plan sponsors make good investment decisions, and understanding one's financial condition is a necessary precursor to making sound investment decisions. This may require telling plan sponsors things they don't want to hear. If investment advisors don't do this, they become enablers of their clients' denial and of the poor decisions that result from that denial.

As a CFA charterholder, Markham annually attested to his compliance with the Code of Ethics and Standards of Professional Conduct (Exhibit 2). Specifically, CFAs must not knowingly make any misrepresentations in investment analysis recommendations. "So if you have an investment recommendation that's based on bad numbers," Markham began, "numbers that are legal and comply with the rules, but you know they're bad, are you violating this ethical rule?

As

Markham was summoned into the conference room to begin his presentation to the board of the state pension fund, he was wrestling with whether or not to raise the liability issue. He knew there were risks either way. There was the risk that his client would choose to take their business elsewhere if he told them what he believed to be the fund's financial reality. Furthermore, such a move would not only result in lost business, but would likely be interpreted as disloyalty towards his firm.

But then he thought about what didn't happen during the 2008 financial crisis, and this reality gnawed at him:

When the subprime crisis played out everybody was asking why, even though there were all these people that had a role in making it happen, no one spoke up? And so does somebody who is playing a bit part in creating a reprise of the last crisis have a responsibility to speak up on behalf of the pensioners themselves even though this is contrary to the wishes of their employer and the board of trustees who has hired their employer to provide investment advice?

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The goal is to demonstrate critical thinking in your analysis; you do not need to become an accounting expert to critically analyze this case study. In your analysis, be sure to include:

1. A summary of the issue.
2. Use of at least one critical thinking strategy or tool to analyze the situation and highlight key facts. Be sure to identify the tool you select and describe its use.
3. A recommendation to resolve the situation, along with reasons why you recommend this solution.