The Ohio Bureau of Workers' Compensation (BWC) fund provides coverage for workplace injuries to two-thirds of its state's workforce and has $22 billion in funds to back it up. In April 2005 this then little-known organization reported investment returns that seemingly made it a star of the financial world - 16.5% per year in a decade when the S&P 500 had earned only 10.6% annually.

Later that year, however, those returns came under suspicion when the BWC burst into the headlines as the focus of a massive investment fraud. It involved unconventional investments

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that had been managed by people closely connected to financial backers of the Ohio Republican Party. Have you ever heard of a state investment fund investing in gold coins or Beanie Babies? This one did.

Upon further review, it turned out that the BWC's reported investment returns were fictitious. "We are unable to establish any basis whatsoever for the 16.5% figure," an outside performance review concluded. The fund had actually earned 7.3% annually - less than half of what it had previously claimed. (Pension plans certainly have their drawbacks. Read about the love-hate relationship employees have to these vehicles in Pension Plans: Pain Or Pleasure?)
In other words, the largest state-operated workers comp fund in the country had massively misrepresented its performance. Subsequent revelations showed that sloppy mathematical calculations weren't the problem. There had been a deliberate, concerted effort involving BWC's investment staff and vendors to inflate the performance.

If a Securities and Exchange Commission-registered money manager had committed similar fraud, it would have been shut down. But governmental investment funds, including hundreds of public pension plans, are generally not subject to SEC regulation. This brings into question not only their overall performance claims but also those of the outside managers they hire. Given that such outsiders are often paid based on the returns they report, and thus have a huge incentive to cook the books, I suspect that many of the numbers issued by public pension funds are wrong. What's more, in my experience, many public funds fail to submit their reported rates of return to the sorts of audits and verification money managers in the private sector regard as mandatory. It's just too politically fraught. I call this politicization of the investment process.

For a look at just how averse outsiders can be to reporting bad numbers, see the Alaska Retirement Management Board. In 2007 the state agency filed suit against Mercer, a unit of MMC). Mercer, the agency contends, made multiple errors as the state's actuarial consultant when it estimated the amounts that two of the state's retirement plans needed to set aside for health care and pension benefits. The agency is seeking damages of $2.8 billion. Now it seems the financial health of these systems is far different from what investors were told, perhaps dire. Liabilities were grossly understated. Again, if an SEC-registered money manager had committed these errors, they'd be held accountable.

Further evidence of shenanigans is coming to light at two of the nation's largest public pension funds - the New York State Common Retirement Fund and the California Public Employees' Retirement Fund (Calpers). In New York, Attorney General Andrew Cuomo has a criminal investigation underway into illegal bribes involving middlemen who were paid for attracting business to private money managers.

In California, disclosures are uncovering evidence that money has been doled out for years to politically favored investment firms. It's not much of a stretch to assume firms that would bribe public officials to gain business might have a cavalier attitude toward reporting the investment returns on which their pay is often based.

Wednesday Calpers disclosed massive underperformance, which amounts to approximately $20 billion. Remarkably this is precisely the California budget deficit the "Governator" is looking for Washington to help with. Not surprising, real estate investments, which have been the subject of pay-to-play investigations, have plunged 47.5% - more than triple the loss in the relevant index. Kick-backs do result in substantial, quantifiable harm.

In conclusion, the investment-performance-related information public funds disseminate is rarely reliable and highly susceptible to manipulation for political and financial reasons. The result is that stakeholders are misled regarding the performance of the assets and liabilities of these systems. There is no effective regulatory scheme to attack these abuses since these funds are, at best, subject only to patchworks of state regulation and often to no regulation addressing specific investment practices.

When trillions of dollars in public fund assets are invested in schemes that are unreliably accounted for, that tainted performance information harms all marketplace participants who rely upon the hyped returns. Taxpayers and other stakeholders who are liable for filling in any holes that later arise in these funds are in for more nasty surprises.