Category Archives: Pensions

Paving over pension liabilities, again

Public sector pensions are subject to a variety of accounting and actuarial manipulations. A lot of the reason for the lack of funding discipline, I’ve argued, is in part due to the mal-incentives in the public sector to fully fund employee pensions. Discount rate assumptions, asset smoothing, and altering amortization schedules are three of the most common kinds of maneuvers used to make pension payments easier on the sponsor. Short-sighted politicians don’t always want to pay the full bill when they can use revenues for other things. The problem with these tactics is they can also lead to underfunding, basically kicking the can down the road.

Private sector plans are not immune to government-sanctioned accounting subterfuges. Last week’s Wall Street Journal reported on just one such technique.

President Obama recently signed a $10.8 billion transportation bill that also included a provision to allow companies to continue “pension smoothing” for 10 more months. The result is to lower the companies’ contribution to employee pension plans. It’s also a federal revenue device. Since pension payments are tax-deductible these companies will have slightly higher tax bills this year. Those taxes go to help fund federal transportation per the recently signed legislation.

A little bit less is put into private-sector pension plans and a little bit more is put into the government’s coffers.

The WSJ notes that the top 100 private pension plans could see their $44 billion required pension contribution reduced by 30 percent, adding an estimated $2.3 billion deficit to private pension plans. It’s poor discipline considering the variable condition of a lot of private plans which are backed by the Pension Benefit Guaranty Corporation (PBGC).

My colleague Jason Fichtner and I drew attention to these subtle accounting dodges triggered by last year’s transportation bill. In “Paving over Pension Liabilities,” we call out discount rate manipulation used by corporations and encouraged by Congress that basically has the same effect: redirecting a portion of the companies’ reduced pension payments to the federal government in order to finance transportation spending. The small reduction in corporate plans’ discount rate translates into an extra $8.8 billion for the federal government over 10 years.

The AFL-CIO isn’t worried about these gimmicks. They argue that pension smoothing makes life easier for the sponsor, and thus makes offering a defined benefit plan, “less daunting.” But such, “politically-opportunistic accounting,” (a term defined by economist Odd Stalebrink) is basically a means of covering up reality, like only paying a portion of your credit card bill or mortgage. Do it long enough and you’ll eventually forget how much those shopping sprees and your house actually cost.

Strong words from the SEC on Public Sector Pensions

As state and local governments begin to pull back the curtain on the true value of their pension liabilities with the implementation of GASB 68, Daniel Gallagher, Commissioner of the SEC issued an important statement last week, noting in plain terms that how governments measure their liabilities would have serious repercussions in the private sector. Here’s part of the remarks worth considering:

 …for years, state and local governments have used lax governmental accounting standards to hide the yawning chasm in their balance sheets…

The riskiness of a pension obligation depends on state law.[32]  If pension obligations have the same preference as general obligation debt, then the municipality’s own municipal bond yield (generally around 5%) would be the proper discount rate.[33]  Or, if as we’ve seen from Detroit, pensions will be saved before all else, then we should use a default-free measure to discount the liability:  specifically, the Treasury zero-coupon yield curve.[34]  This would result in a discount rate in the low 3% range.

Obviously, the higher the discount rate, the lower the present value of the liability.  The difference between a discount rate in the range of seven percent and one in the range of three percent is in large part responsible for the hidden $3 trillion in unfunded liabilities that are currently going unreported.

This lack of transparency can amount to a fraud on municipal bond investors, and it does a disservice to state and local government workers and retirees by saving elected officials from making the hard choices either to fully fund the pension promises that were made to public employees,[35] or not to make the promises in the first place.

In the private sector, the SEC would quickly bring fraud charges against any corporate issuer and its officers for playing such numbers games.  And, we would also pursue and punish the so-called fiduciaries who recklessly seek yield to meet unrealistic accounting assumptions.  We should not treat municipalities any differently.”

GASB 68 asks that sponsors use a high- yield, tax exempt 20-year municipal GO bond only on the unfunded portion of the liability. This will reveal bigger funding gaps in public sector pension plans. But it does not reveal the full value of the liability since it allows sponsors to continue using the higher discount rates on the funded portion of the liability.

 In addition to using the new GASB standards, Commissioner Gallagher advises that governments should also disclose their pension liabilities on a risk-free basis. This would have the effect of showing the value of these promises on a ‘guaranteed-to-be-paid’ basis. Commissioner Gallagher’s suggestions are extremely sensible and a call to basic transparency in public sector liability reporting.

Ignoring the value of pension benefits is not going to make them cheaper to fund, and the longer a state waits to accurately measure the liabilities and payments, the worse it gets. Just ask New Jersey –  which is struggling to balance its budget and meet a fraction of a fraction of the required annual pension contribution to its state pension system. The situation is so dire that it could trigger yet another downgrade for the Garden State.

 

Municipal pension news: Baltimore to offer DC plan

Earlier this month, Baltimore’s city council approved a measure to give the city’s workers a choice between a defined contribution or defined benefit plan plan. According to Pensions and Investments, new hires will contribute 5 percent of their salary to whichever plan they choose, a significant increase from the 1 percent that workers were required to begin contributing to the city’s pension system last year. (Previously, workers had not contributed to their pension). As the article notes, the choice between a DB and a DC plan is a compromise. Mayor Rawlings-Blake preferred to move all newly hired employees to a DC plan, but this was not agreed upon by unions. In total, Baltimore two pension systems have an unfunded liability of $1.4 billion on a GASB-basis.

Baltimore’s proposed reforms are a bit stronger than the plan currently considered by Chicago mayor Rahm Emanuel, which is largely focused on filling in very daunting funding gaps in the city’s multiple plans. The Wall Street Journal reports that the mayor’s plan to raise property taxes by $250 million represents an increase of about $50 a year for the owner of a $250,000 home. And, it’s not enough to cover the gap. The state will demand an additional $600 million in annual payments for the city’s police and fire funds by 2016. In addition, Mayor Emanuel proposes benefit cuts, such as  increased employee contributions and reduced COLAs. But structural reforms aren’t being pushed too strongly, instead, the focus in Chicago appears to be a search for more revenues. Consider a proposal floated by The Chicago Teachers Union. They would like to see a per-transaction tax levied on futures, options, and stock trades processed on the Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange.  Both the CME and Mayor Emanuel oppose the idea recognizing that it will simply drive the financial industry out of town.

 

The “pension tapeworm” and Fiscal Federalism

In his annual report to shareholders, Warren Buffett cites the role that pension underfunding is playing in governments and markets:

“Citizens and public officials typically under-appreciated the gigantic financial tapeworm that was born when promises were made. During the next decade, you will read a lot of news –- bad news -– about public pension plans.”

He zones in on pension mathematics – “a mystery to most Americans” – as a possible reason for accelerating liabilities facing state and local governments including Puerto Rico, Detroit, New Jersey and Illinois. I might go further and state that pension mathematics remains a mystery to those with responsibility for, or interest in, these systems. It’s the number one reason why reforms have been halting and inadequate to meet the magnitude of the problem. But as has been mentioned on this blog before: the accounting will eventually catch up with the economics.

What that means is unrelenting pressure building in municipal budgets including major cities. MSN Money suggests the possibility of bankruptcy for Los Angeles, Chicago and New York City based on their growing health care and pension liabilities.

In the context of this recent news and open talk of big municipal bankruptcy, I found an interesting analysis by Paul E. Peterson and Daniel J. Nadler in “The Global Debt Crisis Haunting U.S. and European Federalism.”(Brookings Institution Press, 2014).

In their article, “Competitive Federalism Under Pressure,” they find a positive correlation between investors’ perception of default risk on state bonds and the unionization rate of the public sector workforce. While cautioning that there is much more at work influencing investors’ views, I think their findings are worth mentioning since one of the biggest obstacles to pension reform has been the reluctance of interested parties to confront the (actual) numbers.

More precisely, it leads to a situation like the one now being sorted out in federal bankruptcy court in Detroit. Pensioners have been told by Emergency Manager Kevyn Orr that if they are willing to enter into a “timely settlement” with the city and state, they may see their pensions reduced by less than the 10 to 30 percent now suggested. Meanwhile bondholders are looking at a haircut of up to 80 percent.

If this outcome holds for Detroit, then Peterson and Nadler’s findings help to illuminate the importance of collective bargaining rules on the structure of American federalism by changing the “rules of the game” in state and local finances. The big question for other cities and creditors: How will Detroit’s treatment of pensions versus bonds affect investors’ perception of credit risk in the municipal debt market?

But there are even bigger implications. It is the scenario of multiple (and major) municipal bankruptcies that might lead to federalism-altering policy interventions, Peterson and Nadler conclude their analysis with this observation:

[public sector] Collective bargaining has, “magnified the risk of state sovereign defaults, complicated the resolution of deficit problems that provoke such crises, heightened the likelihood of a federal intervention if such crises materializes, and set the conditions for a transformation of the country’s federal system.”

Credit Warnings, Debt Financing and Dipping into Cash Reserves

As 2013 comes to an end recent news brings attention to the structural budgetary problems and worsening fiscal picture facing several governments: New Jersey, New York City, Puerto Rico and Maryland.

First there was a warning from Moody’s for the Garden State. On Monday New Jersey’s credit outlook was changed to negative. The ratings agency cited rising public employee benefit costs and insufficient revenues. New Jersey is alongside Illinois for the state with the shortest time horizon until the system is Pay-As-You-Go. On a risk-free basis the gap between pension assets and liabilities is roughly $171 billion according to State Budget Solutions, leaving the system only 33 percent funded. This year the New Jersey contributed $1.7 billion to the system. But previous analysis suggests New Jersey will need to pay out $10 billion annually in a few years representing one-third of the current budget.

New Jersey isn’t alone. The biggest structural threat to government budgets is the unrecognized risk in employee pension plans and the purely unfunded status of health care benefits. Mayor Michael Bloomberg, in his final speech as New York City’s Mayor, pointed to the “labor-electoral complex” which prevents employee benefit reform as the single greatest threat to the city’s financial health. In 12 years the cost of employee benefits has increased 500 percent from $1.5 billion to $8.2 billion. Those costs are certain to grow presenting the next generation with a massive debt that will siphon money away from city services.

Public employee pensions and debt are also crippling Puerto Rico which has dipped into cash reserves to repay a $400 million short-term loan. The Wall Street Journal reports that the government planned to sell bonds, but retreated since the island’s bond values have, “plunged in value,” due to investor fears over economic malaise and the territory’s existing large debt load which stands at $87 billion, or $23,000 per resident.

This should serve as a warning to other states that continue to finance budget growth with debt while understating employee benefit costs. Maryland’s Spending Affordability Committee is recommending a 4 percent budget increase and a hike in the state’s debt limit from $75 million to 1.16 billion in 2014. Early estimates by the legislative fiscal office anticipate structural deficits of $300 million over the next two years – a situation that has plagued Maryland for well over a decade. The fiscal office has advised against increased debt, noting that over the last five years, GO bonds have been, “used as a source of replacement funding for transfers of cash” from dedicated funds projects such as the Chesapeake Bay Restoration Fund.

 

Pension reform from California to Tennessee

Earlier this month Bay Area Rapid Transit (BART) workers went on their second strike of the year. With public transport dysfunctional for four days, area residents were not necessarily sympathetic to the workers’ complaints, according to The Economist. The incident only drew attention to the fact that BART’s workers weren’t contributing to their pensions.

Under the new collective bargaining agreement employees will contribute to their pensions, and increase the amount they pay for health care benefits to $129/month.  The growing cost of public pensions, wages and benefits on city budgets is a real matter for mayors who must struggle to contain rapidly rising costs to pay for retiree benefits. San Jose’s mayor, Chuck Reed has led the effort in California to institute pension reforms via a ballot measure that would give city workers a choice between reduced benefits or bigger contributions, known as the Pension Reform Act of 2014. Reed is actively seeking the support of California’s public sector unions for the measure that would give local authorities some flexibility to contain costs. Pension costs are presenting new threats for many California governments. Moody’s is scrutinizing 30 cities for possible downgrades based on their more complete measurement of the economic liability presented by pension plans.  In spite of this dire warning, CalPERS has sent municipalities a strong message to struggling and bankrupt cities: pay your contributions, or else.

Other states and cities that are looking to overhaul how benefits are provided to employees include Memphis, Tennessee which faces a reported unfunded liability of $642 million and a funding ratio of 74.4%. This is using a discount rate of 7.5 percent.  I calculate Memphis’ unfunded liability is approximately $3.4 billion on a risk-free basis, leaving the plan only 35% funded.

The options being discussed by the Memphis government include moving new hires to a hybrid plan, a cash balance plan, or a defined contribution plan. Which of these presents the best option for employees, governments and Memphis residents?

I would suggest the following principles be used to guide pension reform: a) economic accounting, b) shift the funding risk away from government, c) offer workers – both current workers and future hires – the option to determine their own retirement course and to choose from a menu of options that includes a DC plan or an annuity – managed by an outside firm or some combination.

The idea should be to eliminate the ever-present incentive to turn employee retirement savings into a budgetary shell-game for governments. Public sector pensions in US state and local governments have been made uncertain under flawed accounting and high-risk investing. As long as pensions are regarded as malleable for accounting purposes – either through discount rate assumptions, re-amortization games, asset smoothing, dual-purpose asset investments, or short-sighted thinking – employee benefits are at risk for underfunding. A defined contribution plan, or a privately managed annuity avoids this temptation by putting the employer on the hook annually to make the full contribution to an employee’s retirement savings.

America’s best pension system? The case of Milwaukee

NPR reports that while many municipal and state governments’s pension systems are suffering from deep underfunding, there are some outliers. One such city is Milwaukee, Wisconsin. With a funding ratio of 90 percent, Milwaukee’s public employees’ plan would seem to have beaten the odds with a very simple (and laudable) strategy: fully fund the pension plan every year.

It is common sense. Make the full annual contribution and the plan can ensure that the benefits promised are available when retirement day arrives.

Except, thanks to government accounting guidance, it’s a little more complicated than that.

The problem is that the annual contribution the city is (prudently) making each year is calculated incorrectly. This flawed approach is why Detroit could claim a few short years ago that its plans were 100 percent funded. It is why New Jersey thought its plans were overfunded in the late 1990s.

Public plans calculate their liabilities – and thus the annual amount needed to contribute to the fund – based on how much they expect the assets to return. Milwaukee’s discount rate is 8.25%, recently lowered from 8.5%.

Unfortunately, if these liabilities are considered safe and guaranteed by the government, then they should valued as such. A better rate to use is the yield US Treasury bonds. In economist-speak: the value of liabilities and assets are independent. By way of analogy: Your monthly mortgage payment doesn’t change based on how much you think you may earn in your 401(K).

On a default-free, market valuation basis, Milwaukee’s pension plans is 40% funded and has a funding gap of $6.5 billion.

The good news – Milwaukee’s elected officials have funding discipline. They aren’t skipping, skimming, or torturing their contributions based on  the desire to avoid paying their bills. And this can be said of many other cities and states. Funding a pension shouldn’t be magic or entail lots of uncertainty for the sponsor or employee.

But that leads to the bad news. Even when governments are responsible managers, they’re being sunk by bad accounting. Public sector accounting assumptions (GASB 25) lead governments to miscalculate the bill for public sector pension contributions. Even when governments pay 100 percent of the recommended amount – as it is presently calculated – this amount is too little to fully fund pension promises.

Last week I posted the Tax Foundation’s map of what pension funding levels look like under market valuation. Almost all state plans are under the 50 percent funded level. That is, they are in far worse funding shape than their current accounts recognize.

Until plans de-link the value of the liability from the expected performance of plan assets, even the best -managed plans are going to be in danger of not having put aside enough to pay these promises. Even the best intentions cannot undo the effects of bad accounting assumptions.

 

 

Obama Administration will bailout Detroit

The Obama administration announced today it plans to send Detroit $320 million to “aid in its recovery,” according to The Hill.

The dollars come from existing federal money that is being re-purposed. It includes $24 million to rehabilitate buses and install safety cameras, $1.35 million for a community policing program, and the underwriting of 150 new firefighters. There are also funds for streets lights, police bike patrol, $3 million to hire new police, dollars for urban revitalization, and $25.4 million for demolition. A few months ago the administration said Detroit would have to work with creditors to resolve its bankruptcy issues. The city owes its creditors $18.5 billion.

Another example of how Detroit ended up in this awful position is highlighted in yesterday’s New York Times report of how Detroit City Council members skimmed $2 billion off of the pension system’ “excess earnings” to give employees ‘extra payments’ that had nothing to do with their pension benefits. This practice which spanned a 23 year period was justified as follows, quoting the NYT:

“People were having a hard time, living hand-to-mouth, and we thought we would give them some extra,” Ms. Bassett said.

Of all the nonpension payments, she said, 54 percent went to active workers, 14 percent went to retirees and 32 percent went to the city, which used its share to lower its annual contributions to the fund. The excess payments were often made near the end of the year, when recipients needed money for the holidays, or to heat their homes.

Of course the practice sounds wrong. Except it’s really another example of what happens when pensions value their liabilities based on asset returns. Detroit gave workers these “excess earnings.” New Jersey and scores of other states believed they were overfunded also and they “skipped payments” when the market was hot in the 1990s and early 2000s. The accounting gave them the illusion that this would all work out in the end. It is a dangerous fiction that these pension systems operate under.

That illusion of “overfunding in boom years” flows from the practice – discussed often in this blog – of discounting liabilities based on expected asset returns.The math really matters. For a long discussion, see here. 

How much damage has this accounting assumption and all the behaviors that flow from it caused? For Detroit – a significant amount. The city reports its pensions are underfunded by $634 million. It’s actually $9 billion underfunded on a market basis. 

I am not entirely surprised by the bailout, which sounds like a mini-stimulus via federal municipal grant programs. And I openly wonder what it portends for other cities that find themselves looking at similarly dire economic and financial situations.

New resource: Mercatus Center’s 2013 State and Local Policy Guide

Are you interested in the practical policy applications of the kinds of research the State and Local Policy Project is producing?

For an accessible and very useful review have a look at the inaugural edition of the Mercatus Center’s 2013 State and Local Policy Guide produced by our Outreach Team.

The guide is divided into six sections outlining how to control spending, fix broken pensions systems, control healthcare cost, streamline government, evaluate regulations, and develop competitive tax policies. Each section gives an overview of our research and makes brief, specific, and practical policy proposals.

If you have any questions, please contact Michael Leland, Associate Director of State Outreach, mleland@mercatus.gmu.edu

How are the states doing with pension funded ratios?

The Tax Foundation has a new pension map. It shows the funding levels of plans in the states, based on a risk-free discount rate. The numbers were crunched by State Budget Solutions, using a yield on (notional) 15-year Treasury bonds of 3.2 percent.

They estimate that the overall funding gap in the states is $4.1 trillion, much larger than the $1.3 trillion typically reported when using the state’s own assumptions (or a discount rate of about 7.5 percent). According to this map, no state is anywhere near the general standard of 80 percent funded. Most states are hovering around the 30 to 40 percent funded ratio. The state with the lowest funded ratio is Illionis at 24%funded. Connecticut is next at 25% funded. The best funded are Wisconsin (57%) and North Carolina (54%) – better, but not great.

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