Tag Archives: New Jersey

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.

 

Embrace Change

Kaiserin_Maria_Theresia_(HRR)Whenever someone suggested a new innovation or an improvement, Empress Maria Theresa had a favorite response: “Leave everything as it is.” As the sovereign of most of central Europe during the 18th Century, the Habsburg Empress epitomized absolutist rule, claiming that her powers had no limit.

But as her statement demonstrates, she clearly understood that her powers were limited by new and disruptive innovations. Her husband, Holy Roman Emperor Francis I understood this as well. Daron Acemoglu and James Robinson relate that when an English philanthropist suggested some social reforms for the benefit of Austria’s poorest, one of Francis’s assistants replied: “We do not desire at all that the great masses shall become well off and independent….How could we otherwise rule over them?” (A&R, 224).

This is why these Habsburg rulers did everything they could to stand athwart innovation. As Acemoglu and Robinson put it:

In addition to serfdom, which completely blocked the emergence of a labor market and removed the economic incentives or initiative from the mass of the rural population, Habsburg absolutism thrived on monopolies and other restrictions on trade. The urban economy was dominated by guilds, which restricted entry into professions. (A&R, 224).

Francis went so far as to block new technologies. For instance, he banned the adoption of new industrial machinery until 1811. He also refused to permit the building of steam railroads. Acemoglu and Robinson inform us that:

[T]he first railway built in the empire had to use horse-drawn carriages. The line…was built with gradients and corners, which meant that it was impossible subsequently to convert it to steam engines. So it continued with horse power until the 1860s. (A&R, 226).

Unfortunately, history is replete with examples of despots who stood in the way of innovation. In Russia, Nicholas I enacted laws restricting the number of factories and “forbade the opening of any new cotton or woolen spinning mills and iron foundries.” (A&R, 229). And in the Ottoman Empire, sultans banned the use of printing. So stultifying was the effect that “well into the second half of the nineteenth century, book production in the Ottoman Empire was still primarily undertaken by scribes hand-copying existing books.” (A&R, 214).

The centuries and the miles that separate us from these episodes give us some objectivity and allow us to see them for what they are: the naked exercise of government force to obstruct innovation for the benefit of a few entrenched interests. But how different are these episodes, really, from the stories we read in today’s newspapers? Are they all that different from New Jersey’s refusal to allow car companies to sell directly to consumers? Are they any less silly than the anti-Uber laws cooked up by a dozen U.S. cities? We like to think that our own political process is more enlightened but right now, federal, state and city policy makers are working to block the development of promising innovations such as wearable technologies, 3D printing, smart cars, and autonomous vehicles.

book-cover-smallFor a thoughtful and forceful discussion of what might be called the anti-Maria Theresa view, everyone should read Permissionless Innovation by my colleague Adam Thierer. It is a well-researched and well-argued defense of the proposition that our default policy should be “innovation allowed.” You can find Kindle and paperback versions on Amazon. Or you can check out the free PDF version at the Mercatus Center. For a nice overview of his book, see Adam’s post (and video) here. Please read it and send (free) copies to any modern-day Maria Theresas you may know.

Tesla’s Teachable Moment in New Jersey

Behind every privilege to a particular firm, there is a taxpayer, a customer, or a competitor who ends up paying for it. And those who are privileged today can easily find themselves on the other side of the equation tomorrow.

Tesla Motor Company is coming to learn this lesson the hard way. This past week New Jersey sided with the state’s powerful car dealership lobby to keep the electric car manufacturer from selling directly to consumers.

That’s me, writing over at RealClearMarkets. More here.

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.

 

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.

To merge or not to merge?

Princeton Image

Consolidating municipalities is a common policy prescription from across the political spectrum. In New Jersey in particular, many democratic and republican elected officials have thrown their support behind merging municipalities. In part, this support is based on the experience of Princeton. In 2011, Princeton Borough and Princeton Township moved, the first New Jersey municipalities to do so:

New Jersey GOP Gov. Chris Christie as well as governors in Ohio and Pennsylvania have been urging local governments to seek savings by eliminating unneeded costs. Christie endorsed the Princeton plan and offered to pay 20% of the $1.7-million unification cost, Bloomberg News reported.

The forecast is that Princeton taxpayers will save $3.1 million annually by consolidating services, including those for police and fire protection.

“We have redundancy in government,” borough resident Cole Crittenden told NJ.com in explaining why she supported the merger.

Framing municipal mergers as a way to get more bang for the taxpayer buck makes the proposal difficult for anyone to oppose except for those municipal employees who are redundant after a merger. However, the cost savings of consolidation are not well-understood. In an article in Governing Magazine earlier this week, Justin Marlowe writes:

It turns out that consolidations rarely save money. In fact, for the majority of citizens directly affected in these cases, consolidation has meant higher taxes and spending. Some cities consolidated because a larger government could improve local infrastructure. This has usually meant new debt and new taxes to repay that debt. Others offered generous pensions and health-care benefits to employees pushed out in the consolidation, thus saddling the new government with expensive legacy costs. In the consolidated town of Oak Island, N.C., per capita spending is two or three times higher than before consolidation, and that’s by design. Consolidation allowed this coastal community to offer new services needed to build a vibrant tourist economy.

Superficially, municipal consolidation looks like an opportunity to reduce taxes or to provide increased services for a given level of revenue. However, as Marlowe indicates, larger jurisdictions do not always result in anticipated efficiencies. As policymakers’ gain control of larger jurisdictions and in turn the ability to access more funds from revenue from the state and federal level, they may spend more, rather than less, per capita.

Come learn about whether tax and expenditure limits work

A few years ago I did a study on state Tax and Expenditure Limits (TELs). These are state rules—written into statutes or constitutions—which are designed to arrest the growth of state spending. New Jersey was the first state to adopt a TEL in 1976, and now about 30 states have some variety of TEL.

As I explained in a Wall Street Journal OpEd at the time, though fiscal conservatives have spent decades championing TELs, “these laws may actually be doing more harm than good.” The problem is that the most common variety of TEL—one that limits spending to some share of residents’ income—actually leads to more spending in high-income states. Not all TELs have this feature and my research suggests that the details matter. I found that TELs that limit spending growth to the sum of inflation and population growth, for example, seem to arrest spending in both high and low income states.

Now, Bemjamin Zycher of the American Enterprise Institute has revisited the question with an interesting and provocative new paper that reaches an even more pessimistic conclusion that I did.

Come to AEI tomorrow at noon where I and others will be discussing Zycher’s paper. Other discussants include Nicholas Johnson of the Center on Budget and Policy Priorities and Michael New of the University of Michigan-Dearborn. The event will be moderated by Mark Perry of AEI and the University of Michigan-Flint.

It promises to be a fun and lively discussion. Details here.

Third Edition of Freedom in the 50 States

Today the Mercatus Center released the third edition of Freedom in the 50 States by Will Ruger and Jason Sorens. In this new edition, the authors score states on over 200 policy variables. Additionally, they have collected data from 2001 to measure how states’ freedom rankings have changed over the past decade. While several organizations publish state freedom rankingsFreedom in the 50 States is the only one that measures both economic and personal freedoms.

Ruger and Sorens have implemented a new methodology for measuring freedom. While previously the authors developed a subjective weighting system in which they sought to determine how significantly policies limited the freedom of how many people, in this edition they have use a victim-cost method, assigning a dollar value to each variable that restricts freedom measuring the cost of restricting freedom for potential victims. The authors’ cost calculations are designed to measure the value of the states’ freedom for the average resident. Since individuals measure the cost of policies differently, readers can put their own price on each freedom variable on the website to find the states that best match their subjective policy preference.

In addition to an overall freedom ranking, Freedom in the 50 States includes a breakdown of states’ Fiscal Policy Ranking, Regulatory Ranking, and Personal Freedom Ranking. On the overall freedom ranking, North Dakota comes in first followed by South Dakota, Tennessee, New Hampshire, and Oklahoma.  At the bottom of the ranking, New York ranks worst by a significant margin, with rent control and burdensome insurance regulations dragging down its regulatory freedom score. New York is behind California at 49th, then New Jersey, Hawaii, and Rhode Island.

The authors note that residents respond to the costs of freedom-reducing policies by voting with their feet. Between 2000 and 2011, New York lost 9% of its population to out-migration. In addition to all types of freedom being associated with domestic migration, the authors find that regulatory freedom in particular is associated with states’ growth in personal income. They conclude:

Freedom is not the only determinant of personal satisfaction and fulfillment, but as our analysis of migration patterns shows, it makes a tangible difference for people’s decisions about where to live. Moreover, we fully expect people in the freer states to develop and benefit from the kinds of institutions (such as symphonies and museums) and amenities (such as better restaurants and cultural attractions) seen in some of the older cities on the coasts.

[…]

These things take time, but the same kind of dynamic freedom enjoyed in Chicago or New York in the 19th century — that led to their rise — might propel places in the middle of the country to be a bit more hip to those with urbane tastes.