Tag Archives: pension plans

The use of locally-imposed selective taxes to fund public pension liabilities

Many eyes are on Kentucky policymakers as they grapple with finding a solution to their $40 billion state-reported unfunded public pension liability. As talks of a potential pension bill surface, various proposals have been made by legislators, but very few have gained traction. One such proposal stands out from the rest. A proposal that has since been shut down suggested imposing selective taxes on tobacco, prescription opiates, and outsourced labor to generate revenue to direct towards paying down the state’s pension debt. Despite its short-lived tenure, this selective tax proposal reflects a recent trend in pension funding reform; a trend that policymakers should be wary of. Implementing new taxes on select goods or services may seem like a good idea as it could, in theory, potentially raise additional revenues, but experience at the local level suggests otherwise.

In chapter 12 of a new Mercatus book on sin taxes, NYU professor Thad Calabrese examines the practice of locally-imposed selective taxes that are used to fund public pension liabilities and doesn’t find much evidence to support their continued usage.

Selective taxes are sales taxes that target specific goods and are also known as ‘sin taxes’ because of their popular usage in taxing less healthy goods such as cigarettes, junk food, or alcohol. In the examples that Calabrese examines, selective taxes are used to target insurance premiums as revenue sources for pensions.

Only a select few states have begun this practice – including Illinois, Pennsylvania, as well as municipalities in West Virginia and Missouri – but it may become more popular if courts begin to restrict the way in which current pension benefits can be modified. Once benefits are taken off the table as an avenue for reform, like in Illinois, policymakers will feel more pressure to find new revenue sources.

The proposal in Kentucky may seem appealing to policymakers, especially because of its potential to raise $600 million a year, but this estimate overlooks the unintended effects that such new taxes could facilitate. Thankfully, the proposal did not go through, but I think some time should be spent looking at what similar proposals have looked like at the local level, so that other states do not get tempted pick up where Kentucky left off.

Calabrese draws on the experiences in Pennsylvania and Illinois to examine how these taxes have operated, how the decoupling of setting and financing employee benefits tends to lead to these taxes, and how the use of these taxes is associated with significantly underfunded pension systems. Below I highlight Pennsylvania’s experience and caution against further usage of this mechanism for pension funding.

How it works (or doesn’t)

In 1895, Pennsylvania implemented a 2 percent tax on out-of-state fire and casualty insurance companies’ premiums on in-state property and then earmarked this for distribution to local governments to pay for pensions. Act 205 of 1984 replaced the original act in which the state of Pennsylvania allocated pension aid based on where the insured property was located and instead the new allocation was based on the number of public employees in a locality.

Calabrese explains how the funds were distributed:

“Each public employee was considered a ‘unit,’ and uniformed employees (such as police and fire) each represented two units. The pool of insurance tax revenue collected by the state was then divided by the sum of municipal units to arrive at a unit value. This distribution could subsidize local governments’ pension expenditures up to 100 percent of the annual cost. In 1985, this tax generated $62.3 million in revenues; as a result, each unit value was worth $1,146 – meaning that local governments received $1,146 for pension funding for each public employee and an additional $1,146 for pension funding for each uniformed public employee. Importantly, 75 percent of municipalities received enough funding from this revenue in 1985 to fully offset their pension costs.”

The new mechanism raised more funds, but it also unexpectedly raised costs. If a municipality had to contribute less than the $1,146 annually for a regular employee or $2,292 for a uniformed employee, for example, the municipality was essentially incentivized to increase benefits to public employees up to this limit, because local public employees would receive increased benefits at no direct budgetary cost to the municipality.

“…the tax likely increased insurance costs for residents and businesses (and then only a small fraction of the cost), but not directly for the government employer. Further, this system privileged benefits relative to other compensation, because these payments (borne at least statutorily by out-of-state companies) could only be used for financing pensions and not other forms of compensation.”

A tax originally implemented to fund pension costs statewide resulted in a system that encouraged more generous benefits.

Despite increased subsidies from the state, only 38 percent of municipalities received sufficient allocated funds from the pool to fully offset the costs of pensions. This was because annual pension contributions were growing at a faster rate than the rate at which the subsidy from the state insurance tax was growing.

To highlight a city with severely distressed pension plans, Philadelphia continued to struggle even following the implementation of the state insurance tax. The police pension plan, nonuniformed plan, and firefighter pension plan were all only 49, 47, and 45 percent funded, respectively. In 2009, the City Council passed a temporary 1 percentage point increase in their sales tax and when the temporary rate was renewed in 2014, any revenue in excess of $120 million was dedicated to the city’s pension plans. Additionally, the state permitted the city to pass a $2 per pack cigarette tax to fund a planned budget deficit for the school system; likely because its income tax capacity was largely exhausted.

Philadelphia’s new taxes technically generated new revenues, but they did little to improve the funding of the city’s pension plans.

The selective taxes implemented to fund pension liabilities in Pennsylvania were effectively a Band-Aid that was two small for the state’s pension funding problem, which in turn required the addition of more, insufficient pension Band-Aids. It merely created a public financing system that encouraged pension benefit growth which led to the passage of additional laws requiring certain pension funding levels. And when these funding levels were not met, even more laws were passed that provided temporary pension funding relief, which further grew liabilities for distressed municipalities.

Act 44 became law in 1993 and provided plan sponsors pension funding relief, but primarily by allowing sponsors to alter actuarial assumptions and thereby reduce required pension contributions. Another law delayed funding by manipulating how the required contribution was calculated, rather than providing any permanent fix.

Moving forward

Selective taxes for the purpose of funding pensions are still a relatively rare practice, but as pension liabilities grow and the landscape of reform options changes, it may become increasingly attractive to policymakers. As Calabrese has demonstrated in his book chapter, however, we should be wary of this avenue as it may only encourage the growth of pension liabilities without addressing the problem in any meaningful way. Reforming the structure of the pension plan or the level of benefits provided to current or future employees would provide the most long-term solution.

A solution with the long-term in mind and that doesn’t involve touching current beneficiaries includes moving future workers to defined contribution plans; plans that are better suited to keeping costs contained. The ballooning costs aren’t stemming solely from overly generous plan benefits, but more seriously are the result of their poor management and incentives for funding, only exacerbated by poor accounting practices. The problem is certainly complicated and moving towards the use of defined contribution plans wouldn’t eliminate all issues, but it would at least set governments on a more sustainable path.

At the very least, policymakers interested in long-term solutions should be cautioned against using selective taxes to fund pensions.

Loyalton, CA and the cost of faulty actuarial assumptions

The New York Times has an interesting piece on the pension troubles facing the small town of Loyalton, California (population 769). Loyalton has seen little economic activity since its sawmill closed in 2001. In 2010 the city made a decision to exit Calpers saving the city $30,000. The City Council thought that the decision to exit would only apply to new hires and for the next three years ceased paying Calpers. Four of the the pension plan’s participants are retired and one is fully vested.

In response, Calpers sent the town a bill for $1.6 million – the hypothetical termination liability – for exiting the plan. For years Loyalton operated under the assumptions built into Calpers’ system which values the liability based on asset returns of 7.5 percent. This actuarial value concealed reality. Once a plan terminates Calpers presents employers with the real bill: or the risk-adjusted value of its pension promises based on a bond rate of 3.25 percent.

To see how big a difference that makes to the bottom line for cities, Joe Nation, Stanford professor, has built a very helpful tool that compares the actuarial liability of pension plans with the market value for individual governments in California.

The judge in the Stockton bankruptcy case Christopher Klein characterized the termination liability as presenting struggling towns with a “poison pill” for leaving the system. Another way to look at it is that the risks and costs that were hidden by faulty accounting assumptions based on risky discount rates are coming due as Calpers fails to hit its investment target. The annual costs may start to be shifted, and in the case of termination, fully imposed on local employers.

The four retirees of Loyalton are facing the possibility of drastically reduced pensions. In a town with annual revenues of $1.17 million, Calpers’ bill is far beyond the town’s ability to pay. Negotiations between Calpers and Loyalton are likely to continue. Some ideas floated include putting a lien on the town’s assets or revenues.

 

Local governments reluctant to issue new debt despite low interest rates

The Wall Street Journal reports that despite historically low interest rates municipal governments and voters don’t have the appetite for new debt. Municipal bond issuances have dropped to 20-year lows (1.6 percent) as governments pass on infrastructure improvements. There are a few reasons for that: weak tax revenues, fewer federal dollars, and competing budgetary pressures. As the article notes,

“Many struggling legislatures and city halls are instead focusing on underfunded employee pensions and rising Medicaid costs. Some cash-strapped areas, such as Puerto Rico and the city of Chicago, face high annual debt payments.”

The pressures governments face due to rising employee benefits is likely to continue. The low interest rate environment has already had a negative effect on public pensions. In pursuit of higher yields, investors have taken on more investment risk leaving plans open to market volatility. At the same time investments in bonds have not yielded much. WSJ reporter Timothy Martin writes that public pension returns are, “expected to drop to the lowest levels ever recorded,” with a 20-year annualized return of 7.4 percent for 2016.

The end result of this slide is to put pressure on municipal and state budgets to make up the difference, sometimes with significant tradeoffs.

The key problem for pensions is “baked into the cake,” by use of improper discounting. Linking the present value of guaranteed liabilities to the expected return on risky investments produces a distortion in how benefits are measured and funded. Public sector pensions got away with it during the market boom years. But in this market and bond environment an arcane actuarial assumption over how to select discount rates shows its centrality to the fiscal stability of governments and the pension plans they provide.

Properly funding a defined benefit plan requires solid average returns and some luck

Saving for retirement is something most workers do – either on their own or through an employer – and most are aware that the rate of return on their retirement investment matters. For example, if I save $100 today and it earns 10% per year in interest for the next 20 years I will have $672.75 at the end of 20 years. If the money earns 6% instead I will only have $320.71 at the end of 20 years.

Moreover, if I wanted to have $672 at the end of 20 years and the interest rate was only 6% I would have to save $209.54 today rather than $100. This demonstrates that the higher the interest rate is, the less money I will have to save today in order to have a specific amount of money in the future. This simple truth has important implications for pension funding.

For many years state pension plans assumed average returns of around 8% per year when calculating pension liabilities. Assuming this relatively high rate of return meant that pension plans required less contributions today in order to meet their future goals. But this also came with significant risk – if the average rate of return fell short of 8% then the pensions would not be able to pay out the benefits that were promised. This is demonstrated in the previous example; if a person wanted $672 after 20 years and assumed a 10% rate of return they would have only saved $100. However, if the rate of return turned out to be 6% per year instead of 10%, they would have ended up over $300 short of their goal ($672 – $320 = $352).

It turns out that an expected rate of return of 8% was unachievable and many pension plans are lowering their expected returns. This can generate large pension shortfalls, since a lower rate of return means that more money needed to be saved all along. In many states the budget is tight and it’s not clear where the additional money will come from, but there’s a good chance that taxpayers are going to have make up the difference.

Assuming too high of a return is an obvious problem. But there is a more subtle issue that doesn’t get as much attention yet generates similar results; even if a pension plan gets an 8% return on average, the plan may still fall short of its goal. This is because different returns have different effects on the actual amount of money over time. The chart below provides a simple example, where the goal is to accumulate $100,000 in 10 years.

Based on the $100,000 goal and an 8% yearly return one can calculate that (approximately) $6,400 must be contributed to the plan at the beginning of each year, which is the contribution amount I used. In each scenario in the table the average annual return is 8%, but not every plan returns 8% each year.

pension-avg-return-table2

Scenario 1 is the most straightforward; the plan actually earns 8% each year and the $100,000 goal is reached by year 10. But while this is the simplest scenario, it’s also the most unrealistic. Anyone who follows the stock market knows that it’s volatile – some years it’s up, some years it’s down. Standard pension accounting, however, assumes scenario 1 will occur even though that’s incredibly unlikely.

In scenario 2, the plan earns 8% in each of the first two years, then loses 15% the third year. After that returns are above average and plan actually exceeds its goal of $100,000 at the end of 10 years. In scenario 3 the plan earns 8% for the first 6 years, then 14%, before losing 15% in year 8. In this scenario, even the exceptional gains in years 9 and 10 are not enough to reach the $100,000 goal. And finally, in scenario 4 the gains fluctuate more often – there are some high return years in the beginning and the loss year is relatively late (year 7). In this scenario the plan ends up over $6,500 short of its $100,000 goal.

There are infinite ways a plan could get an 8% return on average, but these 4 examples demonstrate the different dollar amounts that can result even if the average return goal is met. In two of the scenarios (3 and 4) the plan falls short of its actual dollar goal and is underfunded even though it met its return goal. This exemplifies the inherent risk in any pension plan that promises a specific amount of money in some future period, as defined benefit plans do. As the previous example shows, even if the required contributions are made each year AND the plan’s average return goal is met, there is still a chance the plan will be underfunded.

The risks associated with the variability in returns is another reason why many pension reform advocates recommend defined contribution plans rather than defined benefits plans. Defined contribution plans don’t promise a specific amount of benefits, which means they are not subject to the same underfunding risks as defined benefit plans. Switching from defined benefit plans to defined contribution plans needs to be a part of the solution to public sector pension problems. Otherwise there’s a good chance that taxpayers will be required to pick up the tab when plans inevitably miss their funding goals.

 

Banking on risky investments is no way to guarantee a public pension

Over the past several years I’ve spent a lot of time studying public pension systems. That’s involved diving into the economics and actuarial literature, reading through many individual plan reports, and analyzing the trends in those systems in the context of the principles of financial economics. Why do this? It isn’t just a public finance problem. Twenty million Americans participate in these plans. If research points to systematic structural weaknesses in public sector plans, that under the right conditions, can lead to plan failure, then it is an imperative to point it out and recommend solutions to ensure that retirees receive the pensions they’ve been promised without placing unnecessary burdens on taxpayers or forcing painful budget tradeoffs at the worst possible time: during a recession.

The only way to protect pensions is to accurately assess their true value and funded status and then contribute what is needed to pay out those benefits. Unfortunately, the story of US public sector pension is that they are built on investment risk and accounting illusions.

Pension finance is not without controversy. Misunderstandings can arise in part due to the very different approaches taken by financial economists and traditionally trained actuaries over how to most appropriately value pension liabilities and assets, as well as the nature of investment risk.

However, some of the conflict is due to the implications of the pension literature. Applying the economic approach to valuing pension fund liabilities reveals trillions more in obligations and far bigger funding gaps for states and cities. It shows how public sector plans have exposed themselves to an unwise amount of investment risk effectively linking guaranteed pension payments to market volatility and putting taxpayers on the hook for losses. Some state and local governments have responded to this debate either through small accounting reforms or policy changes meant to shore up pension systems. These reforms are not necessarily sufficient but it’s a tacit recognition that the math really matters.

There are some plans that continue to staunchly defend a “More investment risk = safe and guaranteed pension with no downsides” approach. And at least one system has gone on the offense against any suggestion that increasing investment risk in a government-guaranteed pension system amounts to gambling with employees’ pension benefits.

In May 2014 I authored a paper that made the case for economic accounting and better funding for Alabama’s three state-run pension plans.[1] My study was featured in The Advisor in July 2014, the newsletter the Retirement Systems of Alabama (RSA) provides to its members.[2] One article written by “RSA staff” purports to debunk my paper, but ends up missing the implications of both the literature and my analysis.

The RSA staff’s main complaint revolves around one sentence in which I cite a peer-reviewed 2010 study in the National Tax Journal by Joshua Rauh entitled, “Are State Public Pension Plans Sustainable?[3] Rauh finds that, without policy changes, Alabama might run out of assets to pay benefits by 2023, necessitating the move to a pay as you go system. To be sure, that is a sobering claim.

The RSA staff argues that the runout date calculated by Rauh is based on “bad data” from 2006, when Alabama offered a 3.5 percent ad hoc Cost of Living Adjustment (COLA). It further contends the runout date is based on the assumption of a risk-free discount rate and asset values from 2009, and this all unfairly inflates liabilities and cherry-picks a low-point for asset values. In addition, Rauh assumes that the plan only pays for normal costs going forward (not for past benefits), in keeping with the contribution behavior of most plans at the time of the study.

The first two claims by the RSA staff are incorrect. In the “run-out dates” paper, Rauh’s data is assembled from, “the individual plans and the Center for Retirement Research on a plan-by-plan basis.”[4] This dataset was originally developed for a previous peer-reviewed paper with Robert Novy-Marx entitled, “Public Pension Promises: How Big Are They and What Are They Worth?” which drew from the individual Comprehensive Annual Financial Reports (CAFRs) of 116 state-sponsored pension plans.[5] Nine data items were taken from the pension plan CAFRs that were available as of December 31, 2008. (The FY 2008 CAFR contains data for 2007 that the authors project to 2009). These CAFR-derived items are:

  • the plans’ stated liability
  • its state-chosen discount rate
  • the actuarial method (EAN or PUC)
  • a benefit factor
  • a Cost of Living Adjustment
  • an inflation assumption
  • the share of active workers in the plan;
  • the share of retired workers in the plan; and
  • the dollar amount of benefits paid in the most recent year.

The third item – the actuarial method – was drawn from both the CAFR and information from the Center for Retirement Research at Boston College as of 2006.[6]

Novy-Marx and Rauh estimated a total of $42 billion projected liabilities as of June 2009 for all three of Alabama’s plans. [7] The authors’ estimate closely matches the reported value of $41.6 billion in September 30, 2009 in RSA’s FY 2010 CAFR. Novy-Marx and Rauh re-calculate the value of state promised pension liabilities when valued based on risk-free Treasury bonds. They find that Alabama’s total liabilities of $42 billion increase to $61.8 billion when discounted using the risk-free Treasury rate.

Their paper triggered a lot of attention. Clearly, the finding that GASB 25 was leading state plans to obscure the true size of their pension liabilities generates a lot of follow-up questions, such as, “When will they run out of money?”

In a subsequent paper Rauh (2010) tackles this very question. His assumptions are key to interpreting the run out date. Beginning with the data that he and Novy-Marx assembled, Rauh models the cash flows of these pension plans under the rate of return assumed by the plan itself, in the case of Alabama: 8 percent. A further assumption is made that future contributions to the plan will be equal in value to the benefits earned by employees in that year, “an assumption broadly in keeping with states’ recent contribution behavior.”[8] If the state fully funds benefits as they are accrued how long will the assets last under the assumption that the plans earn 8 percent each year?

Under an 8 percent discount rate with no COLA, and only funding the normal cost, Rauh projects that the RSA will run out of assets in 2023. The implication is that state contributions will have to increase, placing a greater demand on state budgets, necessitating increased taxes or cuts to spending. One thing going in Alabama’s favor is that they have a history of making the full contribution each year. However, this contribution amount is calculated under optimistic assumptions that I demonstrate in the paper are based on assuming a large amount of investment risk. And that is where the danger lies.

Contrary to the RSA staff’s claim:

  • There is no COLA assumption in Rauh’s 2010 run-out date study
  • The run out date of 2023 is based on a discount rate of 8 percent.

The RSA staff is correct to note that Rauh’s calculation is based on only paying the normal cost. Since Alabama has a history of making the full annual contribution this will help the system to forestall a run-out. The question is by how much, by how many years? As long as the RSA assumes an 8 percent discount rate and embraces a risky investment strategy they are operating under an accounting illusion that leads them to low-ball the annual contribution needed to fund the system.

If the market has a great run over the next decade with returns exceeding 8 percent per year and the RSA continues to to pay 100 percent of the ARC under these conditions it would stay solvent. The RSA points to the fact that between 2009 and today its assets have grown by 46 percent, or $35 billion. [9]

But there’s another problem. The RSA’s funded status continues its decade-long drop. Let’s look at Alabama’s assets, liabilities, and funded status of the plan between 2008 and 2013 (the most recent data available) taken from the plan CAFRs, with no adjustments to the data. The trend is clear. Liabilities are growing faster than the assets. Funding ratios are falling.

For Teachers’ Retirement System (TRS) over the period the total actuarial value of assets fell by six percent from $20.8 billion to $19.6 billion, while total liabilities grew from $26 billion to $29 billion (11 percent), leaving the system with a funded ratio of 66 percent.

Table 1. Teachers Retirement System Actuarial Accrued Liability and Actuarial Assets (2008-2013) Adjusted for Inflation

($ mil) 2008 2009 2010 2011 2012 2013 % change 2008-2014
TRS Liabilities $26,804 $27,537 $28,299 $28,776 $28,251 $29,665 11%
TRS Assets  $20,812 $20,582 $20,132 $19,430 $18,786 $19,629 -6%

Source: Comprehensive Annual Financial Report (CAFR) for Retirement System of Alabama (RSA) FY 2009-2014.

The same story can be told of the Employees Retirement System (ERS). Assets fell by 4 percent as liabilities grew by 11 percent over the period. The ERS is currently funded at 65 percent, down from 77 percent in 2009. Four years of increased returns have not reversed the decline.

Table 2. Employees’ Retirement System Actuarial Accrued Liabilities and Actuarial Assets 2008-2013

($ mil) 2008 2009 2010 2011 2012 2013 % change 2008-2014
ERS Liabilities $13,078 $13,756 $14,248 $14,366 $13,884 $14,536 11%
ERS Assets $9,905 $9,928 $9,739 $9,456 $9,116 $9,546 -4%

Source: Comprehensive Annual Financial Report (CAFR) for Retirement System of Alabama (RSA) FY 2009-2014

The Judicial Retirement Fund (JRF) had the steepest increase in liabilities. Assets fell by 6 percent and liabilities grew by 28 percent. JRF is the most weakly funded at 58 percent.

Table 1. Judicial Retirement System Actuarial Accrued Liability and Actuarial Assets (2008-2013) Adjusted for Inflation

($ mil) 2008 2009 2010 2011 2012 2013 % change 2008-2014
JRF Liabilities $323 $340 $358 $393 $380 $414 28%
JRF Assets $259 $252 $246 $235 $234 $243 -6%

Source: Comprehensive Annual Financial Report (CAFR) for Retirement System of Alabama (RSA) FY 2009-2014

Looking back at the decade shows an even more dramatic trend. These systems began 2003 with funding levels of 90 percent. They have fallen every year since to their current levels of between 66 percent and 58 percent.

The RSA has stated in the past that 80 percent funding is good enough and that investing assets in a risky portfolio currently comprised of 70 percent equities will enable the system to comfortably meet its obligations. But as these funding trends show a volatile portfolio comes with a downside. The assets may be back to where they were five years ago, but in the meantime, liabilities continue their steady growth.

The next observation the RSA staff makes is that these numbers are too bleak since they are based on 2009 asset values. Since then the assets have grown by 11 percent on average over the period. To be sure, once you exclude 2008, things look better. But that’s a bit like excluding the F when you calculate your average grade for the semester. Ignoring the downturn doesn’t mean it didn’t happen or that it didn’t erode the assets. It takes exceptional and sustained performance to make up for it.

The five and 10-year period tell a less bullish story.

Annualized returns for the RSA for the Fiscal Year ended September 30, 2013. (p. 60)

Total Portfolio 1 year Last 3 Years Last 5 Years Last 10 Years
TRS 14.93% 11.45% 6.68% 6.29%
ERS 14.6% 11.4% 6.17% 5.97%
JFR 14.05% 10.89% 8.74% 7.06%

While investments have rebounded for the RSA, plan funding status is falling despite increased contributions. Since 2012 employers and most employees are making bigger contributions to these plans. Alabama now operates a Two-tiered pension system. Tier 1 TRS and ERS employees (those hired before January 1, 2013) saw their individual contributions rates increase from 5 percent of pay in 2011 to 7.5 percent of pay in 2013. JRF members, firefighters, police officers and correctional officers contribution rates increased from 6 percent in 2011 to 8.25 percent of pay in 2013. Tier II members (those hired after January 1, 2013) will have lower contribution rates and diminished benefits. Both tiers will give something up.

Employers are also contributing more. The state’s contributions have increased. For the TRS (Tier 1 employees), the state’s contribution has risen from 6.3 percent of payroll in 2000 to 11.7 percent in 2014. Employer contributions for the ERS (Tier 1) rose from 4 percent to 12 percent of payroll over the same period. JRF has the largest employer contribution “In 2000, the state contribution to the JRF was 21 percent of payroll. It reached 35% by 2014.”

Rauh’s 2010 study points to a trend worth monitoring. Funding levels are dropping. Assets are not growing fast enough to keep up with the growth in liabilities necessitating more revenues, higher contributions or some other action. Yet the RSA staff points to its recent returns of 11%, as if that is something the RSA can sustain. The stock market does reward risk-taking with high returns in bull markets, but at a cost of negative returns in recession years like 2008. Increasing the risk of RSA assets to chase high stock market returns is banking on something neither the RSA nor anyone else can guarantee.

Valuing a guaranteed pension based on the expected returns of risky and volatile assets increases the chance of a funding shortfall. It is likely that Alabama will find it will need more revenue to fund the RSA. Already inadequate funding levels are falling. The investment portfolio is heavily exposed to market risk. And contribution rates are rising.

The RSA staff’s response to my research is part of a more general problem. Many of those responsible for public sector pensions think that investment risk can be ignored or it can just be passed on to taxpayers. The point of this entire body of literature drives home one theme consistently: public sector pension accounting flaunts the established principles of finance by claiming that there is no price for assuming investment risk. Financial theory can be abstract. But recent history gives us a demonstration of these core principles. Many pensions systems, the RSA included, have ignored the lessons of the Great Recession and are exposing pensions to even more investment risk.

[1] Eileen Norcross, “Pension Reform in Alabama: A Case for Economic Accounting,” in Improving Lives in Alabama: A Vision for Economic Freedom and Prosperity, The Johnson Center at Troy University, May 2014 (https://nebula.wsimg.com/35b439dc51fd0dae2bd46e38024dadd2?AccessKeyId=F0B126F45D4E1A4094F7&disposition=0&alloworigin=1)

[2] “Troy University Report on RSA has Erroneous Assumptions,” by RSA Staff, The Advisor, July 2014 (http://www.rsa-al.gov/uploads/files/Advisor_July2014.pdf)

[3] Joshua Rauh, “Are State Public Pension Plans Sustainable? Why the Federal Government Should Worry about State Pension Liabilities,” National Tax Journal 63(3) p. 585-601, May 2010. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1596679)

[4] Ibid, p. 6 and p. 9.

[5] Robert Novy-Marx and Joshua Rauh, “Public Pension Promises: How Big Are They and What Are They Worth?” Journal of Finance 66 (4), 1211-1249, 2011 (http://www.jstor.org/stable/29789814?seq=1#page_scan_tab_contents)

[6] Ibid p. 1224, “The actuarial method (item 3) combines our own data collection with information from the state and local pension data made available by the Center for Retirement Research (2006.)

[7] Ibid, p. 1239

[8] Rauh, (2010) “Are Public Pensions Sustainable?” p. 2.

 

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.

Some private sector pensions also face funding trouble

A new report by the Pension Benefit Guaranty Corp (PBGC) warns that while the market recovery has helped many multiemployer pension plans improve their funding there remain some plans that,”will not be able to raise contributions or reduce benefits sufficiently to avoid insolvency,” affecting between 1 and 1.5 million of ten million enrollees.

Multiemployer plans are defined as those which unions collectively bargained for, with multiple employers participating within an industry (e.g. building, construction, retail, trucking, mining and entertainment). They are also known as Taft-Hartley plans. Multiemployer plans grew out of the idea of offering pension benefits for unionized employees in transient kinds of work such as construction. These plans have been in trouble for awhile due to a variety of factors. Many plans have taken measures by increasing contributions and in a few cases cutting benefits according to GAO. But those steps have not been nearly enough to fix the growing shortfalls.

When a PBGC-insured pension plan goes insolvent beneficiaries are only guaranteed a fraction of their benefits. Those funds come from the premiums paid by remaining plans. The projected deficit for the ailing multiemployer plans range from $49.6 billion to $79.6 billion in 2022. By contrast the PBGC reports that single employer plans fare better with the current funding deficit of $27.4 billion narrowing to $7.6 billion by 2023.

Source: FY 2013 PBGC Projections Report

 

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.

 

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.