Tag Archives: Public

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.


Corporate welfare spending is not transparent

Over a century ago, the Italian political economist Amilcare Puviani suggested that policy makers have a strong incentive to obscure the cost of government. Known as “fiscal illusion,” the idea is that voters will be willing to spend more money on government if they think its costs is lower than it actually is. Fiscal illusion explains a great deal of public choices, including the popularity of deficit spending.

It also explains why the public knows the least about some of the most controversial items in the public budget such as corporate welfare. But some would like to change this. Here are Jess Fields and Tom “Smitty” Smith, writing in the (subscription required) Austin-American Statesman:

Texans believe in government transparency and accountability. For this reason, we have some of the most advanced open-government initiatives in the nation. Yet one policy area remains outside the view of the general public: economic development.

When local governments cut deals that result in millions in incentives, they can do it behind closed doors in “executive session” — legally — thanks to exceptions to the Open Meetings and Public Information Acts for “economic development negotiations.”

Fields is a senior policy analyst at the free enterprise Texas Public Policy Foundation, while Smith is the director of the Texas office of Public Citizen, a progressive consumer advocacy group started by Ralph Nader in the ‘70s.

Texans aren’t the only ones interested in making corporate welfare more transparent. The Government Accounting Standards Board (GASB) is considering rules that would require governments to report the tax privileges that they hand out to businesses. Here is Liz Farmer, writing in Governing Magazine:

Specifically, GASB is proposing that state and local governments disclose information about property and other tax abatement agreements in their annual financial statements. If approved, the new disclosures could shed light on an area of government finance and provide hard data on information that is assembled sporadically, if at all. Scores of public and private groups support the proposal and it has proven to be one of GASB’s most debated topic yet, as nearly 300 groups or individuals submitted comment letters to the board. But many still say the requirements don’t go far enough.

She notes that the proposal misses a number of tax privileges including:

  • Tax increment financing (TIF),
  • Agreements to discount personal income taxes,
  • “[P]rograms that reduce the tax liabilities of businesses or similar classes of taxpayers.”

Because of these omissions the new GASB rules may only capture about one-third of all tax expenditures.

Puviani would have predicted that.

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.

When new ideas meet old regulatory solutions

With the Pennsylvania Public Utility Commission recently issuing cease-and-desist letters to ride-share services Lyft and Uber, Pittsburgh Mayor Bill Peduto invoked the Age of Reptiles to describe the decision:

“Technologies like ride-sharing evolve with the times and state regulators must, too,” said Mayor Peduto in a prepared statement. “While the commission may wish for Pennsylvania to cling to a Jurassic Age of transportation options, people in Pittsburgh and other communities know our state must adapt or die in the global marketplace.”

That is Christopher Koopman and me, writing in the Pittsburgh Post-Gazette. Click here to read the rest.

What to do when technology outpaces the law?

The recent cease-and-desist letters from the Virginia Department of Motor Vehicles to taxi alternatives Uber Technologies and Lyft remind me of my first trip to D.C. in 1997. An awkward high school junior traveling alone, I landed at National Airport, followed the signs and hopped into a filthy Virginia-sanctioned taxicab. The heavy stench of stale cigarettes clung to the papers, cups and clothes littering the floor.

En route to my hotel, the driver suddenly stopped and, without explanation, got out of the car. After making a 10-minute payphone call, he nonchalantly resumed our drive. I reached the hotel unscathed, but the unpleasant trip — costing about $15 — seemed second-rate to a first-time cab rider.

A few years later, a freshman econ course revealed that economics can explain the sub-par service I received.

TaxiThat is me, writing in the Richmond Times Dispatch. I make the case that ride-sharing companies Uber and Lyft have solved many of the problems that plague traditional taxi models. But instead of thanking the companies, the Virginia DMV has issued cease-and-desist letters.

The best defense of the DMV is that they were simply following the law. From their perspective, Uber and Lyft look like motor carriers. And in Virginia, motor carriers are required to be licensed. To this, Uber and Lyft can reasonably reply that they are not motor carriers. They do not employ any drivers. Instead, they employ software engineers who create mobile applications used by drivers. Their service is simply to connect those with rides to those in need of rides. In this sense, the companies are no more motor carriers than Kayak or Priceline are airlines.

So what to do in this sort of area where technology seems to have outpaced the law?

My colleague Jerry Brito offers a simple idea:

[H]ow about allowing the innovation to continue apace while the government studies it and gets its regulatory house in order? Public officials like [Commissioner of the DMV] Mr. Holcomb might say that their job is to enforce the law, and while that’s true, public officials also have a responsibility to exercise discretion in the public interest. It’s clear that the Virginia legislature did not anticipate the invention of platforms like Uber and Lyft when they designed their motor carrier laws, so it would be perfectly reasonable for the DMV to work with the legislature to clarify the law without first banning the services.

You can read more of Jerry’s views in his latest column in Reason.

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.


Hercules, California’s Herculean debts

What lead the city of Hercules, California to default on its debts? Guest poster Marc Joffe, Principal Consultant at Public Sector Credit, finds a case of mission-creep in the “dynamic city on the Bay’s”  decision to issue debt to finance power plants and affordable housing.

(For more of Marc Joffe’s research on modeling credit risk, read his 2013 Mercatus Working paper comparing Illinois and Indiana)

Hercules, California Public Power Failure Leads to Default

by Marc Joffe

Cities can default on obligations to their creditors without filing for Chapter IX bankruptcy protection.  This is the lesson of Hercules, California – a 25,000-resident San Francisco suburb whose finances are not quite as mighty as its name implies. Hercules experience is also illustrative of the risks that cities take when they expand beyond their core functions of public safety and public works.

The city is threatening to default on $12.8 million of municipal bonds as early as this August.  In a tender offer issued earlier this month, Hercules offered holders of these bonds 90% of their securities’ face value. According to the bondholder notice, “If an insufficient number of bonds are not tendered, the City anticipates it will soon default on the bonds.” Offering bondholders 90 cents on the dollar in order to avoid facing the risk of non-payment is, for all intents and purposes, a default.

In fact, it is the city’s third default in recent years. In 2011, Hercules failed to repay a $3.75 million loan from the California Housing Financing Agency (CHFA). The state loan was intended to support a mixed use development Hercules planned to build. The development, which included a large affordable housing component, was stymied by neighborhood opposition to low income housing and the City’s inability to acquire a portion of the intended construction site from a nearby homeowner’s association. Earlier this year, Hercules sold the site to a developer who plans to build market rate housing. It has also agreed to repay the CHFA loan in installments through 2026 at a reduced interest rate.

Hercules’ second default occurred on February 1, 2012, when it failed to make a $2.4 million interest payments on Redevelopment Agency (RDA) bonds. The default was absorbed by Ambac, the agency’s municipal bond insurer. Ambac filed suit against the city claiming it had failed to remit RDA related property tax collections to the bond trustee as required. In March 2012, Ambac and the City settled the litigation with the City pledging two parcels of land to the insurer. The City further agreed to place these two properties on the market, apparently to offset the $4.05 million property tax remittance the city had failed to make earlier.

The most recent default (or, more euphemistically, the current tender offer) involves bonds issued to finance a failed public power scheme. In 2001, the City established a public power company – the Hercules Municipal Utility (HMU) – on the assumption that it could replace the area’s for-profit utility, Pacific Gas & Electric (PG&E). The expectation was that HMU would generate a similar rate of profit to PG&E, but under public ownership, those profits could fund other city spending priorities. Unfortunately for Hercules creditors and taxpayers, things did not work out as planned.

In a 2011 expose, the Huffington Post reported that HMU was serving only 840 customers, charging rates 17% higher than PG&E and had lost money in every year since its 2003 inception. In 2010, the City issued $13.5 million in new bonds to finance HMU, but the proceeds were never invested. Now the City has agreed to sell its power plant to the local utility – Pacific Gas & Electric. Unfortunately, PG&E’s bid was insufficient to retire the $12.8 million in 2010 bonds still outstanding and (for reasons discussed below) the city lacks reserves that could be used to fully redeem these remaining bonds. Thus the need for a 90% tender offer.

Municipal bond analysts often assess a city’s fiscal well-being by reviewing its audited financial statements. Unfortunately, Hercules routinely files its audited financials on a delayed basis. Currently, the latest available statements for Hercules are for the fiscal year ended June 30, 2011. Many California cities have already filed their 2013 audits. The failure to file audited financials on a timely basis is part of a larger financial management issue in Hercules. In May and November 2012, the State Controller’s Office issued three audits highly critical of the city’s fiscal controls. One report “found the City of Hercules’ administrative and internal accounting control deficiencies to be serious and pervasive.” These insufficient controls may explain why RDA tax revenues could be directed away from debt service, thereby subjecting the city to costly litigation.

As shown in the accompanying table, Hercules has persistently run large General Fund deficits since 2008.  The city’s inability to balance its books has resulted in the depletion of its financial reserves. According to Hercules most recent budget, the city had a negative unassigned General Fund balance at the end of FY 2012 and FY 2013, meaning it had no reserves that had not already been earmarked for one purpose or another. Despite having borrowed over $150 million, the city thus lacked liquid assets to cover contingencies.

Hercules General Fund Performance (FY 2008-FY2013)





























Sources: Hercules Audited Financial Statements (FY 2008-2011), FY 2014 Budget.
FY 2012 and FY 2013 are unaudited estimates.


Hercules fiscal straitjacket appears to be the result of government overreach. Instead of focusing on efficient delivery of basic services and providing effective financial oversight, City leaders ventured into enterprises attractive to many of their Progressive constituents: publicly owned power and publicly-financed affordable housing. Lacking the skills to properly manage these undertakings, city leadership squandered large sums of borrowed money and ran down their financial reserves. The result for Hercules will be years of higher taxes, subpar real estate performance and reduced access to the municipal bond market.


When Regulatory Agencies Ignore Comments from the Public

A few days ago, the Department of Energy (DOE) finalized a rule setting energy efficiency standards for metal halide lamp fixtures. Last October I wrote a public interest comment to the DOE to point out several problems with the agency’s preliminary economic analysis for the rule. As part of the Administrative Procedure Act, agencies are required to solicit, and respond to, comments from the public before finalizing regulations. Unfortunately, the DOE failed to even acknowledge many of the points I made in my submission.

As evidence, here are some of the main takeaways from my comment:

1)      The DOE claims consumers and businesses are acting in an irrational manner when purchasing metal halide lamp fixtures because they forgo modest long term energy savings in order to pay a low upfront price for lamp fixtures. Yet the agency offers no convincing evidence to support the theory that consumers act irrationally when purchasing metal halide lamp fixtures. At the same time, roughly 70% of the estimated benefits of the rule are the supposed benefits bestowed upon the public when products people would purchase otherwise are removed from the market.

2)      The DOE is currently adding together costs and benefits that occur in the future but that are discounted to present value using different discount rates. It makes no sense to add together costs and benefits calculated in this manner.

3)      The DOE is using a new value of the Social Cost of Carbon (SCC), a way to measure benefits from reducing carbon dioxide emissions, that may be of questionable validity since the analysts who arrived at the estimate ignored recent scientific evidence. Additionally, the DOE is using the new SCC in its analysis before the public has even had a chance to comment on the validity of the new number.

4)      In its analysis, the DOE is including benefits to foreign countries as a result of reduced carbon dioxide emissions, even while the costs of the metal halide lamp fixture regulation will be borne largely by Americans.

Regarding #1 above, the DOE provided no direct response to my comment in the preamble to its final rule. This even though #1 puts in doubt roughly 70% of the estimated benefits of the rule.

The DOE also failed to respond to #2 above, even though I cited as support a very recent and relevant paper on the subject that appeared in a reputable journal and was coauthored by Nobel laureate Kenneth Arrow.

Regarding #3 and #4, the DOE had this to say:

On November 26, 2013, the Office of Management and Budget (OMB) announced minor technical corrections to the 2013 SCC values and a new opportunity for public comment on the revised Technical Support Document underlying the SCC estimates. Comments regarding the underlying science and potential precedential effect of the SCC estimates resulting from the interagency process should be directed to that process. See 78 FR 70586. Additionally, several current rulemakings also use the 2013 SCC values and the public is welcome to comment on the values as applied in those rulemakings just as the public was welcome to comment on the use and application of the 2010 SCC values in the many rules that were published using those values in the past three years.

In other words, the DOE is committed to continuing to use a value of the SCC that may be flawed since the public has the opportunity to complain to the Office of Management and Budget. At the same time, the DOE tells us we can comment on other regulations that use the new SCC value, so that should reassure anyone whose comment the DOE ignored related to this regulation!

All of this is especially troubling since the DOE is required by statute to ensure its energy efficiency rules are “economically justifiable.” It is hard to argue this rule is economically justifiable when roughly 94% of the rule’s benefits are in doubt. This is the proportion of benefits justified on the basis of consumer irrationality and on the basis that Americans should be paying for benefits that will be captured by citizens in other countries. Without these benefits, the rule fails a benefit-cost test according to the DOE’s own estimates.

The requirement that agencies respond to public comments is designed to ensure a level of democratic accountability from regulators, who are tasked with serving the American public. A vast amount of power is vested in these agencies, who are largely insulated from Congressional oversight. As evidence, Congress has only used its Congressional Review Act authority to overrule major regulations once in its history. If agencies ignore the public, and face little oversight from Congress, what faith can we have that regulators will be held accountable for any harms that inevitably arise from poorly designed regulations?

Crony Capitalism and the Revolving Door

A colleague just handed me the latest issue of the Harvard Journal of Law and Public Policy (it’s hot off the presses, so an electronic link still isn’t available; here is a link to the previous issue). It features a short essay by Jonathan Macey of Yale Law School called “Crony Capitalism: Right Here, Right Now.”

The entire piece is worth reading. But this anecdote, which I hadn’t heard before, jumped out:

The Senate confirmed Jack Lew as Secretary of the Treasury in February 2013, and one of the striking things about that appointment is that his contract at Citibank, where he did administrative work with a hedge fund, stipulated that he would receive a bonus if, and only if, he were appointed to a senior position in government.

Macey cites this Bloomberg piece by Jonathan Weil.

It is tempting, of course, to blame Citibank. And part of me does. But P.J. O’Rourke has a nice line about this phenomenon which I quoted in The Pathology of Privilege. “When buy­ing and selling are controlled by legislation,” he says, “the first things to be bought and sold are legislators.”

It may seem disgusting that, as Weil put it, “Citigroup might have agreed to pay Lew some sort of a bounty to seek out, and be appointed to, such a position.” But in today’s modern crony-capitalist economy, high-ranking government officials sometimes determine whether a firm lives or dies. When that is the case, it’s only prudent to have a man on the inside. Stories like this reinforce the point that government-granted privileges to particular firms sully the reputation of both government and markets.

H/T, Richard Williams.

Public pension plan portfolios: pursuing higher risk at what cost?

How should a public sector pension plan invest its assets? A trend since the 2007 financial crisis is public pension funds making up for losses by seeking higher returns in riskier portfolios. Michael Corkery at The Wall Street Journal takes a look at the Texas Teachers’ Retirement Fund which is placing more of its assets in private equity in an attempt to “hit its target” of 8 percent annual returns. Therein lies the problem.

Due to how public pension liabilities (i.e. the benefits owed to retirees) are valued (based on the expected return on plan assets), there is pressure to invest plan assets to achieve a targeted return that is linked to how the liability is valued. This approach is deeply flawed and been criticized often. Instead, plan assets should be invested in a way that hedges the risks inherent in the liability. These risks include changes in wages and interest rates since the value of the retiree’s benefits is affected by changes to wages and are usually indexed to inflation.

In a recent paper in the Journal of Pension Economics and Finance entitled Portfolio Allocation for Public Pension Funds, George Pennachhi and Mahdi Rastad find that a “benchmark” portfolio for public pensions would consist of 160 percent fixed income, with a 9 percent short position in equities, a 67 percent short position in hedge funds and a 24 percent investment in private equity. A short position implies the fund should borrow in other asset categories to increase its holdings in fixed income. Where short selling isn’t feasible or permitted  one would take a 100 percent position in fixed income.

Instead public plans tend to invest assets with a view towards meeting a numerical goal. Over time, this has led plans to increase their exposure to higher risk investments, changing the composition of pubic sector plan portfolios from being more heavily invested in bonds (almost exclusively so in 1952) to more heavily invested in high-return, high-risk investments like real estate, with the average plan exposed to a 21 percent investment in alternatives.

There are two inter-related problems here. Firstly, the liability is undervalued based on high-risk discount rates and secondly, the asset investment strategy is focused on targeting returns rather than hedging risks in the liability. An unfortunate but predictable result of this flawed linkage between liability valuation and asset investments is that during a downturn, plans have opted to “double-down” on risk and expose plans to potentially bigger losses down the road.

Indeed, as plans continue to fall short of return expectations many are turning to alternative investments including “exotics,” a strategy  that shows no sign of abating, according to Pensions & Investments.