Pension Pulse

Monday, December 9, 2013

Friday, December 6, 2013

The Public Pension Problem?

The New York Times invited six contributors, including yours truly, to debate The Public Pension Problem:

It’s been a bad week for public workers. On Tuesday, in a ruling that has implications for other cities, a federal judge ruled that Detroit’s public employee pensions are not protected in a federal Chapter 9 bankruptcy. On that same day, the Illinois legislature passed a deal trimming retiree benefits and increasing state contributions, providing a template for other states to follow.

Amid all this, is the continuing refrain that Wall Street fat cats are responsible for “looting the pension funds.” Are government retirees being forced to pay for pension fund problems caused by bad investments? If so, what’s the solution?

Let me begin by thanking Susan Ellingwood, opinion editor at The New York Times, for inviting me to contribute my thoughts. She also did a great job editing my comment and finding the contributors.

You can join The New York Times' Room For Debate on twitter (@roomfordebate) and Facebook and keep up-to-date on news events and other timely issues. You can also post your comments online.

The six contributors discussing this topic are:

Nicole Gelinas, a contributing editor to the Manhattan Institute's City Journal.
Dean Baker, an economist and the co-director of the Center for Economic and Policy Research.
Eileen Norcross, a senior research fellow with the Mercatus Center at George Mason University.
Connie M. Razza, the director of strategic research at the Center for Popular Democracy.
Andrew G. Biggs, former principal deputy commissioner of the Social Security Administration, and a resident scholar at the American Enterprise Institute.
And me, Leo Kolivakis, the publisher of Pension Pulse blog and a former senior investment analyst at two of the largest public pension funds in Canada.

Ms. Gelinas writes, Wall Street Isn’t the Problem, Benefits Are:

As states and cities from California to Illinois to New York start to take public-sector pension costs seriously, defenders of generous benefits have taken up a new argument for keeping things as they are. They say that the problem isn’t guaranteed pensions and early-retirement ages. Rather, the problem is Wall Street. Public-pension fund fees are too high, and sucking money from retirees, they say. They’re right that is a problem – but it is not the main problem.

Earlier this week, a coalition of labor unions and civil-rights groups teamed up with Occupy Wall Street to point out that New York City pays far too much in public-pension fund fees. Their report notes that New York City’s public pension plans, which control $200.4 billion in assets, now pay $472.5 million in fees to money-management firms annually. They say that’s way too much.

That’s true – and it’s not news. Last year, I reported that the fees New York State pays also top half a billion dollars, up 54 percent from half a decade ago. Fees have gone up in fact because the state – along with other public-sector entities – has put more and more of public-pension fund assets into expensive investments run by hedge funds and private-equity funds. These deals aren’t only expenses. They pose other dangers, including opacity – it hard to know how much an investment in a hedge fund is worth, as it doesn’t trade publicly like a stock – as well as corruption.

But a much-need rethink in how New York City or State spends pension money won’t fix the problem.

Consider New York City again. Say the city cut the fees it pays by 60 percent – for a nearly $300 million savings. That’s something – but the city will spend $8.2 billion this year on pension contributions, and $8.5 billion a year by the mid-point of Mayor Bill de Blasio’s inaugural term.

The city must pay so much not largely because fees are so high, but because its pension benefits simply don’t make sense as people worldwide expect both to live and work longer.

A newly hired police officer, for example, can retire after 22 years with half-pay (often higher with disabilities). City taxpayers must support this retired officer or his surviving spouse likely for longer than the officer worked. Last year, the NYPD had more than 12,096 retirees younger than 55, making an average of nearly $43,000 in pension benefits. The city now pays more in public-safety benefits than in wages and salaries.

New York – and other municipalities as well as states – should certainly rein in payments to Wall Street. But eventually, it’s still going to have to rein in retirement benefits, too.

Dean Baker writes, Pay Retirees What They’ve Earned:

Cutting pension benefits amounts to taking away pay from workers after they already put in their work. If governments feel the need to take property, they should look for wealthy victims. But, of course, the Wall Street folks who bear much of the blame for the problem seem likely to get away unscathed.

Much of the underfunding dates to the 1990s stock bubble, when many pension managers made minimal contributions because the stock market run-up was financing their funds for them. The bond-rating agencies green-lighted this practice, effectively assuming the bubble would grow ever larger. (Some of us knew better.) Wall Street types engorged themselves on fees from these funds, taking money that could be used to pay retirees.

Once governments got in the habit of not making contributions, they found it hard to break when the bubble burst. Illinois and Chicago went a decade without making required contributions. The collapse of the housing bubble devastated state and local revenue, while increasing expenses, making the obligations harder to meet.

Still, in most cases, the unfunded liabilities are not nearly as large as has often been claimed and can still be met. For example, I've calculated that Chicago’s unfunded liabilities are around 0.6 percent of the value of future income over the next 30 years.The figure is comparable for the state of Illinois. These sums are hardly trivial, but presenting them in this light is not as scary as simply reporting that tens of billions of dollars are owed, as those pushing cuts are prone to do.

Taking care of these obligations could mean some increase in taxes, which is inconvenient, but this is money owed. As with the federal debt ceiling, another source of scare mongering, the place to deal with the problem is when the commitments are being made, not when it is time to pay up.

In the case of Detroit, there will be no choice but to have the state intervene as it already has in appointing a city manager. The city is a creation of the state. Under its constitution, which requires pensions be paid, it is difficult to see how the Michigan can avoid taking responsibility and paying the pension obligations.

The crucial point is that employees worked for these pensions. They are not a gift from the government; they were part of their pay package. Governments are not looking to seize properties that may have been sold at too low a price or to reclaim tax breaks and incentives to sports teams and other businesses that may have been too generous. Why do so many people on the political arena think it’s a good idea to take back the money that workers have already earned?

That says a great deal about politics in America today.

Eileen Norcross writes, A Reality Check on the Pension Crisis:

Judge Steven Rhodes’ ruling that Detroit may reduce pensions under Chapter 9 bankruptcy now means that all parties must face a hard mathematical reality with consequences for real people: The city cannot afford to pay the benefits it has promised.

Detroit’s unfunded pension liabilities are immense, at over $9 billion on a risk-free (guaranteed-to-be-paid) basis. Unfortunately, they were valued and funded incorrectly. For years, the city assumed it would earn 8 percent annually on plan assets, an uncertain expectation that did not match the certainty of pension payments.

This “asset-liability mismatch” means the plan took a gamble that didn’t pay off. Accounting tricks during boom years made the fund look flush giving the city the impression it could dole out "13th checks" for some employees.

Former Mayor Kwame Kilpatrick also engaged in “fancy financing” using pension bonds financed with interest rate swaps resulting in a $1.44 billion debt.

How does Detroit restructure public sector retirement in a “fair and equitable” manner for retirees and workers?

1. Stop the bleeding and close the defined-benefit system. Every day the defined-benefit plan is open, the liability grows.

2. Transition younger workers into a defined-contribution or private-annuity plan. They have more time to plan for retirement. Give them ownership over their retirement contributions.

3. Accurately value defined-benefit plans according to the likelihood of payment.

4. Invest the assets in a liability-matching portfolio. Do not rely on uncertain and volatile asset returns.

5. Current workers who have accrued benefits in the defined-benefit system should face higher retirement ages to collect full benefits.

6. Current retirees should bear the smallest burden. If it is necessary to trim their benefits, adjust future payments through cost of living adjustments, rather than cutting current payments.

Detroit’s story is a lesson for union leadership and for other cities. Accounting fiction and financial escapades produce the worst-case scenario for workers, retirees and residents. Toss the political rhetoric and face the real numbers before it’s too late: It’s the only way to ensure economic justice and retirement security for public-sector workers.

Connie M. Razza writes, Bring Financial Managers in House:

This past year, investment management fees on New York City pensions increased 28 percent. Over the past seven years, they have more than doubled to $472.5 million annually. The city pays very high fees even in years when the funds lose value.

These fees unduly burden the funds and add to the uncertainty with which our city's retired and current employees face the future. The rapid rise in pension fund fees is just one of many symptoms of our badly broken financial system, which fails to serve the broader economy and promote general prosperity. Instead, it promotes and exacerbates inequality.

As part of the New Day New York Coalition, the Center for Popular Democracy has proposed a sweeping solution. New York should create a highly skilled in-house financial management team for pension fund assets. Even with salaries high enough to attract top quality managers, the city would not pay the typical "2 percent of assets under management, plus 20 percent of profits" that hedge funds, private-equity firms and real-estate firms typically charge. The profit motive of in-house managers will be fully aligned with city employees and they will be better situated to ensure that investments are financially responsible, contributing to our broader economy and to the funds' bottom line. The creation of the in-house financial team would save the pension funds hundreds of millions of dollars a year.

As significant a change as this would be, it is an idea that the city's former chief investment officer has advocated, and that incoming city comptroller Scott Stringer has expressed interest in. Also, pension funds in Alaska, California, Wisconsin and Ontario, Canada, already do this, to varying degrees. All of these funds also rely on outside managers for some of their investments, but insourcing much of the pension investment management would give the city funds meaningful leverage when working with outside management firms.

Building an internal capacity to manage the pension fund assets of city workers is an important step toward rebalancing the city's relationship with Wall Street.

Andrew G. Biggs writes, Pension Cuts Must Be on the Table:

Public employee pensions pose increasing risks to state and local budgets. Pensions are bigger, and their investments riskier, than ever before. Both costs and risks must be brought under control. Modest benefit reductions, particularly for better-off retirees, should be on the table. This shouldn’t mean open season on public employees. But nationwide, public pensions are underfunded by $4 trillion or more, a figure that exceeds the explicit debt owed by cities and states. Many financially beleaguered cities are pushing the limits of “service insolvency,” in which rising pension and health costs force unacceptable reductions in basic services.

It’s easy to point to low average benefits for public employees, but these averages include workers who spent only a few years in government employment. In reality, public employee pensions are typically much – I repeat, much – more generous than those paid in the private sector. For instance, a full-career Detroit city employee would receive a traditional “defined-benefit” pension equal to two-thirds his final salary, for which he contributed nothing. Detroit workers could voluntarily contribute to a 401(k)-styled “defined-contribution” plan, on which the city guaranteed 7.9 percent annual returns even in bad times. In good times, both the defined-benefit and defined-contribution pensions received bonus payments. Add in Social Security, and it’s possible to earn more while retired than while working. It’s hard to argue that the typical Detroit taxpayer is doing as well.

The vast majority of public pension benefits owed should, and will, be paid. But in bankruptcy, nothing should be off the table. More important, cities and states need the right, which is taken for granted in the private sector, to alter the rate at which public employees earn future benefits. Reforms also should include greater risk-sharing between employers and employees. Wisconsin, for instance, bases cost of living adjustments, or COLAs, on plan performance, while Nevada splits all required contributions evenly between workers and the government. As unfortunate as Detroit’s circumstances may be, they start a conversation on how to make public pensions equitable and sustainable.

Finally, I write that Independent, Qualified Investment Boards Are Needed:

The main driver of public pension deficits isn't the financial crisis, it's decades of fiscal mismanagement. For years states willfully ignored their pension payments, borrowing money from public pension plans to create the illusion that they were balancing their budget every year.

To keep contributions down, stakeholders of public pension plans, including unions, deluded themselves into believing the pension rate-of-return fantasy -- a fantasy because it is based on the erroneous assumption that public pension funds will be able to attain their 8 percent investment bogey over a sustained period. With interest rates at historic lows, it's clear that discounting future liabilities using such rosy investment assumptions will only make matters worse.

These ridiculous investment targets have led to an even bigger problem, excessive risk taking among U.S. public pension funds that have allocated a large portion of their assets into alternative investments like private equity, real estate and hedge funds. In some cases, this approach is warranted and successful but in most cases, U.S. public pension funds are wasting billions in fees praying for an alternatives miracle that will never happen.

The legislative response to public pension deficits is predictable and shortsighted. Some reforms, like raising the retirement age and using career average earnings for determining pension benefits, are necessary as people are living longer.

Other reforms, however, are silly and promote long held myths on public pensions. In particular, shifting public sector workers into defined-contribution plans shifts retirement risk entirely onto workers, ensuring more pension poverty down the road.

Legislators need to understand that defined-benefit plans are superior to defined-contribution plans, and they must take measures to maintain public pensions and expand defined-benefit coverage to private sector workers. This will actually help reduce fiscal debt in the long-run as retirees earning predictable benefits will spend more money and pay higher taxes.

But there is a caveat to all this. U.S. pension reforms need to incorporate the shared risk model that has worked so well in the Netherlands. This way workers, retirees and plan sponsors will share the risk of the pension plan. Moreover, U.S. pension funds need to incorporate the same governance model that has allowed Canadian public pension funds to flourish. This means adopting independent investment boards that operate at arms-length from the government and compensating public pension fund managers more in line with what private sector fund managers receive.

Until U.S. public plans get the governance right by implementing independent and qualified investment boards and compensating their public pension fund managers properly, all other reforms are cosmetic and do nothing to slay the pension dragon.

Once more, I thank Susan Ellingwood, opinion editor at The New York Times, for inviting me to contribute my thoughts on this important topic.

If you want to add your thoughts, feel free to do so directly on The New York Times site after each comment. All you need to do is register.

Alternatively, if any of the experts that routinely read my blog want to add their comments here, just email me (LKolivakis@gmail.com) and I will edit this comment over the weekend to add a postscript.

Below, Fox Business New's Jeff Flock reports on how Detroit's chapter 9 bankruptcy ruling could impact public pensions across the United States.

Sadly, Detroit's cries of betrayal will be heard all over the U.S., including in Illinois, and even in Canada and elsewhere. The public pension problem is real but hardly insurmountable. It's time to implement sensible reforms, especially reforms on governance.

Thursday, December 5, 2013

Revisiting New Brunswick's Pension Reforms?

CBC News reports, Controversial pension changes approved in legislature vote:

The Alward government's controversial pension reform has been passed into law.

The bill got final approval from the Legislature late Wednesday, passing 33-9 in a vote along party lines.

The new shared-risk system will see civil servants and retirees take on more risk for the pension fund's performance.

Current employees will see pension plan contributions increase at the start of the new year, with an average increase of $1,200 a year. Retirees could see cost-of-living increases curtailed if the markets perform poorly in the future, although Higgs says that risk is small.

Under the present system, only the government is at risk if there is a downturn in the markets. With the changes, the risk is shared between government, employees and retirees.

Higgs has been pushing the pension reforms through for two years, arguing that with retirees living longer, the pool of pension money may not be enough to cover their benefits under the current system.

"We have much more demands on this plan than it ever was designed to fund," said Higgs. "That is the reality.

"So in order to fix it, you have to structurally change it. We're confident in what we're putting forward and we're confident it will withstand any legal challenge."

Retirees argue the change amounts to breaking a contract and have hired pension rights lawyer Ari Kaplan of Ontario and threatened to sue the province over the changes.

The New Brunswick Pension Coalition has also vowed to defeat the Progressive Conservative government at the polls next September if the changes go through.

Liberal Leader Brian Gallant argued again yesterday for more time to debate the change.

"This will be seen as one of, if not the, most important pieces of legislation his government will put forth in its mandate," said Gallant.

But after two raucous years of debate inside and outside the legislature about the changes, the government pressed forward.

"Mr. Speaker there comes a time when you have to fish or cut bait," said Higgs.

The bill will be signed into law before Christmas and takes effect on New Year's Day.

I covered New Brunswick's pension reforms a couple of weeks ago and was largely sympathetic to these proposals, especially after I read Jim Leech and Jacquie McNish's book, The Third Rail.

But last week I saw Bernard Dussault, Canada's former Chief Actuary, at a pension conference in Ottawa where we discussed if Canada is on the right path. Bernard wasn't impressed with the reforms in New Brunswick and I don't think he was particularly impressed with Jim Leech's new book either.

So what's got Canada's former Chief Actuary up in arms? Bernard's main qualm is that he thinks the new reforms shift more costs to employees and restricts the growth of their retirement benefits:

According to government information about the plan, employees will have to increase their own contributions to the pension plan by 30 per cent or more starting next spring, even though benefits they can accumulate will be less generous.

"What the government calls risk sharing is more risk dumping," said Bernard Dussault, former chief actuary of the Canada Pension Plan, who has been assisting New Brunswick retirees with their fight.

I asked Bernard to expand on this and he was kind enough to provide his insights below. Please note these are his personal views (the email is bilingual but main points are outlined in English):

Tel que convenu je te fournis ci-bas ici le plus d’informations possible sur mes opinions personnelles et publiques (non confidentielles) concernant les enjeux du monde des pensions au Canada, et en particulier celui du système de pensions à risques partagés proposé du (et bientôt en vigueur au) Nouveau Brunswick.

Le 7 mai 2013 j’ai fait à Charlottetown la présentation ci-jointe à la Conférence du IFEBP. Porter une attention particulière aux pages (slides) 9 et 10 qui indiquent comment les régimes à prestations déterminées devraient (et auraient toujours dû) parer aux effets des fluctuations du marché sur la santé (soundness) financères des régimes de retraite.

Le lien http://www.ifebp.org/inforequest/0164303.pdf donne accès à l’article paru dans le numéro de septembre 2013 du IFEBP Newsletter (cet article paraphrase ma présentation du 7 mai). Le lien http://www.pensioncoalitionnb.ca/regional-meetings donne accès à la conférence de presse que le Front Commun des membres du régime de pension de la fonction publique du NB a donnée à Fredericton le 20 novembre.

Le discours que j’ai donné à cette conférence se résume à ceci:

A- The Common Front of active and retired members of the NB Public Service Pension Plan (PSPP) understands that the PSPP current debt of about $1 billion identified in the April 1, 2012 actuarial report is a major issue for the NB government as well as for all NB taxpayers, and accordingly deserves to be addressed diligently in an appropriate manner.

B- The Common Front considers that the Shared Risk Pension Plan (SRPP) that is proposed by the NB government through Bill C-11 tabled November 19, 2013 in replacement of the NB PSPP is not an appropriate solution thereof because:

although not properly identified and designed in Bill C-11, the proposed increase in PSPP members’ contribution rates and the proposed increase from 60 to 65 in the age at which PSPP members become entitled to a normal (unreduced) retirement pension, respectively, are the only areas of remedies that are relevant to the unfavourable financial findings identified in the April 1, 2012 actuarial report on the PSPP;

it is unfair, as it does make pension indexation, both active and pensioned members, dependent upon the ongoing financial experience of the PSSA through the use of inappropriate actuarial and accounting mechanisms that properly account for indexation in the contributions and assets of the PSPP but not at all in its liabilities;

it fails to show the proportion of the PSPP cost that will be shared by active PSSA members; and

it is too complex, which was publicly acknowledged by the Minister of Finance, as he did himself publicly stated that he does not fully understand it, and as its implementation, management and day to day administration would be an overly expensive and intricate endeavour.

C- The Common Front accordingly recommends that the financing and benefit changes envisioned by Bill C‑11 be repealed and replaced exclusively by the following two ones, which should well address in a relevant and consistent manner the unfavourable financial findings, identified in the April 1, 2012 actuarial report on the PSPP, by:

reducing its cost;

optimizing the reduction in the volatility of the PSPP contribution rate from year to year;

eliminating any surplus ownership issue; and

optimizing intra and inter-generational equity.

1. In respect of future accruing pensionable service, the age at which PSPP members become entitled to a normal (unreduced) retirement pension remains 60 for any member born in or before 1950 but is increased by 2 months for each year by which the calendar of birth exceeds 1950. Therefore, the entitlement age would for example be increased to 61 for members born in 1956, 62 if born in 1962, 63 if born on 1968, 64 if born in 1974, 65 if born in 1980 and 70 if born in 2010, and so on.

2. The PSPP normal cost, i.e. the contribution rate expressed as a percentage of salary and determined on a realistic ongoing (as opposed to solvency) valuation basis, would be shared equally by its members and its sponsor, i.e. the total normal contribution rate would be split equally, i.e. on a 50%/50% basis, between the plan sponsor and the active members. Likewise, any emerging surplus or deficit identified in any of the actuarial reports on the PSPP, including the report as at April 1, 2012, would be amortized over 15 years through a decrease or an increase, respectively, in the normal contribution rate, still split equally between active members and the plan sponsor.

As I indicated to you at the Westin conference in Ottawa, the reason why plan sponsor “adore” the conditional indexation provision, modeled after the Dutch Pension System, is not that it reduces pension costs (essentially, it does not reduce them) but rather that it perversely causes the elimination from the pension liabilities the portion pertaining to the cost of indexation, which portion normally ranges from about 20% to 30%.

In this connection, the liabilities under the NB PSSA as per the actuarial report as at April 1, 2012 amount to about $6 billion while the assets are about $5 billion, for a debt of about $1. Coincidentally, conditional indexation would essentially remove that $1 debt from the NB balance sheet.

I thank Bernard Dussault for sharing these important insights with my readers. Bernard is a leading expert in pension policy and in my opinion, he's the best actuary in the country. He really understands the intricacies of pension policy and unions should have consulted with him first before accepting these reforms (his email is bdussault@rogers.com).

It's quite disconcerting seeing public sector workers and pensioners getting squeezed while Wall Street profits off of excessive fees it charges public plans, effectively giving it a license to steal. Chris Tobe, author of Kentucky Fried Pensions and founder of Stable Value Consultants, went over the 2 big myths about Illinois pension reform which I covered in my last comment and shared this with me:

Government retirees are definitely being forced to pay for pension fund problems caused by bad investments and Wall Street fees. The Detroit Bankruptcy judge locked in that possibility for Detroit employees yesterday and thousands of others around the country. It is well documented with FBI and SEC investigations that there were bad investments and excessive fees in the hundreds of millions in Detroit and now it looks like the retirees will bear the brunt of this corruption.

In a 106 page report on Rhode Island, former SEC attorney Ted Siedle documented that the excessive fees and bad investments directly hurt pensioners, because their Cost of Living Adjustments (COLA’s) are only allowed with a funding ratio of over 80%. Excessive fees and bad investments lower funding ratios so these COLA triggers are a definite way that pensioners will lose billions to Wall Street excessive fees and corruption. Ironically COLA triggers are being pushed by the Arnold Foundation/Pew Studies in over a dozen states (which were paid for by former hedge fund owner and Enron trader John Arnold).

Keep all this in mind as New Brunswick and Illinois pension reforms are being rammed through. The fat cats on Wall Street are loving it but public sector workers and retirees are right to be concerned.

Below, Susan Rowland, Chair of the Pension Task Force for the Province of New Brunswick, discusses the why reforms were needed. But as New Brunswick moves forward with sweeping pension reform, considerable opposition to pension reforms remains and I now think some unions fumbled badly on this file. They still have a chance to address the issues Bernard Dussault raises above but the courts will have to decide the fate of New Brunswick's public pension plan.

Wednesday, December 4, 2013

Did Illinois Slay Its Pension Dragon?

Joanne Van Alroth and Karen Pierog of Reuters report, Illinois lawmakers pass long-awaited pension reform:

Illinois' Democratic-controlled legislature on Tuesday passed a landmark pension reform bill, choosing to address the state's crumbling finances over strong public labor union opposition to cuts in retirement benefits.

The bill addresses problems that have built up over decades in the nation's worst-funded state pension system, which is underfunded by $100 billion. The vote comes despite union threats to challenge pension reform in state court, based on claims it would violate a state constitution provision that guards against cuts to pension benefits.

Changes in the bill include reducing and suspending cost-of-living increases, raising retirement ages, and limiting the salaries on which pensions are based.

Championed by Democratic and Republican legislative leaders, the bill passed the Senate in a 30-24 vote and the House in a 62-53 vote after lengthy and at times emotional debate. It now heads to Governor Pat Quinn, who told reporters he hopes to sign the bill into law soon, although it will not take effect until June.

"I look forward to signing it," said Quinn, a Democrat. The vote in both houses, which required support from both Democrats and Republicans, was "a bipartisan victory for the state," he added.

Union opposition was a big obstacle to securing votes, said House Speaker Michael Madigan, a Democrat. "This was difficult because of the strength of the opposition and the intensity of the calls and contacts generated by organized labor for the Democrats," Madigan said.

With the state's finances buckling under a $100 billion unfunded pension liability, House Speaker Michael Madigan and others said the bill would save the state about $160 billion over 30 years and immediately reduce the unfunded liability by at least 20 percent.

Madigan noted that pension contributions already are eating up 20 percent of Illinois' general fund revenue. The cash-strapped state can no longer afford to pay for the retirement promises made to teachers and state government, university and college workers, he said.

Labor unions called on Quinn to veto the "unfair, unconstitutional bill. If he doesn't, our union coalition will have no choice but to seek to uphold the Illinois Constitution and protect workers' life savings through legal action," the union group We Are One Illinois said in a statement.

The measure will affect nearly half a million current and retired public sector workers, according to a union spokesman. Unions argue the law violates a state constitutional prohibition against diminishing pension benefits.

Illinois will not be the first state to face a legal fight over pension changes. Rhode Island, which restructured its state pension system in 2011, is defending the move in state court.

CHICAGO NEXT?

Senate President John Cullerton said he welcomes any court challenges to the constitutionality of the reform measures in the bill.

Cullerton also said he is committed to passing reforms to ease the pension burden on local governments in Illinois.

Chicago Mayor Rahm Emanuel has pushed for reforms of the state pension system in the face of a looming state-mandated jump in pension payments for two of Chicago's four pension funds. Emanuel has indicated he cannot push forward with reform of Chicago's pensions until statewide reform takes shape.

"The pension crisis is not truly solved until relief is brought to Chicago and all of the other local governments across our state that are standing on the brink of a fiscal cliff because of our pension liabilities," Emanuel said in a statement. "Without providing the same relief to local governments, we know that taxpayers, employees, and the future of our state and local economies will remain at risk."

The affirmative vote on state reforms came after a failed effort in the legislature's spring session, a summer of wrangling by a special legislative committee, and weeks of closed-door talks among the leaders. It also followed years of discussion and study, previous reform measures that provided limited improvements or failed to pass, and numerous downgrades of the state's credit ratings.

The measure offers some sweeteners for workers and retirees. Employees would contribute 1 percent less of their salaries toward pensions, while contributions from the state, which has skipped or skimped on its pension payments over the years, would be enforced by the Illinois Supreme Court. A limited number of workers would also have the option to choose a 401(k)-like investment vehicle for retirement.

In a preamble section, the bill lays out an argument seemingly designed to thwart a potential constitutional challenge. The state's finances are so squeezed by pension payments, the section argues, that Illinois has been forced to cut funding for core services such as health care and education. The preamble also alludes to Illinois' structural budget deficit, fueled by billions of dollars in unpaid bills spilling from one fiscal year to another.

Continued inaction on pension reform has hurt ratings on Illinois debt, with credit agencies warning of further downgrades, and investors in the U.S. municipal bond market are demanding higher yields to hold the state's bonds.

"Having considered other alternatives that would not involve changes to the retirement systems, the General Assembly has determined that the fiscal problems facing the state and its retirement systems cannot be solved without making some changes to the structure of the retirement systems," the preamble states.

Some lawmakers during the floor debates worried that Illinois could be in for another round of credit downgrades should the bill fail. Its passage could brighten the prospects for a $350 million bond sale Illinois has planned for next week.

"Any positive step will be embraced by the market," said Dan Heckman, municipals strategist at U.S. Bank, adding Illinois may still need more reforms or higher taxes.

Tim Jones and Mark Niquette of Bloomberg also report, Illinois Lawmakers Approve Pension Fix After Years of Gridlock:

Decades of pension shortchanging and years of political gridlock were shoved aside in six minutes when Illinois lawmakers -- first the Senate, then the House -- approved a $160 billion rescue of the worst-funded state pension system in the U.S.

The votes yesterday in the General Assembly provided a big step in the state’s effort to rehabilitate itself from years of mismanagement that led to the lowest credit rating of the 50 states, due largely to a pension shortfall of $100 billion.

While a legal challenge from unions has been promised, Democratic Governor Pat Quinn, who had repeatedly watched lawmakers ignore his calls to restructure the system, declared victory. Quinn has promised to sign the measure into law.

“This day will always go down in history as the day where the people of Illinois, through their elected representatives and senators, took action for the future,” Quinn said in a briefing for reporters after the vote. “The people have won. We have all won.”

If the measure survives a court battle, Illinois should emerge from worst-in-the-nation in pension funding status. While U.S. states have lost ground for five straight years in setting aside money for retired workers, Illinois was among five states where retirement-funding ratios fell at least 21 percentage points from 2007 to 2012, data compiled by Bloomberg show.

Go Time

The state Senate moved first, passing the measure 30-24. The House followed suit, capping almost three hours of debate with a 62-53 vote. The votes came after years of legislative frustration that produced larger shortfalls and bigger portions of annual state spending going to pay retirement obligations.

“We have a crisis; we have a problem,” said Representative Elaine Nekritz, a Democrat from Des Plaines and a member of the committee that developed the measure approved in Springfield. “We owe $100 billion. Illinois will be better tomorrow because of our actions today.”

Senator Kwame Raoul, a Chicago Democrat, said lawmakers had to act.

“Perfection is never achieved,” Raoul said from the Senate floor. “However, we have the worst unfunded liability in the United States of America and we can’t continue to be cemented into a stalemate.”

While many Republicans and a coalition of public-employee unions opposed the measure, they couldn’t block it. For the unions, a lawsuit is the next step, challenging the constitutionality of the pension changes.

“This is no victory for Illinois, but a dark day for its citizens and public servants,” said a statement from We Are One Illinois, a union coalition.

Constitutional Question

The vote followed days of lobbying that divided Democrats and Republicans alike. Unions that represent about 760,000 workers and retirees, in pledging to challenge the measure in court, claim it violates language in the Illinois constitution that says retirement benefits “shall not be diminished or impaired.”

Dan Montgomery, president of the Illinois Federation of Teachers, said opponents plan to make their legal challenge to the bill “as soon as we find it appropriate to be in court.”

“This so-called $160 billion of savings is illusory because this is not legal,” Montgomery told reporters. “We wanted to see a solution that would pass legal muster.”

The proposal agreed to by legislative leaders Nov. 27 was designed to limit annual cost-of-living allowances and raise the retirement age for some workers. That would produce the bulk of the $160 billion of savings over the next 30 years, according to the plan.

Too Tiny

To some Republicans, the measure didn’t go far enough in cutting costs.

“We don’t have time for small reform, but that is what is before us,” said Representative Jeanne Ives, a Republican from Wheaton. “This bill does not go big and it is not substantial or solid.”

Investors disagreed. The penalty on Illinois general-obligation bonds has declined since legislative leaders announced the tentative agreement last week. The yield spread on debt due in 10 years, relative to benchmark munis, fell to 1.7 percentage points Nov. 29, the lowest since August, according to data compiled by Bloomberg. A shrinking spread usually signals investor confidence that state finances will improve.

The most frequently traded Illinois pension-obligation debt changed hands today at an average yield of 6 percent, down from 6.1 percent yesterday, data compiled by Bloomberg show. On Nov. 29, it traded at 5.8 percent, the lowest since Aug. 1.
Sixth Try

Illinois plans to offer $350 million in general-obligation bonds next week in a competitive sale, John Sinsheimer, the state’s director of capital markets, has said. The governor said he hopes that rating companies and bond buyers will take note of the bill’s passage.

The bipartisan votes were born of the realization that the state couldn’t continue to run up deficits as its credit rating sank. Representative Darlene Senger, a Republican from Naperville, said Illinois would have been a laughingstock had lawmakers failed again to act.

It was their sixth attempt in 16 months to repair the system.

Lastly, Mark Peters of the Wall Street Journal reports, Illinois Passes Pension Overhaul:

Legislators passed an overhaul of the state public-employee retirement system Tuesday, cutting benefits for workers and retirees in a move that sets up a likely court battle with organized labor.

Supporters say the Illinois pension legislation is expected to save $160 billion and will fully fund the retirement system over 30 years.

"We're here today because the cost of our present state systems are simply too rich for the resources available," said House Speaker Michael Madigan, a Democrat.

Gov. Pat Quinn, a Democrat, is expected to sign the bill into law.

Illinois has seen its credit rating fall in recent years to the lowest among U.S. states as it has struggled to address a gap in its pension funds that is nearing $100 billion.

The measure also gives Chicago officials a template to follow as they move to address the city's own pension crisis; Chicago's credit rating is among the lowest for major U.S. cities.

"The pension crisis is not truly solved until relief is brought to Chicago," said Chicago Mayor Rahm Emanuel. "Without providing the same relief to local governments, we know that taxpayers, employees, and the future of our state and local economies will remain at risk."

The Illinois overhaul package relies on benefit cuts, including reducing the annual cost-of-living increase for retirees and raising the retirement age for younger workers.

But the bill also gives public-sector workers the right to take the state to court if their pension funds receive less from the government than what actuaries recommend, long a problem in Illinois. The legislation also sets up additional state payments into the system to boost funding in the years ahead.

The strongest opposition in recent days has come from organized labor, which argues the plan goes too far, and from conservatives, who believe it doesn't go far enough.

Passage of the bill came after legislative leaders from both parties reached agreement on the details last week.

Still, the floor debate in the House and Senate were rife with concerns over the legality of the measure. And while the measure passed, the margins were razor thin on legislation more than two years in the making.

Republicans such as U.S. Sen. Mark Kirk and Bruce Rauner, a businessman vying for the Republican gubernatorial nomination, have pushed back against the legislation, saying it doesn't save enough and won't fix the problem over the long term.

"Springfield politicians today voted to slap a small bandage on an open wound," Mr. Rauner said.

Meanwhile, public-sector unions say Illinois is addressing the pension system on the backs of their members even though the crisis stems largely from years of underfunding by state government. They plan to challenge the legislation in court after it becomes law.

"We are very confident the courts will reject this," said Dan Montgomery, president of the Illinois Federation of Teachers.

Unions had long argued that government workers shouldn't be punished for decades of mismanagement by state officials. But union leaders have seen support erode as concern over the state's finances grows and their sway in a statehouse dominated by Democrats ebbs.

The challenge has long been discussed by unions, with the state likely to argue that certain benefits aren't protected, particularly in light of the state's fiscal problems and certain concessions it makes in the bill.

Mr. Quinn has staked much of his tenure on righting the retirement system, making Tuesday's passage of an overhaul plan particularly important as he prepares to run for re-election next year.

The governor is seen as vulnerable in his bid for a second term, with a crowded field of Republicans vying to challenge him.

A poll conducted by Public Policy Polling in November showed 34% of those surveyed approved of Mr. Quinn's job performance.

"Today, we have won," Mr. Quinn said.

Let me begin by stating flat out Governor Quinn is full of it, nobody has won anything because of the passage of these pension reforms. The unions are going to challenge this in court and they're right, the primary reason behind this colossal pension mess is decades of mismanagement by the state of Illinois which failed to top up public pension plans for years.

But fiscal mismanagement is only part of the story, albeit a big part. There are other problems with Illinois' public pensions. First, like so many other states, all stakeholders including unions held onto the pension rate of return fantasy, foolishly believing that they will magically consistently earn their 8% bogey on a sustained basis over many years.

That led to an even bigger problem, terrible investment decisions where public pension fund managers took on excessive risk in all sorts of exotic investments to attain their target return. Unfortunately, things didn't work out as planned. Three years ago, I asked whether pensions are the next AIG and got this response from Illinois Teachers Retirement System on my "death spiral" comments. In November 2011, I explained why Illinois' TRS is going for broke.

Things have gotten better since then. U.S. public pension assets recently hit record highs but that doesn't mean public pensions are out of the woods. Historic low interest rates and longer life spans are weighing heavily on pensions and some state plans are so chronically underfunded that no matter what they do to bolster their investments, they still need to implement major reforms to control pension costs.

The following key reforms are being proposed in Illinois:

— Raise the retirement age for people 45 and younger, on a sliding scale basis.

— Guarantee the state will make its full annual contribution to the funds and allow the systems to sue if the payments aren’t made.

— Change the cost-of-living increase from the current rate of 3 percent, compounded annually, on the full annuity benefit. Retirees would receive increases at that rate only up to a certain amount of annuity benefit. Legislative leaders say the new structure would benefit lower-income workers who held their jobs longer. Employees also would miss some annual cost-of-living adjustments, depending on their age.

— Cap the amount of salary on which a pension benefit is based. In 2013, that amount would be about $110,000.

— Decrease the employees’ own contribution to their retirement funds by 1 percent.

— Provide workers the option of participating in a 401(k)-style defined contribution plan.

Some of these reforms make perfect sense while others are flimsy or stupid. The retirement age needs to be raised to reflect the simple fact that people are living longer and the state should be sued if it skips pension payments. As far as capping the amount of salary on which pension benefits are based, they should make it illegal to spike pensions and use career average earnings to set these benefits.

The cost-of-living increase clause is debatable but the one measure which I find stupid is participating in a 401(k)-style defined contribution plan. Why would public sector workers give up the benefits of defined-benefit plans to switch over to a defined-contribution plan, pretty much ensuring pension poverty? This is bad economic policy for the state of Illinois and they really need to drop the silly idea that defined-contribution plans are the cure-all to their pension woes.

Chris Tobe, author of Kentucky Fried Pensions and founder of Stable Value Consultants, went over the 2 big myths about Illinois pension reform:

You need current pain for current gain. This spineless plan promises mostly future theoretical gain, by future theoretical pain and changing history by clawing back earned benefits. From what I have seen it most likely will have a negative impact on cash flows in 2014-16, which is likely to force more downgrades of Illinois debt.

Politicians are using the unions as whipping boys to take the heat off their own actions.

The first myth is the cause of the deficit. This money was borrowed from pensioners to create the illusion of a balanced budget every year for over 10 years. After 10 years of making half the mortgage and allowing the house to go underwater, they now say they cannot afford the house.

Public workers for the last 30 years were paid, most thought, a fair total compensation package which included salary, health care and a defined-benefit retirement system. I don't recall many legislators in Illinois or anywhere else claiming that a single teacher, policeman or firefighter was over compensated until now. If their pensions were too high, then perhaps their salary was too low.

The second big myth is that this liability can be fixed by altering future benefits and shifting everyone to a 401(k). This makes for much theater as labor fights to keep benefits and others fight to take them away. However the bulk of the liability is from taking from the modest past earned benefits of retirees and veteran workers and is totally unaffected by all this theater.

In fact I saw that this "reform" would free up over a $1 billion for spending and/or tax cuts, and cuts worker contributions by 1% of their pay, both of which makes things worse. Solvency is based on cash flows primarily in 2014, 2015, and 2016 and this reform hurts cash flow in the critical years.

That means this reform could actually lower credit ratings instead of raising them.

As public pension expert Alicia Munnell opined in my book, Kentucky Fried Pensions, “Fiscal discipline simply appeared not to be part of the state’s culture.”

There is no one in Springfield willing to regulate or enforce any fiscal discipline. The Feds also caved into political pressure and chose not to enforce this discipline, letting Illinois mislead municipal bondholders about their financial statements. The SEC wrote up a mild slap on the wrist, but since it involved no admission of guilt and not one dollar in fines, it actually enabled Illinois to continue bad financial practices as evidenced by this proposal.

Legislatures in places like Illinois and Kentucky attempt to deflect the blame to workers while covering up their own misdeeds and dig their states into even bigger holes. Unions do their job advocating for their members. By avoiding tough budget and taxing decisions, legislators aren’t.

There is no gain without pain, but legislators know any sign of pain will most likely result in them being kicked out of office.

Chris Tobe is right but he left out a third myth, namely, the passage of this "spineless plan" isn't going to make an iota of a difference because it fails to reform the governance of Illinois' public pension funds in any meaningful way. As I stated in my last comment on Wall Street's license to steal, unless states implement independent and qualified investment boards and start paying their pension fund managers properly, pension reform a hopeless cause.

So while Illinois' politicians pat each other on the back for slaying their pension dragon in a pathetic display of bipartisan pandering to bondholders, I would caution everyone to take a deep breath and come to grips with the fact that this plan won't really make a difference until they get the governance right.

Below, IFT President Dan Montgomery discusses the passing of the newest 'draconian pension theft' scheme known as SB1. Illinois' public unions should contact Bernard Dussault, Canada's former Chief Actuary, to help them argue their points in court (email him at bdussault@rogers.com).

Senator Kwame Raoul (D-Chicago) spoke with the media after the Illinois Senate approves SB 1, which outlines Illinois' pension reform. Watch the clip below. He's right, pension costs in Illinois need to come under control but he fails to mention why the situation spiraled out of control.

Finally, Detroit, once the symbol of U.S. manufacturing muscle, was given the authority to try to pare billions in debt and slash employee pensions in a federal court ruling that may have implications for distressed cities across the U.S (watch clip below). I warned you, Detroit's cries of betrayal will be heard all over the United States, starting with Illinois and Chicago.

Postscript: Wall Street likes the deal but is withholding the love for now. Maybe bondholders and credit rating agencies read my comment and weren't so impressed with the latest reforms.

Tuesday, December 3, 2013

Wall Street's License to Steal?

Phyllis Furman of the New York Daily News reports, Bad deals with Wall Street are costing the city as much as $1 billion a year:

Wall Street has put the squeeze on the city to the tune of $1 billion, a report due out Tuesday claims.

As much as $723 million worth of unnecessary fees and bad deals, coupled with $300 million in bank subsidies should be rejiggered, says a study from a new left-leaning coalition called New Day, New York Coalition.

"New York City could be saving $1 billion annually just by changing the way it does business with Wall Street," one of the report's authors, Connie Razza, director of strategic research initiatives at the Center for Popular Democracy, told the Daily News.

The study, dubbed "Leveraging New York's Financial Power to Combat Inequality," kicks off a week of events organized by the group, culminating in a rally set for Thursday at Foley Square.

The coalition, whose members include veterans of Occupy Wall Street, labor unions such as 1199SEIU, and faith organizations, says its goal is to "draw attention to the ways Wall Street and big corporations continue to siphon resources away from average New Yorkers and point toward solutions that would help reduce inequality and build economic fairness."

Mirroring a key campaign theme of Mayor-elect Bill de Blasio, the report notes the huge disparity between the city's haves and have-nots, with the 1% controlling a whopping 40% of the city's income.

The city and its pension funds have tremendous leverage that can be used to bridge the gap, the study says: $350 billion that travels through the financial system.

"We should be using that leverage to demand a different relationship" with Wall Street, Razza said.

Among the key findings: the city, its pension funds and the MTA pay $563 million in Wall Street fees each year.

Rather than pay out megabucks to Wall Street big shots, the city should set up an in-house group to manage its pension assets and bond offerings, the report recommends.

That suggestion comes on the heels of a recent city report that showed fees paid by New York City pension funds surged by 28% to $472.5 million in the year ended June 30.

The idea of bringing the management of the city's money in-house isn't new.

New York's former chief investment officer, Larry Schloss, recommended just that before he recently stepped down. A number of public pension funds in Canada, including Ontario's $126 billion teachers' pension fund, have already moved in that direction.

But achieving that goal here is a long shot, said Leo Kolivakis, publisher of Pension Pulse Blog.

"Attracting and retaining qualified managers to manage money in-house is a huge challenge," Kolivakis told the News.

Patrick Muncie, a spokesman for Mayor Bloomberg, noted the financial services industry's crucial contributions to the local economy.

"The financial services sector is a critical driver of New York City's economy, providing more than 400,000 jobs and generating $3 billion in tax revenue last year alone," he said.

A spokesman for outgoing New York City Comptroller John Liu said the report encapsulates many of the comptroller's efforts, including "better and more cost-effective in-house management of pension assets."

The report "effectively and succinctly aggregates the real underlying issues of deepening inequality," Liu said in a statement.

Reps for de Blasio and incoming New York City Comptroller Scott Stringer, declined to comment.

Other recommendations of the report include holding banks to firm commitments to improve the community in exchange for the $300 million a year they receive in subsidies.

Martin Z. Braun of Bloomberg recently reported, Wall Street Fees Paid by NYC’s Pension Funds Climb 28%:

Scott Stringer vowed during his successful campaign for New York comptroller to reduce the $370 million in fees the city’s five pension funds pay money managers and consultants annually. His job, which starts Jan. 1, just got harder.

The charges climbed to $472.5 million in the year ended June 30, enough to pay the salaries of 6,440 teachers, a city report shows. The 28 percent gain is more than double the return on the $137.4 billion retirement system’s assets in the same period. In the past seven years, investment expenses for the pensions, which are overseen by the comptroller’s office, surged by $280 million.

“I’m going to take a hard look at all of our fees,” Stringer, a 53-year-old Democrat, said in a statement. “We need to limit costs, ensure payments are commensurate with performance and leverage our size and relationships with other pension funds to negotiate lower fees.”

The growing cost underscores the challenge Stringer and municipal officials across the U.S. face in reducing pension-management fees and boosting returns as the gap between promises to retirees and the assets they have to pay for them has widened to $1 trillion, according to data compiled by Bloomberg. New York’s funding deficit alone totals $72 billion.

Riskier Investing

To help shore up their funding, retirement systems such as New York’s have turned to riskier and more expensive asset classes, such as private equity, hedge funds and real estate, to hit targeted annual returns of 7 percent to 8 percent. Money managers of those funds typically charge 2 percent of assets they oversee, plus 20 percent of profits, which is higher than traditional stock and bond funds.

New York City’s pensions had 11.6 percent of their assets in such alternatives at the end of fiscal 2013, compared with 4 percent in fiscal 2006, according to city comprehensive financial reports. Blackstone Group LP (BX), Apollo Global Management LLC (APO), and Pacific Investment Management Co. are among the city’s almost 250 money managers.

As the pension has moved into such alternative investments, its costs have increased to about $8 billion this year from $1.5 billion in 2002, when Mayor Michael Bloomberg took office.

“The long-term trend in asset allocation for most funds is a move to more private markets,” said Alan Torrance, a partner at Toronto-based CEM Benchmarking Inc., a consulting company. “Private markets are more expensive than public markets.”

Retiree Benefits

U.S. pension-fund costs increased by 0.26 percentage point on average from 2001 to 2010 as retirement systems shifted money to alternative assets that aren’t managed in-house, according to a 2012 report by CEM for New York City’s pensions. For a fund with a $1 billion in assets, the average increase is equivalent to $2.6 million.

Fees erode investment gains crucial to funding benefits for New York City’s more than 237,000 retirees, and future payments to 344,000 employees. The pensions have a 10-year average annual return of 7.5 percent, compared with a 7.2 percent gain for public pensions with more than $5 billion in assets, according to Santa Monica, California-based Wilshire Associates.

“We constantly work to reduce fees across all asset classes, including shedding poorly performing managers, moving public-market funds into indexes, and negotiating lower fees in alternatives,” Matthew Sweeney, a spokesman for outgoing Comptroller John Liu, said in an e-mailed statement.

“It’s misleading to cherry-pick one year and compare a rise in fees with the rate of return,” Sweeney said. “Many alternative investments, such as private equity and real estate, have front-loaded fees that don’t generate returns for several years.”

Since Liu took office in 2010, the funds have increased in value to $144 billion from $100 billion, Sweeney said. He said alternative investments have reduced risk.

Managing In-House

The pensions believe alternative investments will diversify their portfolio against events such as the stock market collapse in 2008 and provide attractive, risk-adjusted returns, he said.

Before departing last month to become president of investment adviser Angelo, Gordon & Co., the city’s chief investment officer, Larry Schloss, recommended that the pensions hire staff with Wall Street experience and pay them higher wages to manage money in-house. That would reduce fees and boost returns, he said.

New York City is the only one of the 11 biggest U.S. public-worker pensions that doesn’t manage any assets internally.

Ontario Model

Schloss pointed to Ontario’s C$130 billion ($126 billion) teachers’ pension fund, which manages most of its assets internally. The fund has returned an average 9.6 percent annually on its investments since 2003, 1.6 percentage points better than New York’s funds.

Trustees of the city pension funds, who include representatives of unions, were skeptical and didn’t adopt Schloss’s strategy.

They also balked at a plan proposed by Mayor Michael Bloomberg and Liu two years ago to overhaul management of the funds. The five boards, which have a combined 58 trustees, were to be pared down to a single 12-member panel that would set investment policy. The move would drive down costs, improve decision-making and boost returns, the mayor and comptroller said in October 2011.

In a July interview, Stringer, who is finishing his term as Manhattan borough president, said the city doesn’t need to pay a lot more to get talented money managers. The comptroller’s office could attract public-spirited employees, “the best and the brightest,” without paying Wall Street salaries and bonuses, he said.

“Any time we bring down consultant fees and streamline the bureaucracy, that’s more money for schools and cops on the other side,” he said.

Investments in alternatives to stocks and bonds, such as private equity and real estate, more than doubled to 24 percent of public-pension portfolios between 2006 and 2012, according to Cliffwater LLC, a Marina del Rey, California-based firm that advises institutional investors.

The mayor is the founder and majority owner of Bloomberg News parent Bloomberg LP.

According to aiCIO, New York City and South Carolina’s retirement systems each shelled out just under half of a billion dollars to asset managers in the most recent fiscal year. Both public defined benefit schemes outsource effectively all of their assets to external investment firms. Allocations to alternatives are by far the most expensive part of each system’s portfolio—and both are under fire for doling out excessive fees.

Earlier this month, Mary Williams Walsh of the New York Times reported, New York Is Investigating Advisers to Pension Funds:

Public pensions in New York State have some of the most reliable funding in the country, but what happens to the money once it is in the pension system can be less clear-cut.

Now, state financial regulators have subpoenaed about 20 companies that help New York’s pension trustees decide how to invest the billions of dollars under their control to determine whether any outside advice is clouded by undisclosed financial incentives or other conflicts of interest.

“The recent financial difficulties in Detroit serve as a stern wake-up call, demonstrating why strong oversight of New York’s public pension funds is so important,” Benjamin M. Lawsky, the New York financial services superintendent, said in letters sent last month to the trustees of the top state and city public plans.

Detroit’s municipal pension fund suffered severe losses on real estate investments, among other problems, and now that the city is bankrupt, investigators are trying to find out exactly what went wrong. In some cases, certain Detroit pension trustees were taken on junkets dressed up as investment site inspections. And in one instance, an investment promoter paid a bribe to win pension money for real estate projects in the Caribbean but then spent the money building an $8.5 million mansion in Georgia.

Mr. Lawsky said in his letter to New York’s pension trustees that he wanted to look at “controls to prevent conflicts of interest, as well as the use of consultants, advisory councils and other similar structures.” Together, the city and state trustees serve as stewards for $350 billion of retirement money.

Public workers and retirees are not the only ones with a stake in New York’s public pension system. If money is wasted, or invested in assets that lose money, the retirees still receive their checks, but local taxpayers must make up the losses.

Representatives of New York pension trustees said they were cooperating with Mr. Lawsky’s inquiry but already had extensive controls in place to make sure the retirement money in their care was invested properly. State Comptroller Thomas P. DiNapoli, the sole trustee of New York’s big state-run pension system, has called that system “one of the most transparent and accountable public pension funds in the country” in a statement on his website.

The latest subpoenas were sent last week to consultants that range from large firms like Wilshire Associates, Callan Associates, Towers Watson and Russell Investments to smaller firms that are not well known outside the world of institutional investing. Some of the firms advise public pension trustees in New York, but others do not. Mr. Lawsky apparently included both types in his investigation to learn more about bidding processes in general. Some of the subpoenaed firms had submitted unsuccessful bids and are now being asked for their records.

Mr. Lawsky’s subpoenas seek information like the consultants’ pitchbooks on various investment proposals, their compensation practices, their relationships with money managers and their methods of tracking investments that do not trade on public markets. One person briefed on the inquiry said the regulators appeared to be trying to learn whether any consultants were being paid by the firms they recommended, including in-kind payments or job offers.

Public pension funds typically have one or more general consultants who advise the trustees and senior staff members on developing an asset allocation policy, which assigns different shares of the total investment portfolio to stocks, bonds, real estate and other types of assets. In recent years, concerns have been raised that general consultants have been encouraging trustees to shift more pension money into aggressive investments in hopes of earning higher annual returns than can be achieved with stocks and bonds. That exposes taxpayers to greater risks because assets that promise the biggest potential rewards are also generally the most volatile.

In banking and insurance, which Mr. Lawsky also regulates, riskier assets are counted at less than their full value, and financial institutions can be downgraded or even forced to take corrective action if their portfolios are too volatile. Those principles have so far not been applied to public pensions, but Mr. Lawsky said in his October letter that he had “decided to take a new approach to pension fund oversight.”

“Where we find areas that need urgent and prompt corrective action, we may propose new regulations to increase accountability and transparency at those funds,” he wrote.

In addition to their general consultants, New York’s pension funds also work with specialized consultants who handle single asset classes. The state retirement system has separate consultants for private equity funds, hedge funds, real estate, fixed income, international stocks and domestic stocks. The more esoteric the investment class, the higher the fees these consultants are paid because nonstandard investments like hedge funds are generally harder to track and measure.

New York State’s private equity consultants received $2.1 million for their work last year, for example. Hedge fund consultants were paid about $1 million, while the consultants working with ordinary United States stocks received just $63,000, even though such securities represent a much larger share of the fund’s total portfolio.

Pension trustee duties are especially sensitive in New York, one of the few remaining states with a pooled system governed by a sole trustee instead of a board. New York’s immediate past sole trustee, Alan G. Hevesi, became the target of a wide-ranging pay-to-play investigation led by Andrew M. Cuomo, the attorney general at the time. Mr. Hevesi was eventually found, in effect, to have sold pension investment contracts to money managers, and served 20 months in a medium-security prison. He was released on parole last December.

That scandal generated calls to replace New York State’s sole trustee with a board, which were unsuccessful. Instead, Mr. Hevesi’s successor as sole trustee, Mr. DiNapoli, instituted a number of reforms and control measures intended to ensure that investments were chosen on the merits instead of secret payments.

Senior officials of the New York State pension fund said they had screened all of their consultants after the scandal and were satisfied that their bidding process was competitive and ethical. They said they did not think their investment consultants charged money managers to be included in their databases. Nor did they permit the pension system’s stock-trading business to be directed to any particular brokerage firms as part of an overall compensation package.

The New York officials said the state fund’s investment staff now reviewed all bids, whether for consulting work or investment contracts. They said a separate group of state employees reviewed the bidders’ proposals for how they wanted to be compensated. They said their outside consultants carried out the initial searches for investment managers, but the fund’s staff reviewed the finalists, doing background checks, site visits and other evaluations.

The offices of the New York State Teachers’ Retirement System and New York City Comptroller John C. Liu were closed for Election Day, and no one could be reached to comment on Mr. Lawsky’s investigation.

Ted Seidle of Benchmark Financial Services also wrote an article for Forbes earlier this month, stating the list of the 20 pension advisers to receive New York Subpoena may grow:

New York state financial regulators have subpoenaed 20 companies that advise public pension trustees around the country on how to invest the trillions in assets under management in government plans. According to an informed source, this is an ongoing investigation of the pension consulting industry, initially targeting firms that have advised New York funds, or pitched services to them. The investigation may broaden to include other pension advisory firms nationally.

The firms subpoenaed are in the business of providing advice regarding allocation of pension assets and selection of managers, as opposed to actually managing money. The advice they are paid by pensions to provide is supposed to be objective—uncorrupted by any payments to the gatekeeper-evaluator from the money managers under review.

In recent years, however, the Department of Labor, the Securities and Exchange Commission, and the General Accountability Office have each publicly stated that conflicts of interest related pension advisers are widespread, and that these conflicts have resulted in reduced returns and higher fees for retirement investors.

New York’s inquiry into public pension advisers should come as no surprise.

As I noted in the findings of my forensic investigation of the Rhode Island state pension a few weeks ago, Rhode Island Public Pension Reform: Wall Street License to Steal, the investment consultant retained by the Rhode Island State Retirement System to review and recommend hedge fund and other alternative investments, Cliffwater LLC, had disclosed in its regulatory filings with the SEC that it received compensation from the investment managers it recommended or selected for its clients. “A conflict of interest arises under these circumstances because the consultant may recommend managers to the pension based upon such undisclosed compensation it receives, as opposed to investment merits,” I wrote. In my report I recommended that the SEC look into the facts behind the firm’s disclosures.

Cliffwater was not included in the firms that have received New York subpoenas to date but Pacific Corporate Group, a former Rhode Island pension adviser and Pension Consulting Alliance, a current adviser, were.

The 20 firms subpoenaed were:

Aksia; Albourne America; Callan Associates; Courtland Partners Ltd; Gallagher Retirement Services; Hamilton Lane; Hewitt EnnisKnupp, Inc.; LP Capital Advisors, LLC; Mercer; Pacific Corporate Group; Pension Consulting Alliance; Russell; RV Kuhns & Associates; Situs Strategic Advisors, LLC; Smith Graham & Company Investment Advisors, LP; Stepstone Group LLC; The Townsend Group; Torreycove Capital Partners LLC; Towers Watson; and Wilshire Associates.

As Benjamin M. Lawsky, the New York financial services superintendent, said in letters sent last month to the trustees of the top state and city public plans, “The recent financial difficulties in Detroit serve as a stern wake-up call, demonstrating why strong oversight of New York’s public pension funds is so important.”

Across the nation, those responsible for overseeing the integrity of public pensions hopefully are waking up and smelling the coffee. Anyone who’s ripped-off public pensions and government workers should be starting to sweat.

Seidle has been relentless in exposing the secret pension money grab. He's been particularly critical of Gina Raimondo, Rhode Island's Treasurer, and his report, Rhode Island Public Pension Reform: Wall Street License to Steal, does raise important points that merit a closer look.

He provided the complaint to The Providence Journal, specifically asking the SEC to look at:

Investment fees that have been “grossly understated” and “intentionally withheld” from public view;

Investment agreements that allow hedge fund managers to withhold information from the state while they share it with other investors, putting them in a position to benefit at the state’s expense, or, as the complaint puts it, “steal from the state pension”;

Raimondo’s claims about the performance of two funds “she formerly managed” and which the state pension fund has since invested in;

Conflicts in which the state’s investment consultant “receives compensation from the very investment managers it recommends or selects for its clients.”

Siedle said his findings provide a more complete picture of Raimondo’s work as general treasurer, including her work on a 2011 state pension system overhaul to address what was seen as a severe pension-funding crisis. The legislation, passed by the Democrat-controlled General Assembly, raised the retirement age, suspended annual cost-of-living adjustments and replaced the state’s defined-benefit pension with a hybrid that includes a 401(k)-style plan.

“If she had slashed the pension costs at the same time as she was slashing the benefits, then she could argue that that’s pension reform. But to slash the benefits and exponentially increase the fees to Wall Street, that’s not reform,” Siedle said. “What I have done for Rhode Island is to draw attention to the other side of the balance sheet, the other side of the income statement, which is how much has been paid to Wall Street.”

A spokesman for Raimondo, a Democrat and likely candidate for governor in 2014, responded Monday by calling Siedle’s claims “misleading political attacks designed to discredit the treasurer and the important reforms that have protected pensions for public employees and retirees.”

Keep in mind, Ms. Raimondo is one of the people Jim Leech and Jacquie McNish praise in their book, The Third Rail. I gained a deeper appreciation for her after reading the book as she fought a tough battle to slay the pension dragon, but Seidle raises legitimate concerns.

As far as investment consultants, you already know my thoughts. Most of them are utterly useless, charging outrageous fees, recommending well-known brand name funds that charge even more outrageous fees as they gather assets from unsuspecting public pension funds praying for an alternatives miracle. It's quite disconcerting and it's high time state auditors look into this (not so) secret pension money grab.

On governance, I need to keep hammering this point, the pension governance model in the United States is all wrong. An increasing number of U.S. public pension funds are moving to emulate their Canadian counterparts, managing more assets in-house, but unless they implement independent and qualified investment boards and start paying their pension fund managers properly, it's a hopeless cause.

That's why when Phyllis Furman of the New York Daily News contacted me yesterday, I told her flat out I was highly skeptical of these new reforms. Nobody is going to go work for a U.S. public pension fund as part of their "civic duty." You need to pay professional pension fund managers properly to attract and retain qualified staff. I'm not talking Canadian-style hefty payouts, but something a lot more in line with the private sector.

Finally, I do realize the shift into alternative investments is more costly and requires specialized advice but don't kid yourself, alternatives are no panacea and they don't reduce risk. I would fire any risk officer who claims otherwise. There are plenty of risks in alternatives and pensions taking on too much illiquidity risk are in for a rude awakening when the next crisis hits.

Luckily for pensions, as long as central banks keep printing, they will postpone the next crisis out by a few more years. Unfortunately, they're sewing the seeds of an even bigger crisis and will stir up more bubble anxiety along the way.

Below, Forbes Magazine writer and founder of Benchmark Financial Services, Ted Siedle, discusses his new report on Rhode Island's pension system - and the results aren't pretty. Unfortunately, this is an endemic problem across the United States and until they get the governance right, mitigating political and union interference, these shenanigans will continue giving Wall Street a license to steal.

Disclaimer

Pension Pulse is a collection of my thoughts pertaining to issues on pension funds and financial markets. The information and opinions contained on this site are merely guidelines. This site does not guarantee any monetary claims by following these recommendations. This website is not liable for any loss that you incur due to these programs, nor do we ask for any monetary gains from your success of using these recommendations.

We also do not guarantee the results of any products or recommendations listed on this site. You must do your own due diligence before investing in any product.

Monday, December 9, 2013

More on The Public Pension Problem

Friday, December 6, 2013

The Public Pension Problem?

Thursday, December 5, 2013

Revisiting New Brunswick's Pension Reforms?

Wednesday, December 4, 2013

Did Illinois Slay Its Pension Dragon?

Tuesday, December 3, 2013

Wall Street's License to Steal?

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