Tuesday, April 10, 2012

The Pension Basket Case You Forgot About?

Josh Barro, contributor to Forbes.com and a fiscal policy analyst reports in Bloomberg, Illinois Is Pension Basket Case You Forgot About:
Rod Blagojevich is in prison. But the worst things the former governor did to Illinois (BEESIL) weren’t even illegal.

This month, the Teachers’ Retirement System of the State of Illinois made a dire announcement to its members. TRS, which covers most public-school teachers in Illinois outside Chicago and has more than 360,000 members, said the following:

“If the General Assembly does not continue to provide all of the funding called for in state law, calculations done by TRS actuaries show that the System could become insolvent as soon as 2030. Preventing insolvency may include significant changes for TRS -- new revenues must be generated and if they are not benefits may have to be reduced.”

The teachers’ fund is one of the country’s worst-financed statewide pension systems, reporting that it is only 47 percent funded. And that’s if you buy the system’s rosy accounting assumptions, including that it will achieve 8.5 percent annual returns on its assets. This level is tied for the most aggressive investment assumption among state pension funds in the country, and the fund has had to get creative in an effort to meet it. Pensions & Investments magazine says it has the fourth-riskiest pension investment portfolio in the U.S., with less than 17 percent of its investments in fixed income and cash.

Teachers Left Hanging

Perhaps the teachers’ fund will be fabulously lucky, and rich investment returns will cover pension costs so taxpayers won’t have to. But the odds of that are vanishing. Indeed, the system’s funding status is so poor that it achieved a 23.6 percent return on investments in 2011 and still managed to shave only $2 billion off its $46 billion unfunded liability. And it’s not as though the fund can make such gangbuster returns consistently -- in 2009, it returned negative 22.7 percent.

Closing the TRS funding gap -- and the gap at the State Retirement Systems of Illinois, which is only 36 percent funded -- will depend on taxpayers’ willingness to start paying far more than they ever did for pensions. And as the TRS statement makes clear, that is far from a sure bet, meaning that pensioners may see their benefits cut.

Public pensions are a problem all over the country, but they are a special problem in Illinois, mostly because the state has failed, for decades, to make proper contributions into its pension funds. Illinois, more than most states, has used its pension funds as a vehicle for off-balance-sheet borrowing, financing high spending without high taxes by making unfinanced pension promises.

No individual is more personally responsible for allowing this to happen than Rod Blagojevich, who became governor in 2003 and who was impeached in 2009. Illinois is not unique because it has struggled to manage its budget in the recession; many states have similarly failed to act responsibly in the last four years. It is much more notable as a place that let its fiscal problems spiral out of control while the economy was strong, leaving an unusually daunting mess for lawmakers to clean up in the recession.

Of course, he didn’t act alone. Illinois made bad pension decisions before he was elected, and the Legislature approved his worst ideas. But the governor pushed other lawmakers to give in to their most irresponsible impulses.

One of his first initiatives was a pension-obligation bond plan. For years, Illinois had been struggling to come up with enough cash to make required payments into its pension system (even though its law stating what was “required” was more lax than what was recommended by the Governmental Accounting Standards Board). Blagojevich proposed that the state shore up its pension funds by issuing $10 billion in bonds and investing the proceeds in the pension fund.

No Bond Windfall

In principle, nothing is wrong with pension-obligation bonds. They simply swap one form of indebtedness (unfunded pension obligations) for another (bond debt). But in practice, when a jurisdiction issues these bonds, it is usually up to no good, and this was no exception.

The pension funds would invest the proceeds in stocks and bonds with a target investment return of 8.5 percent a year, but the interest on the bonds was only about 5 percent. This was marketed as a free lunch, but it wasn’t one: Interest payments were fixed but Illinois taxpayers were on the hook to pay if the assets underperformed, which they did.

A second problem was that the governor used the expected free lunch to justify putting only $7.3 billion of the $10 billion in bond proceeds into the pension fund. The remaining $2.7 billion went to pay bond interest and to cover part of the state’s required pension contributions in 2003 and 2004 -- freeing up money to spend on other initiatives, including an aggressive expansion of Medicaid and the Children’s Health Insurance Program. This meant that when you added together the unfunded liability and the outstanding balance on the bonds, the plan widened Illinois’s overall funding gap for pension benefits.

Even after the proceeds from the pension-obligation bonds had run out, Blagojevich and the Illinois Legislature continued to underpay the required pension contributions, by $300 million in 2005, $1.2 billion in 2006 and $1.1 billion in 2007.

As the recession hit, the Legislature started passing budgets it knew were unbalanced, causing the state to run out of cash mid-year and run up billions of dollars in unpaid bills. Periodically, the state would issue general-obligation bonds to pay off the bills backlog, again shifting pension liabilities into bond debt.

Even as the state budget fell apart and he spent profligately, Blagojevich, a Democrat, steadfastly opposed increases in the income or sales tax. He even alleged that his impeachment on the grounds of having tried to sell Barack Obama’s Senate seat was a plot to get him out of the way so that the Legislature could raise the income tax.

Income Tax Increase

Starting after the 2010 election, with Blagojevich gone, the Legislature did raise the income tax, from a flat 3 percent to a flat 5 percent. But Illinois’s budget situation was so dire that even a 66 percent increase, which raised general fund revenues by about 20 percent, still left an annual gap of more than $1 billion.

In 2010, Republicans gained seats in the Legislature and have blocked any further general-obligation bond issuances to close budget gaps. As a result, the unpaid bills backlog has reached more than $8 billion, and there is no plan to pay it off. Because of the tax increase, at least the backlog is no longer growing very much, and vendors can expect to be paid on a rolling basis after waiting about five months.

But the state hasn’t taken the steps it needs to reform its precarious pension system. Michael Madigan, the Democratic speaker of the state Assembly, has belatedly become an advocate for aggressive pension reform, but Governor Pat Quinn and public-employee unions stood in his way through 2010 and 2011. The state did sharply reduce benefits for workers hired after 2010, but material savings from those changes won’t materialize for decades, and the state used those estimated savings to shave a few hundred million dollars off its annual required pension contributions in the near term.

Much of the current trouble would have existed with or without Blagojevich. But when fiscal times get tough, it falls to the governor to tell the Legislature “no.” In the middle of this decade, while neighbors like Indiana (BEESIN) were getting their fiscal houses in order, Blagojevich was the one telling the kids in the Legislature to eat all the candy they wanted and stay up as late as they felt like. And that has left lawmakers with a much bigger mess to clean up now.

Illinois' pension system is a basket case. It has gone past the point of no return. While pension deficits do not alarm me, when I read that Teachers' Retirement System (TRS) is only 47 percent funded, I realize that even though the 'death spiral' incident is behind them, they are in terrible shape and extremely vulnerable to another market meltdown. They need major pension reforms on all fronts: contributions, benefits, retirement age and most importantly, pension governance.

And Illinois isn't alone. Florida's billion dollar pension battle is brewing but many other states face dire consequences with their unfunded and poorly managed pension plans. In California, James Nash of Bloomberg reports that California Teacher Pension Plan's Unfunded Liability Widens:
The California State Teachers' Retirement System, the second-biggest U.S. public pension, said the gap between its assets and projected obligations rose $8.5 billion as investment gains failed to cover previous losses.

The unfunded liability climbed 13 percent to $64.5 billion as of June 30, according to a report from actuaries released today. The system had about 69 percent of assets needed to cover promises to current and future retirees at the end of fiscal 2011, down from about 71 percent a year earlier.

The widening gap may require increased state funding, plan officials have said. Public pensions nationwide had a median of about 75 percent of the funds needed to cover obligations in 2010, according to Bloomberg Rankings data. The California fund's overseers said losses on invested assets in 2008 and 2009 added $12.7 billion to the new deficit figure.

"The projected revenue shortfall is due primarily to investment return experience averaging 5.5 percent per year over the last decade that was significantly less than the long-term actuarial assumption of 7.5 percent," Milliman Inc. consultants said, according to the report. The study will be formally presented to the $152 billion plan's board members April 12.

Smoothed Results

The so-called funding ratio has been less than 100 percent since 2001. Because the ratio is "smoothed" by averaging three years of investment returns to minimize volatility, the latest gap only partially reflects the almost 24 percent net gain from investments in fiscal 2011, according to the report. The system earned 2.3 percent on assets in the past calendar year, according to a January study.

Teachers pay 8 percent of their income toward retirement. Districts add 8.25 percent, while the state's share is about 2 percent. Contribution rates for teachers and school districts haven't changed since 1990.

In February, plan overseers lowered the assumed rate of return on investments to 7.5 percent from 7.75 percent. The change retroactively added $3.5 billion to the system's funding gap as of June, according to the plan report.

By comparison, the California Public Employees' Retirement System, the largest U.S. public pension with $234.8 billion of assets, has between 70 percent and 75 percent of the money it needs to cover future liabilities, according to Brad Pacheco, a spokesman. Calpers, as the fund is also known, cut its assumed rate of return to 7.5 percent from 7.75 percent March 14.

The system for state and local government workers was fully funded when the last recession began. Its ratio of assets to projected costs dropped to as low as 65 percent after a 28 percent drop in value from December 2007, when the slump started, to June 2009, when it ended, as the global downturn depressed equity and property values.

In fiscal 2011, Calpers had an almost 21 percent return on investments, its best performance in 14 years.

CalSTRS's funding gap isn't alarming yet but clearly they're in far worse shape than Ontario Teachers' Pension Plan (OTPP) whose $9.6 billion funding shortfall means they're still 92% funded (and OTPP uses a lower discount rate). Unlike their North American peers, OTPP delivered exceptional investment gains in 2011, up 11.2%, and yet the media kept harping on their deficit as if it's the end of the world!

The key issue for many state plans is implementing pension reforms, including a different governance model based on the success of Canadian and Dutch pension funds, before the funding gaps widen to the point where extremely difficult political decisions need to take place, possibly calling upon taxpayers to shore up public pension plans.

Unfortunately, states and municipalities are increasingly betting on pension bonds to get them out of their pension woes but this is a recipe for disaster because most pension funds are using the proceeds to increase their risk in alternatives that are failing to pay off.

As I stated in my weekend comment on the great pension slaughter, there is a war being waged on retirement plans and the financial and political elites are gunning for defined-benefit plans. This isn't a conspiracy theory; it's a reality based on the secular shift away from defined-benefit (DB) plans toward defined-contribution (DC) plans.

My conviction remains that we need to bolster defined-benefit plans and increase coverage to all citizens in the public and private sector. My biggest fear, however, is that the same 'debt lunatics' sounding the alarm on debt (it's not a debt crisis but an unemployment crisis!) calling for savage austerity will use Illinois' pension basket case and countless others to kill defined-benefit plans, reducing coverage, increasing pension poverty and exacerbating economic inequality. This is the crime of the century, one that will end up costing societies a lot more over the long-run.

Below, Bloomberg's Sara Eisen reports that the yield on Spain’s 10-year benchmark bond surged almost 20 basis points to 5.94 percent today as Economy Minister Luis de Guindos declined to rule out a rescue for Spain and Bank of Spain Governor Miguel Angel Fernandez Ordonez said the nation’s lenders may need additional capital if the economy weakens more than expected. She speaks on Bloomberg Television's "Inside Track."

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