Monday, August 12, 2013

Are We All Going to Pension Hell?

Megan McArdle of Bloomberg reports, We Are All Going to Pension Hell:
One of the most startling moments of the Detroit bankruptcy was when a judge stepped in to stay the bankruptcy at the behest of the city’s public sector unions…and then said that she was going to tell the president about this.

“It’s cheating, sir, and it’s cheating good people who work,” the judge told assistant Attorney General Brian Devlin. “It’s also not honoring the (United States) president, who took (Detroit’s auto companies) out of bankruptcy.”

Aquilina said she would make sure President Obama got a copy of her order.

"I know he’s watching this,” she said, predicting the president ultimately will have to take action to make sure existing pension commitments are honored.

Aside from turning President Obama into a quasi-mystical entity who is apparently sacred party to all transactions involving any government, anywhere, this was a veiled confession that she did not have the power to order what she was ordering. She could issue a piece of paper telling Detroit to protect its pensions, but that piece of paper would not give the city any more resources to pay them. It was a quixotic attempt to stop the unstoppable, to fix the unfixable. The only way her order made sense was if some outside force stepped in to provide the cash.

The invocation of St. Obama is probably not going to do Detroit much good. The federal government is not going to bail out Detroit. Nor should it; bailing out cities that got themselves into financial trouble is an invitation to much more financial trouble. In Illinois, state and local officials are squabbling over who is going to pay for the disastrously underfunded retirement benefits of state and local employees:

State leaders have argued over the meaning of a state constitutional provision protecting government pensions in Illinois, and, in private conversations, over the potential political fallout from unions if benefits are cut. But Mr. Emanuel has openly called for increasing retirement ages, raising workers’ contributions toward their own pensions and temporarily freezing inflation adjustments now paid to retirees, all of which amount, union leaders say, to benefit cuts.

Public sector union leaders have been enraged by Mr. Emanuel, who was at the helm in 2012 during this city’s first teachers’ strike in 25 years and who has announced plans to phase out city health care coverage by 2017 for some city retirees. A change in pension benefits could affect more than 70,000 people who worked as Chicago police officers, teachers, firefighters and others, and who now receive average annual benefits ranging from about $34,000 for a general-services retiree to $78,000 for a former teacher with 30 years of service.

Some labor leaders say the city, not the state, is ultimately responsible, arguing that Chicago leaders long ago should have begun planning how to pay for pensions promised to its workers, regardless of insufficient state contribution formulas.

“The city failed to fund this all along, and now Mayor Emanuel has made it clear he is going after the hard-working men and women on the Chicago Police Department to make up for that,” said Michael K. Shields, president of the Fraternal Order of Police, who described Mr. Emanuel, simply, as anti-labor. “He’s trying to stiff us out of our pay.”

Chicago’s teacher pension fund is, says the New York Times, “dangerously close to collapse”; another may run out of money within the next decade.

The rage of public sector unions is understandable. And this debate is going to be bitter, because unlike with regular firms, there’s no clear point at which you can say, “Yes, that’s it, we all agree they’re insolvent.” While a private firm cannot (thank God) simply take more money from their customers, in theory, governments can generally raise taxes and cut other spending to pay pensions. And in theory, they should, most of the time, because the taxpayers promised those pensions through their elected representatives.

Yes, I know that this was often bad politics, not sound public stewardship. But we have to treat decisions made by elected officials as, well, decisions made by the citizens of those locales. If the citizenry can demand to renege at any time because they don’t like the outcome, government can’t function at all -- not even the bits we like, like police and roads.

We can’t seize and sell off the city of Chicago to make those obligations good. And so we will argue … in court and out of it, because the fact is, many state and local governments will be unable to pay for all the promises made by the politicians of yesteryear:

If you define municipal debt simply as what states and localities have borrowed, the total nationwide comes to about $3 trillion. Nevertheless, these governments actually owe more than twice that much, according to estimates from groups like the States Project. The reason for the discrepancy is that states and localities carry another kind of debt -- promises of retirement benefits to public-sector workers -- and they have radically underfunded the systems that must pay for it. As Boston University Law School professor Jack Michael Beermann wrote recently in the Washington and Lee Law Review, the situation is a “double whammy” for future taxpayers, who not only will have to pay for “the consumption of prior generations” but also will receive “reduced government services” as increased spending on retirement debt crowds out other programs.

There is, in the end, a limit to how tightly past taxpayers, or their representatives, can bind the citizens of the future. It is a genuine tragedy that people who worked hard for the city of Detroit for 30 years should lose pension benefits. But that doesn’t mean that the city of Detroit should turn off the streetlights and get rid of schools and ambulance service in order to fund those lost pensions. And it’s hard to argue that the taxpayers of other places are morally obligated to step in.

But how much should cities have to cut, once the tax base is exhausted? Senior centers? Parades? Maintenance at city parks? We’d better start asking those questions, because pretty soon, we’re going to need to answer them.
Josh Barro of Business Insider reports, Detroit Fight Shows Why Public Pensions Are Bound For Problems:
One of the many points of contention in Detroit’s bankruptcy is how underfunded the city’s pension systems are. Kevyn Orr, Detroit’s state-appointed emergency manager, says the pension funds are underfunded by $3.5 billion, out of $18 billion in total city liabilities. The funds’ managers say they are only short by $650 million, because they use more aggressive assumptions that lead to a higher estimate of fund assets and a lower estimate of liabilities.

Orr is closer to being right. But the dispute between the two sides shows a key reason that governments get into trouble with pensions: Their accounting is very complicated and highly subjective, meaning it’s easy to make promises that are larger than you understand, or larger than voters understand. Politicians make decisions about pension policy all the time without knowing how much their jurisdiction owes. In most places, these errors won't lead to insolvency. (Indeed, the pension liability is not the primary driver of Detroit’s insolvency.) But they do lead to taxpayers forking over more for pensions than they ever intended, and governments having a reduced ability to invest in infrastructure, provide public services, or cut taxes.

This post explains why Orr is right, and what’s at stake for Detroit in the calculation. I should note first a counterintuitive fact about the Detroit situation: a finding that the pension funds are deeply underfunded is likely in the interest of pensioners. Detroit is seeking, through bankruptcy, to reduce obligations to various creditors. In the case of the pensioners, Detroit’s obligation is the amount by which promised pensions exceed the asset balance in the pension funds.

If Detroit’s restructuring were based on the premise that the pensions were fully funded, pensioners would likely get nothing beyond the pension fund assets. The more underfunded the pensions are deemed to be, the stronger a claim the pensioners have to additional payments from Detroit. They still get the actual pension fund assets either way. Bondholders, who are competing with pensioners for Detroit’s limited dollars, therefore want the bankruptcy to proceed based on the idea that the pensions are as well-funded as possible.

The pension liability is hard to measure because both sides of the pension funds’ balance sheets are controversial: the value of their asset portfolios, and the cost of the promises they have made to retirees. Let’s take the asset side first, because it’s simpler. Pension funds invest in a mix of assets, typically principally equities (stocks) and fixed income (bonds). It’s easy to figure out their market value. But when pension funds report how well-funded they are, they don’t actually use the market value. Instead, they use what’s called an actuarial asset value, which relies on a smoothing of asset returns.

Let’s say a pension fund anticipates an annual return on assets of 8 percent. But there’s a bad year, and asset values decline by 12 percent. The pension fund will go ahead and book the 8 percent return anyway. Then, it will recognize the -20 percent deviation from expected returns over a period, usually five years. With five year smoothing, a pension fund would actually recognize a 4 percent gain in the year with a real 12 percent loss, and then phase in 4 percent losses over each of the next four years, to reach the 12 percent decline by the end of the fifth year. You might say “that’s B.S.” You’d be right. This practice leads to pension funds, including Detroit's, claiming to hold assets that don’t exist. Actuarial smoothing does serve a useful fiscal purpose—it prevents wild swings in pension funds’ reported funded status, and therefore prevents wild swings in the amount that actuaries are telling governments they should contribute to pension funds. That helps prevent the need for sudden tax increases or program cuts to accommodate pension funds.

What a smoothed asset value does not do is tell you, accurately, how well-funded a pension system is. Nor does the underlying premise of smoothing (that the sponsoring government can make up for missed payments now with added payments later) apply to Detroit, which is seeking to stop making payments into its pension systems. So, if you’re trying to figure out how large a gap there is in Detroit’s pension funds for the purpose of its bankruptcy, you shouldn’t use a smoothed asset value. Detroit is actually a bigger offender than usual on smoothing, using a seven year period instead of five. That means Detroit’s pension funds still haven’t fully recognized losses from the stock market declines of 2008-9. Orr hasn’t disclosed his smoothing assumption, but it’s likely he’s using true market value for assets, as he should be.

The other controversy regards the pension funds’ liabilities, which are a stream of payments to retirees due in the future. The key question here is, if you owe somebody $100 in ten years, what is your liability today? To calculate this, you apply a “discount rate,” which is like a reverse interest rate, to account for the fact that a payment due in the future is less burdensome than one due now. If you owed $105 in a year and applied a 5 percent discount rate, you would say that your present-value liability is $100. Public employee pension funds typically set their discount rates equal to their expected return on assets. And typically, they have used expected returns in the ballpark of 8 percent. That aligns with this rule of thumb about a pension fund's portfolio: 70 percent invested in equities returning 10 percent a year and 30 percent in fixed income securities returning 4 percent.

The use of such high discount rates even for healthy funds is controversial. Financial economists say that pension funds should actually use discount rates that align with the risk experienced by pensioners. That would mean a discount rate aligned with bond yields, probably in the ballpark of 4 percent or 5 percent. The lower the discount rate, the higher your reported liability, and the more money you need to set aside to cover your promises. When pension funds use a higher discount rate, they assume that equity returns are a free lunch, which they’re not—taxpayers provide valuable insurance of those returns, by agreeing to shore up pension funds which underperform when the economy does badly. The 8 percent discount rate is also controversial because, even if you do believe discount rates should be tied to expected returns, that figure is likely too high. Low inflation and low real interest rates mean that a 4 percent return on a fixed income portfolio is no longer realistic. In the last four years, many pension funds have cut their discount rates into the 7s because of this critique. But Detroit is still using 8 percent and Orr has said he thinks 7 percent would be more appropriate.

In Detroit’s case, any discount rate tied to expected asset returns is inappropriate. That’s because the use of an asset-linked discount rate assumes that the pension fund has an infinite time horizon, and can ride out any temporary market dips with the sponsoring government making additional contributions as necessary. Obviously, Detroit isn’t going to do that. Think of it this way. Let’s say that Detroit’s pension funds were 100 percent funded based on an 8 percent discount rate, and Detroit terminated any further obligations to pensioners, leaving them only with the assets in the fund. Would it be true that the pensioners lost nothing of value? Obviously not. Currently, they have an insurance policy: if the 8 percent return target isn’t met, Detroit taxpayers will backstop their pensions. Losing that insurance policy hurts pensioners.

The only way to make pensioners whole for the loss of the backing guarantee is to give them enough assets to cover all expected pension payments even if the assets are invested in low-risk bonds. To have that much money, you’d have to be 100 percent funded based on a low discount rate, perhaps below 4 percent. All of which is to say, Orr’s figures, if they are based on the 7 percent discount rate he has voiced support for, likely understate the funding gap in Detroit’s pension funds. They clearly don’t overstate it.

My qualified support for Orr's position does not necessarily mean that Detroit’s plan for bankruptcy restructuring allocates resources correctly between bondholders and pensioners, or that it ought to allocate more toward pensioners. Chapter 9 municipal bankruptcy is a much more flexible and arbitrary process than corporate or personal bankruptcies, and there might be good reasons for the city to prioritize some obligations over others. But we shouldn’t conclude that Detroit has made its proposal based on a trumped up claim that its pensions are underfunded. If anything, the city's assumptions are still too aggressive.
The editors of Bloomberg recently published an editorial, Public Pension Shortfalls Are Everyone’s Problem:
The pension liabilities that helped bankrupt Detroit have cast a harsh light on similar problems in Chicago and other large American cities, adding urgency to the question of who should close the shortfall. This is a challenge that public-sector workers and retirees shouldn’t bear on their own.

The public pension problem is by now well known. Detroit’s emergency manager estimates its unfunded liabilities at $3.5 billion, about a fifth of the city’s debt. As of last year, Chicago had funded just 36 percent of its pension obligations, while, as of 2011, Philadelphia had put aside just 50 percent of its promised benefits.

States aren’t doing much better. Thirty-four states failed to make their required pension contributions last year, and nine have set aside less than 60 percent of what’s needed. All told, U.S. state and municipal pensions are underfunded by at least $1 trillion, and perhaps much more.

The twin questions facing policy makers are how to fix the problem and how to apportion the cost among workers, retirees and taxpayers as a whole.
Self-Delusion

First, governments need to stop lying to themselves. Money that’s slated to cover annual pension and health-care fund contributions but is instead siphoned away to cover other costs won’t magically reappear in later budgets. In the future, states and cities should agree only to benefit packages that are based on reasonable rates of return and annual contributions they can actually make -- and then make them.

Many jurisdictions will also have to scale back their past grandiose promises. Given the magnitude of the shortfall, this will have to entail asking public sector employees to accept a new deal, including some combination of working longer, contributing more to their pension and health-care costs, and getting reduced benefits. It may also, as a last resort, require sacrifices by workers who have already retired.

A particularly thorny issue is the future of defined-benefit pensions, which most public sector workers still enjoy but private employers have largely replaced with cheaper defined-contribution plans. Those benefits help governments compete with private employers, which may be able to offer higher wages. They also reflect the power of public-sector unions, which have mostly outlasted their private-sector counterparts.

If governments continue to provide defined-benefit plans, it should be under more stringent conditions, including conservative assumptions about rates of return, larger initial payments and protections against gaming the system. Or, they can scale back gradually to defined-contribution pensions by first adopting hybrid plans, in which lower benefits are topped off with 401(k)-style accounts.
Shared Pain

No matter how gracefully such changes can be accomplished, it won’t be fair to expect workers and retirees to be the only ones to sacrifice. After all, they are not the people who set the unaffordable policies in the first place.

Some jurisdictions will have to help meet their pension obligations by cutting spending elsewhere, finding new revenue or both. Those steps won’t be popular, but this is a shortfall too large to close easily or cheaply.

The lesson of Detroit is that states and cities can’t afford to ignore their obligations forever, and waiting makes things worse.
As I've previously stated, Detroit's cries of betrayal will he heard all over the United States as many local and city governments are grappling with the same issues and their pensions are in terrible shape.

Are we all going to pension hell? I don't think the situation is as dire as the media makes it out to be but there is an urgent need to implement sensible reforms which will include shared sacrifices from all stakeholders -- public sector unions, taxpayers and plan sponsors. Pension promises are only as good as the foundations they are built on. If the assumptions and the governance is all wrong, then those promises are worthless.

What worries me is the politicization of pensions and how ill-informed the public is when it comes to understanding why we need to bolster defined-benefit pensions for everyone, not dismantle them. I'm a huge proponent of large, well-governed defined-benefit plans. I know the benefits of Canada's top ten and I'm convinced that they need to be part of the solution to bolstering our retirement system. Their governance model should be copied elsewhere, especially in the United States.

Finally, the real pension hell will come if we shift everyone to defined-contribution plans and leave them at the mercy of a merciless market. This is a recipe for widespread pension poverty and will place even more pressure on public finances as social welfare costs skyrocket out of control. The sooner we realize that everyone deserves to retire in dignity and security, the better off we'll all be.

Below, Harvey Miller, partner at Weil, Gotshal & Manges, tells Bloomberg Law's Lee Pacchia that Detroit's recently filed Chapter 9 bankruptcy case will not be an easy restructuring. In addition to the profound economic challenges facing the city and the limited ability of a bankruptcy court to force changes on its government, the fundamental tension between bondholders, pensioners and taxpayers could mean Detroit will remain in tangled up in litigation for a long duration of time. "There's going to be a lot of legal fighting in this," he says.