Tuesday, July 24, 2018

Behind the US Public Pension Crisis?

Elizabeth Bauer of Forbes reports, The Public Pension Crisis Is Not The Result Of Legislators' Failure To Fund:
Or, to be more, precise, it's not the primary cause.  Rather, a study by Wirepoints made available on their website yesterday points to a far more troubling cause:  the value of promised benefits has skyrocketed in the years since 2003, both in absolute terms and relative to measures such as those states' GDP growth.

Here is their headline, eye-popping chart:

What's going on?

In some cases, there is a simple answer:  as readers will recall from my prior article, the accounting rules for public pensions differ, depending on whether there's enough future projected assets, including future scheduled contributions, to cover promised pension benefits.  If there is, the plan discloses liabilities based on the expected future returns from those assets.  If not, then for the portion of the benefits which are not even hypothetically funded from planned future contributions, a municipal bond rate is used instead.  This can lead to swings in the liability, based solely on whether the legislature has a future contribution schedule in place -- when, of course, the real pension debt doesn't change whether you have a plan to fund it, any more than a hypothetical balloon mortgage isn't any more or less of a debt depending on how you plan to save up for it.

But this accounting rule is new, with the change being phased in starting in 2015.  Previously, plans could use this expected asset return even if the level of funding was only a trivial sum relative to the overall funding level.  As Bloomberg reported in 2017, Minnesota saw a dramatic increase in its liability, and a decrease in its funded status, as a result of the new accounting standard.

But much of the growth in benefit liability is, in fact, growth in benefits promised. As detailed at Crain's in 2015, the history of Illinois public pensions has been a litany of pension increases. In 1989, the state increased its cost-of-living adjustment from a non-compounded to a compounded basis.

As Crain's reports,
The bill's sponsors, including former Democratic Senate President Emil Jones, never said during floor debate how much that change might cost, once again leaving lawmakers in the dark about what they were voting on. It wound up passing by lopsided margins of 41-12 in the Senate and 108-4 in the House.
Subsequent legislation increased benefit formulas for "regular formula" state employees and teachers (1998), increased "alternative formula" benefit formulas for state employees and implemented earlier retirement ages for state employees (2001), and provided for early retirement benefit enhancements, described again by Crain's:
In 2002, as it became clear Democrats would retake state government, [former governor George] Ryan signed off on a lucrative exit strategy for thousands of state employees who got their starts under Republican administrations.

Ryan declined an interview request from Crain's. His plan, touted as a way to avoid nearly 7,000 layoffs, gave state workers and downstate and suburban teachers the option of speeding up their retirements by buying age and service credits needed to qualify for a pension.

Initial forecasts by the nonpartisan Illinois Pension Laws Commission estimated that 7,365 people would take advantage of the plan at a cost to the pension systems of $543 million over 10 years. . . .

The offer of full pension benefits to retirees as young as 50 proved so enticing that some state workers took out home-equity loans to generate enough money to gain eligibility. All told, 11,039 employees took the offer, a CGFA analysis in 2006 showed. That increased the liability to the state pension systems to $2.3 billion.
It's a pattern that is repeated over and over again: legislators using pension benefits as a form of "free money" to give away without the immediate and tangible financial consequences that would arise if they gave the affected employees pay raises.

Another state on this chart of most dramatic increases, New Hampshire, again, has a similar list of benefit increases over time, from multipliers and early retirement eligibility made more generous in 1974, to the use of asset gains in good years to fund cost of living adjustments, rather than reserve for lean years (1983), as well as expansions in medical subsidies, spouse's benefits, and a special program allowing for voluntary savings with generous interest crediting.

(Nevada appears to be something of an exception, since the benefits, while exceptionally generous, have been only modestly enhanced in recent years.  To what extent their growth in benefit liability is a long-term consequence of its earlier explosive population growth, from 800,000 in 1980 to 3 million now, requires some further math.)

Yes, reports on pension contribution holidays, or the "Edgar Ramp" detailed at Crain's, in which the former governor put together a funding plan which amounted to "let future generations pay" are enough to make your blood boil.  But this wouldn't have been avoided, only mitigated, if only shortsighted governors hadn't taken contribution holidays.  Even after reducing benefits for new employees in 2011, the cost of the annual new pension accrual for active employees amounts to 20% of pay in the Illinois Teachers' Retirement System, and 21% for the Illinois State Employees' Retirement System -- and, for the latter system, due to the generous early retirement provisions, the liability for retirees is double that of those still working.

How does your state rank? Take a look at the Wirepoints full 50-state listing to see.
I suggest you all read the study from Wirepoints which is available here.

There is no doubt that far too many states have overpromised, crippling their public pensions. You can click on the image below to see the worst offenders:


Not surprisingly, the public pension crisis is receiving a lot more attention because taxpayers are seeing their property taxes rising and wondering where all that money is going, and when they read to pay bloated public pensions, they understandably get very angry.

Who made these pension promises? Politicians buying union votes, that's who. The same thing happened in Greece where I can tell you of crazy, almost insanely crazy generous public pensions for decades until the debt crisis hit and the pension party came to an abrupt halt.

There are a lot of ubber generous public pensions in the United States because of pension spiking, double-dipping and good old political favors where unions got what they wanted from politicians buying votes.

Add to this folly pension contribution holidays which I would make constitutionally illegal no matter what and you have the makings of a giant public pension crisis just waiting to blow up.

And don't kid yourselves, the pension crisis never really went away. It started after the dot-com blow-up in 2001, got much worse after the 2008 great recession and when the next crisis hits, it's going to expose a lot of chronically underfunded US public pensions for what they really are -- a time bomb waiting to explode or implode.

"But Leo, Google shares are soaring, Facebook shares are making a new 52-week high, the yield curve is steepening, financials like JP Morgan are rallying today, everything looks great."

Who cares? The big party is coming to an end, I warned all of you last week the yield curve is flattening for a reason, global PMIs are weakening, there is a day of reckoning coming and when it strikes, the fallout will last for years, bond yields will hit a new secular low, and many chronically underfunded US public pensions on life support will need a bailout or face collapse.

Luckily, the US can look at the Canadian model and adopt two important components which I discussed in my comment on Pennsylvania's pension furry:
It looks like all hell is breaking loose in Pennsylvania and I will be the first to admit that I was aware something was cooking here as I was approached months ago by a lady consulting the state treasurer telling me they're looking closely at fees being paid out to alternative investment managers at SERS and PSERS.

I put her in touch with a bunch of people I knew in Canada and never heard back from her. I also carefully explained the Canadian pension model to her so she understands that the success is built on two principles:

  1. World-class governance: Allows Canada's pensions to hire top talent across public and private markets and pay them properly. This is why over 70% of the assets are typically managed internally, lowering fees and costs, adding meaningful alpha over benchmark index returns over the long run.
  2. A shared-risk model: This means when pensions run into trouble and there is a deficit, the risk of the plan is shared which in turn means higher contributions, lower benefits or both. Pension plans in Canada with a shared-risk model have adopted conditional inflation protection to partially or fully remove cost-of-living-adjustments for a period until the plan's funded status is fully restored again.
I also explained to her that Canada's large pensions also pay big fees to private equity and real estate funds but they are doing more co-investments to lower overall fees (see my recent comment on PSP upping the dosage of private equity).

But to develop a solid, long-term co-investment program where pensions can invest alongside a GP on larger transactions where they pay no fees, they first have to invest in the traditional funds where they pay big fees and they need to hire qualified people to evaluate co-investment opportunities as they arise.

Still, if done properly, a good co-investment program allows pensions to scale into private equity and maintain target allocations without paying a bundle on fees.

I mention this because I guarantee you very few US public pensions have developed their co-investment program to rival that of Canada's large public pensions which is why they're paying insane fees to their private equity managers per dollars invested in their PE portfolio.
The two most important reasons as to why Canada's large pensions are fully funded are right there, world-class governance which separates governments from pensions allowing public pensions to manage more internally and adopting a shared risk model typically in the form of conditional inflation protection.

Pensions are all about managing assets and liabilities. You can have a "dream team" of investment managers managing assets but if your liabilities soar because rates are dropping and you're overpromising, your pension deficits will soar too.

US public pensions need to 1) get real on their return assumptions, 2) adopt world-class governance to attract top talent to their pensions and manage more internally and last but not least 3) adopt a shared risk model and replace guaranteed inflation protection with conditional inflation protection.

Let public sector unions scream and shout, it doesn't matter, confront them head-on and ask them to present a better solution to sustain their public pensions as more and more people retire with generous benefits.

By the way, politicians should take an ax to these generous benefits once and for all. This is just ridiculous, pensions aren't there to fully replace your average lifetime earnings or in some cases, make them even better in retirement.

On the one hand, public sector unions castigate America's CEOs for their lavish retirement packages and on the other, they defend gross abuses at their own public pensions allowing people to retire with eye-popping $100,000+++ pensions. Totally unacceptable.

That's why when I read a new Connecticut pension group is slated to meet for the first time today to tackle that state's ongoing pension crisis, I say don't bother, read this comment first and get ready to implement some very hard changes which will definitely piss off all your stakeholders.

There are no easy solution folks. The stock market won't save you, the Fed won't save you, Congress won't save you, pension obligation bonds won't save you, only common sense modifications and very hard choices will save your public pensions from ruin.

I know I sound like a broken record but I've been around ten years blogging on pensions so I think I know what I'm talking about. It doesn't matter if you ignore me because when the next crisis hits and stays with us, you're all pretty much screwed and will need to implement major changes to your public pensions.

Below, Thad Calabrese, NYU, and Kuyler Crocker, Tulare County Board of Supervisors, discuss why cities are investing in the market through the issuance of pension bonds.

I keep embedding this clip because I find it depressing that states and local governments are turning to pension obligation bonds to fund their pensions. That's only buying them time, it does nothing to solve the deep-seated structural problems plaguing US public pensions and will only make the situation worse when the next crisis hits.

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