The Big Apple's Pension Hell?
For years, New York City has been dutifully pumping more and more money into its giant pension system for retired city workers.This is an excellent article which lays out the public pension problem plaguing many U.S. cities and states. I want to highlight a few points in the article.
Next year alone, the city will set aside for pensions more than $8 billion, or 11 percent of the budget. That is an increase of more than 12 times from the city’s outlay in 2000, when the payments accounted for less than 2 percent of the budget.
But instead of getting smaller, the city’s pension hole just keeps getting bigger, forcing progressively more significant cutbacks in municipal programs and services every year.
Like pension systems everywhere, New York City’s has been strained by a growing retiree population that is living longer, global market conditions and other factors.
But a close examination of the system’s problems reveals a more glaring issue: Its investment strategy has failed to keep up with its growing costs, hampered by an antiquated and inefficient governing structure that often permits politics to intrude on decisions. The $160 billion system is spread across five separate funds, each with its own board of trustees, all making decisions with further input from consultants and even lawmakers in Albany.
The city’s pension assets have fallen further and further behind its obligations — the amount needed to cover future pension payouts — a troubling trend that could eventually ripple across the entire city budget, but which has so far received little attention under Mayor Bill de Blasio.
Whether he can restore balance to the city’s pension system promises to be one of his biggest challenges, one that will affect not just future generations of workers, but all city residents and taxpayers.
Pension analysts compare the worsening situation in New York to watching someone try to fill a sink when the drain is open. “They’re never going to catch up,” said Sean McShea, president of Ryan Labs, a New York-based asset management firm that works for pension funds and other institutions.
The fallout can be seen in measures of the pension system’s financial health. From 1999 to 2012, for example, the plan for general workers fell to just 63 percent funded from 136 percent.
Last year, Morningstar, the investment research firm, evaluated for the first time the strength of state and local pension systems across the country and rated New York City’s as poor. Only a few major cities’ pension systems garnered such a low rating, said Rachel Barkley, a municipal credit analyst who wrote the report for Morningstar.
Mr. de Blasio, who has appeared less engaged with the city’s pension problems than his predecessor, Mayor Michael R. Bloomberg, is confronting a legacy of costly and questionable decisions going back at least to the years of Mayor Rudolph W. Giuliani, a review by The New York Times found.
Like many public systems, New York has promised irrevocable pension benefits to city workers on the thinking that fund investments would grow enough to cover the cost — but they have not. Its response so far has been to take advantage of a recovering local economy and inject a lot more city money into the pension system quickly — an option not available to declining cities like Detroit, which filed for bankruptcy last year, or a tax-averse state like New Jersey, which has been underfunding its pension system for years.
At the same time, New York has been aggressively chasing higher investment returns, shifting more money into riskier assets, which come with higher fees. Even as the system’s returns have lagged, pension officials have resisted making changes in the oversight structure that many experts believe could lead to improvements.
Complicating matters for Mr. de Blasio, wages and benefits are likely to swell even more in the near future, in line with a new teachers’ union deal that sets a baseline for more than 100 other expired contracts.
All of these factors have made the system acutely dependent on investment income. Yet its investment strategy is subject to the whims of the city’s electoral calendar, changing whenever a new comptroller is elected.
Regulators are now paying closer attention, very aware of the financial crises that have gripped other cities.
Despite state laws calling for regular audits of the city pension system, there has not been one since 2003. Now Benjamin M. Lawsky, the state’s financial services superintendent, appears to be making up for lost time. In November, he subpoenaed about 20 companies that help pension trustees decide how to invest the billions under their control.
Regulators from his office have also been sifting through documents at New York’s pension office, Diane d’Alessandro, executive director of the general workers’ fund, said at a recent meeting of trustees.
Letters accompanying the subpoenas said that “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.”
Clashing Voices
Many cities have one pension plan, or two, separating general workers and uniformed personnel. But New York City has five, covering general workers, the police, firefighters, teachers and other school personnel.
Each fund has its own trustees. The exact makeup for each fund differs, but the mayor, the comptroller and organized labor each have their representatives, and their interests are frequently diametrically opposed.
The boards are fond of personally vetting investment firms — something experts in model boardrooms say they should not be doing. Politics can often intrude. The teachers’ union, for example, keeps a list of investment firms it sees as unacceptable because of their connections to groups that, say, favor charter schools.
Ranji Nagaswami, who served as Mr. Bloomberg’s first chief investment adviser, said that changes in the governing structure — consolidating, professionalizing and depoliticizing the pension boards — could result in “vastly improving outcomes.”
In the existing environment, important questions about cost and sustainability can be broached only with great diplomacy. In 2010, Blackstone Advisory Partners, a private equity firm, found out what can happen otherwise. On a conference call with investors, a company official answered a fiscal question by saying retirement benefits for public workers across the country were excessive. When New York City’s trustees got wind of the comment, they called for Blackstone’s chairman to apologize in person. A few months later, he did, and when that proved insufficient, Blackstone issued a statement saying it opposed “scapegoating public employees.”
When the dust finally settled, Blackstone survived as one of the system’s biggest investors.
New York’s pension system is also the only major governmental system in the country to outsource virtually all of its investment decisions to outside money managers, pension experts said. That inevitably leads to higher investment fees. In 1997, the city’s biggest fund, the New York City Employees’ Retirement System, known as Nycers, spent $17.3 million in investment fees for a $31.7 billion portfolio. By 2010, it was spending $175 million for a $35.4 billion portfolio.
Some have argued the pension system would perform better if it hired its own professionals to manage the money in-house. Fees would drop, and the overall strategy would be more coherent, they contend.
For years, pension officials saw little reason to alter investment strategies or governing, in part because the stock boom of the 1990s made it seem as if they had a winning strategy. Even after the tech crash beginning in 2000, the city’s pension reports relied on an unusual calculation that made the system appear 99 percent funded. When that calculation was disallowed in 2006, Nycers’s reported funding level tumbled to 64 percent. Even then, some economists said the city was still underestimating its total obligation.
As it turns out, Robert C. North Jr., the system’s actuary, had been preparing his own stark projections, buried in annual reports. They are based on fair-market values and reflect what an insurer would charge for annuities designed exactly like the pensions. He estimated last year that Nycers was only 40 percent funded, a figure normally associated with funds in severe distress.
Expectations and Reality
In the complex world of pension math, one number looms larger than the rest: the expected rate of return on investments over the long term.
The higher the assumed rate, the less money the city will be asked to inject in the pension system each year.
In New York, this all-important number is chosen by the State Legislature, with input from the pension boards’ many trustees and the system’s actuary. The temptation is to be overly optimistic, because that makes the whole pension plan look more affordable and, therefore, more politically palatable. The more money the city needs to contribute, the more it becomes a problem for the city budget and the greater the likelihood the costs breed resentment against public employee unions.
But excessive optimism can lead to financial disaster, because regular shortfalls could ultimately leave the city unable to fulfill its required payouts. For years, the investment return expectation was set at 8 percent. In reality, the system’s returns have often fallen well short of that, earning just 2 percent on average from 1999 to 2009, for instance. (The returns have ticked up as the market has risen.)
Yet the pension boards have been reluctant to ask Albany to lower its investment-return assumption, out of concern that it would incite a backlash toward unions and pensions.
Already, the growing sums consumed by the pension funds have forced officials to scrimp on certain programs or abandon them, said Marc La Vorgna, a press secretary during Mr. Bloomberg’s administration. One casualty was the Advantage program, which helped homeless people move out of shelters and into apartments. It was eliminated in the Bloomberg administration.
Nicole Gelinas, a fellow at the conservative Manhattan Institute, cited infrastructure spending as another priority that has been affected. Pension costs are “suffocating our ability to make long-term investments,” she said.
In 2012, the pension trustees asked the State Legislature to lower the system’s long-term investment expectation to 7 percent, at the prodding of Mr. North. Many experts say 7 percent is still too high. But cutting the assumption to 7 percent from 8, along with some other adjustments, was going to cost the city an additional $2.8 billion in contributions in the first year. Mr. North eventually lowered the contributions total to $600 million by spreading the cost over 22 years.
The additional cash will certainly help the pension system, but it will still take years and luck in the markets for the city to close the gap from the years it should have been contributing more.
It is the pursuit of higher returns that has led the trustees, and lawmakers in Albany, to authorize more aggressive, alternative strategies, mirroring a national trend among public pension systems. The approach carries the possibility of a greater upside but also brings greater risks and costlier fees.
“There’s nothing wrong with taking the risk,” Mr. North said. “The risk, however, should be recognized and understood as it is mostly borne by future generations,” people who were not consulted on these decisions.
In New York, private equities — stocks that do not trade on any exchange or have a published price — have become a favored asset class. Private equity investments are typically done through partnerships with specialized firms, which last for several years. Until they run their course, the returns cannot be calculated accurately. The fees are high, and it is not yet clear that the partnerships are delivering consistently higher returns.
In one example, John Murphy, a former executive director of Nycers, the fund for general workers, said he noticed in 2011 that the Allegra Capital Partners IV fund had just come to an end, making a final accounting possible. After long delays, he received data showing that Allegra had lost 8.24 percent per year, on average.
“Nycers invested $24 million and got back $11.66 million,” Mr. Murphy said. “This is clearly an imprudent strategy for a large pension fund.”
Mr. Murphy said that Nycers had lost money in just five years out of the last 30 — all in the 2000s, after the system adopted its private equities program. Out of curiosity, he calculated what the returns might have been if Nycers had continued its strategy of investing solely in publicly traded stocks and high-rated bonds. The answer was: billions of dollars ahead of where it is today.
Low Priorities
The city’s decades-old structure for its pension system almost changed in 2011. Mr. Bloomberg and the comptroller at the time, John C. Liu, bitter rivals, unveiled an ambitious plan to consolidate the five plans.
The aims included hiring professional in-house investors and breaking the link between the pension system and the political calendar. Most of the ideas died, however. Some labor leaders felt that they had not been consulted, and Mr. Liu became hobbled by a federal investigation into his campaign finances.
Now, of course, there is a new mayor and a new comptroller, both of whom have been staunch labor allies. A new chief investment officer started last month, and Mr. North, the system’s actuary for nearly 25 years, is expected to retire this year.
It is unclear whether pensions will be a top priority.
Mr. de Blasio, notably, did not mention the word “pension” during his hourlong budget presentation in May. Mr. Bloomberg, by contrast, raised the issue often and made his final formal speech a stemwinder on pension costs.
In May, Comptroller Scott M. Stringer announced he would try to commit $1 billion to smaller investment firms led by minorities and women, despite research showing that initiatives geared toward emerging firms make it harder to achieve top investment returns.
Mr. North said that Mr. de Blasio’s recent deal with the teachers’ union — and two subsequent deals with health care workers and nurses — would necessitate bigger pension contributions from the city. But precisely how much bigger remains unknown because the contracts are complex.
After Mr. North leaves, it would be easy for New York to tweak key assumptions and lowball its contributions. That would save the city money, but it could wreak havoc on the future. He has urged the trustees to be mindful of the city’s not-so-distant past.
“It’s less than 40 years since we were near bankruptcy,” he said.
First, governance or lack of governance. Why does New York City need five pension plans? Why doesn't it consolidate all these plans, hire professional money managers, pay them properly and have them supervised by an independent investment board which operates at arms-length from the government (ie., the Canadian model).
Second, why are they still sticking with that ridiculous 8% (now 7%) investment bogey which everyone is quickly abandoning? What if 8% (or 7%) is really 0%? Who's going to make up for the shortfall? New York City taxpayers which are already paying some of the highest taxes in the United States?
Third, New York City desperately needs to commission an independent investment and fraud audit of all its pension plans to look into the decision-making process and how much money they've lost gambling big on alternatives. How much money has been plowed into alternative investment managers and what are the net returns of these investments? How much money has been doled in fees to these alternative investment managers?
Also, I suspect fraud and corruption might be present in these city pension plans so it's a good idea to have a team of highly trained certified fraud examiners look into their fraud checklists.
Finally, and most importantly, New York City needs to adopt risk sharing in all their pension plans so that the risks of the plans are equally distributed among the employer and employees. I just finished discussing problems at Ontario's electricity pension plans and discussed why risk sharing is the key to sustaining these plans over the long-run.
Below, the longest-serving chairman of the Securities and Exchange Commission and Bloomberg Radio’s Arthur Levitt reports on the New York City pension fund system on “Market Makers.”
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