|September 10, 2013
In the wake of Detroit’s unprecedented July bankruptcy filing — making the city the largest in the United States ever to seek bankruptcy protection — an argument over the health of the city’s municipal pension fund for Detroit’s 11,645 public employees has begun. Kevyn Orr, the state-appointed emergency manager for Detroit, has argued that the city’s pension funds are underfunded by $3.5 billion. The Orr camp argues that the fund managers’ methodology in evaluating the fund’s return — namely, not using a rate of return based in reality — significantly underestimate the fund’s future liability.
What that means is this: Detroit never had the cash to pay for its employees’ pensions, despite reporting to the contrary. Under the system set up by the fund managers, the city was contributing too little toward the fund while overestimating the return on the fund’s investments. The fund would never have been able to meet its obligations, especially considering that the city’s tax base has shrunk.
The Orr camp, per a FOIA-released communique published by the Detroit Free Press, felt that depending on the methodology and “sensitivities” embraced, the rate of return should have been acknowledged at 6.3, 7.0 or 7.5 percent — far from the 8.0 percent the fund managers had been operating on.
Detroit is not alone in this. This “conflicting math” represents the growing problem with the nation’s public pension plans. According to a recently published report from State Budget Solutions, the nation’s public pensions are unfunded by 69 percent, leaving a funding gap of $4.1 trillion. Seven states, per the study, have an unfunded level of 70 percent of more — Alaska, Connecticut, Illinois, Kansas, Kentucky, Mississippi and New Hampshire — while the state with the best-funded public pension system — Wisconsin — had an unfunded level of 43 percent.
This translates to a per capita debt liability as high as $32,425 in Alaska and as low as $5,676 in Tennessee. With a total debt amounting to almost a quarter of the national gross domestic product, this means that the national public pension system as it stands now is irrevocably broken. For the approximately 20 million state and municipal employees currently working in the United States as well as those currently drawing a pension, this could mean a collapse in benefits in as little as 12 years.
This markedly conflicts with official reporting. For example, according to the Milliman 100 Pension Funding Index, for the nation’s top 100 defined benefit pension plans in June 2013, the combined market value was $1.359 trillion for a projected benefit obligation of $1.538 trillion. This would make for an unfunded percentage of just 11.7 percent. Milliman projected that the June estimate was the lowest pension deficit in two years.
State Budget Solutions argues that this discrepancy is due to the same type of questionable accounting that ultimately resulted in the Great Recession: liability misrepresentation. As explained by the Economist:
To calculate the cost of pensions, one must use a discount rate on future liabilities. The higher the discount rate, the lower the liabilities appear to be. States and municipalities use the expected return on assets in their pension funds, which they guess to be 7.5%. But this is a strange approach. The liability will still exist even if the expected return is not achieved. If the stock market performs badly, taxpayers will have to make up the shortfall. Pensions are a bond-like liability, so the discount rate should be based on a bond yield. In any case, the states’ assumed investment return is far too high at a time when Treasury bonds yield a piffling 2%.
Public pensions, much like any other rotating fund system (such as bonds or Social Security) rely on current receipts to meet obligations. If the discount rate — the amount of the debt due by the fund’s owners that is actually paid — does not meet the needs of the payout, the fund’s debt grows. By assuming a fixed rate, the fund managers cannot adjust for the ebb and flow of national and international commerce. The fund is like a moored ship in a storm.
To illustrate this, let’s create a hypothetical situation. Let’s say Fund XYZ anticipates a return of 8 percent on its assets. Let’s also say that actual asset values for the fund dropped last year by 12 percent. Fund XYZ will still announce a 8 percent return.
Now, some readers are now probably screaming “shenanigans!” after that last sentence, and they would be right. The way the fund justifies this is by recognizing a 20 percent deviated loss from expected returns over a set amount of time — let’s say five years in this case. So for this year, the fund will recognize a 4 percent gain in assets with a real 12 percent loss, and then will add an additional 4 percent loss over the next four years. By the end of the five years, the 12 percent loss would be fully recorded. But at no time was the fund exposed to the full 12 percent loss all at once.
This is called “actuarial smoothing,” and it’s used to shelter assets from market volatility. However, such tactics also shield assets from everyday realities. Detroit’s pension managers used “smoothed” calculations. A “smoothed” result doesn’t tell the viewer if financial security actually supports the number; now it’s increasingly turning out that these “smoothed” calculations are floating in mid-air.
According to Moody’s, Illinois has the most accumulated liability, at 241 percent of the state’s resources. What this means is that Illinois owes nearly two and a half times the whole of the lifetime earning of its pension fund in promised payouts to its current and future retirees. Connecticut comes in second at 189.7 percent, with Kentucky (140.9 percent), New Jersey (137.2 percent) and Hawaii (132.5 percent) completing the top five. This represents a difficult situation; with a market-value liability of almost $379 billion, Illinois’s state public pension debt is equivalent to more than half of thestate’s gross domestic product.
California has the largest public pension system in the nation, with market-valued liabilities at $1.1 trillion and actuarial assets calculated at $459.5 billion. With an unfunded liability of nearly two-thirds of a trillion dollars, the state finds itself struggling to stay afloat, despite recent talk of a surplus in the state’s budget. California’s problems, in part, were compounded by adjustments to public pension formulas, which for certain classes of employees — such as firefighters and police officers — more than doubled the pension allowances without increasing the reserve. Because of the slow reaction time of large-scale pension systems, the effects of changes would not be felt for years or decades after the shift.
So the pension changes made in the economic expansion of the tech boom are being paid for now, in the wake of the Great Recession. “These numbers indicate the cost of benefits given away a decade ago are finally coming home to roost,” said Dan Pellissier, a pension reform advocate who failed to put a measure to roll back pensions before California voters last year. “We’re finally having to pay the pension piper.”
Public pension increases have been one of the dirtiest and least reported political tricks in the American political system. This is how it works: a politician runs for office, promising relief to state and municipal pensioners by increasing the monthly payment rate. Anyone that points a finger to argue that this is fiscally foolish are yelled down as a naysayer and as being unsympathetic to the poor. The candidate wins the 65-plus vote (which is usually enough to clinch the election), enters office and increases the disbursement rate, as promised. As the discount rate is fixed, this increase in disbursement does not raise the government’s payment into the fund, meaning that the repercussions of the politician’s actions will not be felt until the fund runs out of money many years (and hopefully, a new administration) later, or — optimistically — the fund recovers under a period of economic expansion.
This places the burden squarely on the shoulders of the current and future retirees. As lifespans increase and as the relative health of the nation’s senior population improves, the natural strain of the nation’s public pension funds would have made funding problematic even without any artificial manipulation. As an increasing number of communities go bankrupt, are forced to make extreme cuts to promised benefit cuts or are struggling to balance budgets in light of credit rating downgrades, ballooning interest payments and a shrinking revenue base, the realization that most Americans are not aware of the extent of the public pension crisis bears ill winds for the financial health and security for millions of Americans.
As argued by Salon’s Adam J. Levitin,
There is no federal insurance for public sector pensions. The lack of an insurance safety net for public sector pensions was based on the assumption that public sector pensions were sacrosanct. The logic was simple: Outside of bankruptcy, the Contracts Clause of the federal Constitution and frequently state constitutional provisions or other state laws prohibit municipalities from reducing their pension obligations, and real municipalities never filed for bankruptcy. Ergo, municipal pensions were safe.
As this assumption is put into question, the unique vulnerability of municipal pensioners becomes clear. Absent special protection in state law, pensioners are already behind most other creditors in municipal bankruptcies. Banks that enter into derivatives transactions with cities, such as interest rate swaps, get paid first. Then come most of the bondholders. Most bondholders hold so-called revenue bonds rather than “general obligation bonds.” Detroit, for example, has $6.4 billion in revenue bonds outstanding, but only $650 million in general obligation bonds. These revenue bonds give bondholders first dibs on particular municipal revenue streams, such as tolls or sewage taxes … Pensioners have to compete with general obligation bondholders for repayment after the swaps and revenue bonds get paid.
In the tug-of-war for votes, public pensions, which affect only a certain portion of the population, tend to be favored for cuts rather than universally-opposed tax hikes or reductions of services. This is creating a class of people that will not only have to make due without the financial protection needed for their care in old age, but also who are not being paid their promised compensation for work already done.
As it stands now, the nation’s public pension system will collapse under its own weight eventually. While there are no magical cures that can save the system overnight, economists have recommended some “fixes.”
One is simple: the industry has to use the same system of valuation and same minimum funding levels. Currently, every public fund is free to evaluate its assets as it pleases and there are no federal regulators that ensure the numbers add up. In July, New York state’s superintendent of financial services announced an examination of New York City’s pension plans — the first time a state official actually looked at the city’s municipal pensions. The office has also conducted audits of the state’s pensions, not because wrongdoing is expected but because a full inspection hasn’t been carried out recently.
“Detroit’s recent financial difficulties show that rigorous oversight regarding the operations and liabilities of public pension funds are vital to protecting taxpayers and retirees, and fostering a strong business climate,” Superintendent of Financial Services Benjamin Lawsky said, according to a copy of his prepared remarks.
Another proposal, introduced by Joshua Rauh, an assistant professor of finance at the Kellogg School of Management of Northwestern University, would have the federal government issue tax-subsidized bonds to assist in funding pensions for the next 15 years. This would come on the condition that the states receiving assistance must ban the starting or granting of any defined benefit plan for new employees for a minimum of thirty years, must continue to make payments to its existing underfunded plans according to its actuarially required contribution, and must introduce its new workers to Social Security and provide for a properly funded, defined contribution plan.
Regardless of the solution, a remedy must be found quickly. As it stands now, the nation’s failure to keep its promises to those that served it may ultimately mean a long, painful road for everyone.
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