Monday, October 16, 2017

Part IV: Public pension plans in crisis: Share the risk or fail

Part IV: Public pension plans in crisis:  Share the risk or fail

When public pensions get to the point where they only have about 60¢ or less to cover $1.00 worth of obligations, the solutions are going to be painful for taxpayers and beneficiaries alike.  That’s the reality of a pension plan that has been allowed to fall so far short of its proper funding.  However, solutions exist that preserve a high proportion of the promises governments have made to their employees and retirees while creating incentives to keep the plans solvent once they’ve undergone reform.  States with deeply troubled plans should look to New Brunswick in Canada and to the Netherlands to find pension plans that have achieved sustainable reforms.  They might also reach out to Pro Bono Public Pensions.  Gordon Hamlin, whose story I told in the first post of this series, has developed a road map that might just put troubled pension plans on the road to recovery. Recently Gordon described the path forward on Kentucky Educational Television.[1]

As I discussed in part three of this series, solutions that put the entire burden on taxpayers or beneficiaries aren’t solutions.  In most instances, the deficit remains and/or government becomes incapable of funding its other vital obligations.

If deeply troubled pensions are to be saved and existing deficits addressed, three perspectives are going to have to change.

Beneficiaries have to agree to more realistic and sustainable pension benefits.  To be clear, I am saying that pensions will have to be somewhat less generous in the future. 

Taxpayers and their political representatives have to accept more realistic assumptions about investment returns and the liability being funded.  Again, so there’s no misunderstanding, taxpayers will be asked to make somewhat higher and more consistent contributions.

Shared risk has to become imbedded in public pension plans.  In other words, both taxpayers and beneficiaries have to bear responsibility when pension plans face challenges and enjoy rewards when they do well.  Without shared risk, pension plans will remain prone to insufficient funding and/or unrealistic benefits, which are the twin causes of instability.

When all the constituencies finally decide to solve the problem, public employees and retirees are going to have to accept some combination of longer working careers and more realistic retirement ages before drawing benefits.  In many public pension systems, beneficiaries can retire long before traditional retirement age.  Moreover, they have been living longer and therefore drawing substantially more benefits.

All too many public plans have automatic COLAs, which have continued to escalate the liability in deeply troubled pension plans.    COLAs do not have to disappear entirely, but they should be paid if and only if pension plans can afford the payments.

The traditional back-end loaded salary formula that drives retirement benefits will have to be modified to a formula that creates a more realistic average salary.   This is especially important for the highest paid positions in public pension systems.

The discount rate, which drives the assumed rate of return and discounts the pension’s liability, needs to be calculated at a more realistic level of 4.5% to 5.0%.  Most pension plans use discount rates that encourage excessive risk taking with the assets while grossly understating the liabilities.  This change will necessitate higher contributions by taxpayers, offset by the reforms already described in the previous paragraphs.

Politicians, beneficiaries, and trustees need to agree to a set of risk-sharing rules by which employer and employee contribution rates as well as benefits are adjusted depending on the financial condition of the pension plan.  If the plan’s funding falls below specified levels, contributions must increase and in certain cases benefits may have to be pared (with a guaranteed floor).  If benefits are reduced, priority should be given to restoring benefits before contributions are reduced.  Conversely if a plan performs well the same sorts of formulae should allow contributions to be reduced and/or COLAs to be paid.

To achieve a workable model all the stakeholders have to have a seat at the negotiating table.  Any one party trying to dictate a solution will probably be stymied by legislative intransigence or court challenges.  The stakeholders will have to jointly hire lawyers and actuaries to advise them.  If each side relies exclusively on its own experts it will be near impossible for the parties to agree on the financial impact of the reforms or the legal strategy for implementing those reforms.

The stakeholders will have to agree on a series of transition steps that bring about reforms over time.  Whether it’s raising the retirement age or changing the discount rate, change will have to be implemented in steps.   Public pension plans didn’t get in trouble in one or two years, and they won’t be restored to health quickly either.

If politicians, employees, retirees, and trustees can’t reach a sustainable solution for deeply troubled pension plans, states, municipalities, school districts, and all the other public entities with pension obligations will inflict major damage on their economies and the people they serve.   Shared risk or fail: those are the choices.


Thursday, October 12, 2017

Part III: Misconceptions and about the Pension Crisis and Solutions

Part III: Misconceptions and about the Pension Crisis and Solutions

Over the past several years all sorts of proposals have been made to solve the public pension crisis.  Many of these ideas have the benefit of being simple while creating the appearance of solving the problem.  Unfortunately they don’t address the pension deficit in any meaningful way.

Converting current and/or new public employees to a 401(K) solves the pension crisis. 

This is the preferred solution of free market conservatives and libertarians.  It’s galling that economically sophisticated advocates would propose a solution that is economic nonsense.  Shifting public employees to a 401(K) doesn’t do anything to reduce the unfunded liability.  The liability already exists and will require employer funding.   Government will still have to make contributions to retire the liability while simultaneously making matching payments to employee 401(K)s.   The 401(K) is simply a risk-shifting mechanism that puts the entire onus for funding retirement on the public employee.  Moreover, the 401(K) provides far less retirement security for the most vulnerable public employees, those toward the average and bottom end of the pay scale. 

Raising contributions to whatever level is required to fund the pension solves the crisis.

This is the preferred solution of retirees and many employee groups and understandably so.   The majority of retirees don’t have any realistic opportunities to increase their income.  While deeply troubled pension plans are unsustainable, retirees argue that the shortfall or insolvency is someone else’s problem to solve.  I know this is a hugely unpopular statement to make, but in the most seriously imperiled plans the retirees are going to lose part of their benefit.  Even worse, retirees will incur greater harm as time passes without a real solution.  In stark terms the pension crisis is merely a bankruptcy that has yet to be filed.  There’s still enough cash to pay benefits for a while, but these plans are economically bankrupt.  In fact the most poorly funded pension plans are so troubled that the taxes and fees that would be needed to dig out of the deficit would badly impair the ability of governments to provide other vital government services. 

Attract a lot more public employees, whose contributions to the pension plan would solve the problem.

Many public pension advocates have lamented that fewer and fewer current employees are “supporting” retirees.   They believe that public pension plans would be stable if there were many more contributions being made on behalf of young employees.  Most pension plans have aging populations, but even if they didn’t it wouldn’t solve the problem.  While more cash would come into the plan to pay current benefits, the long-term pension obligation would be growing to account for those additional employees, and that obligations would have to be funded as well as the existing liability.    It’s important to note here that public pensions aren’t “pay-as-you-go” plans in which each year’s contributions are used to pay benefits.

A maturing pension plan isn’t an existential problem if an aging plan is properly managed over time.  If contributions and investment practices are adjusted as the demographics change, a pension can remain stable.  As I discussed yesterday, those adjustments have not been made quickly enough for many plans.

The beneficiaries of reasonably funded plans have nothing to worry about.

While a decently funded plan doesn’t present any immediate worries to its beneficiaries, these plans are also prone to trouble in the long run.  Many of these plans are all too willing to maintain unreasonably optimistic investment assumptions, and they carry flawed actuarial assumptions that are hiding the true extent of the liability.  They are governed by boards who are too willing to enlarge benefits or retirement formulae without proper funding. Many pensions in states where politicians with very short time horizons aren’t inclined to fund long-term responsibilities.  In other words, the same sins committed in the worst-funded plans have yet to surface in better-funded plans.  Far-sighted politicians, trustees, employee associations, and retiree representatives would insist on immediate reforms.  However, it’s not going to happen.  There’s virtually no evidence that pensions will be reformed before they reach a state of crisis.

Tomorrow we will look at reforms that would address the pension crisis.

Wednesday, October 11, 2017

Part II: Public pension beneficiaries have reason to be angry, but anger won’t solve the pension crisis

Part II: Public pension beneficiaries have reason to be angry, but anger won’t solve the pension crisis

Public pensions are short $3.5 trillion to $4 trillion in assets required to fund the estimated long-term cost of paying beneficiaries their future benefits.    That’s a big number, but it’s very misleading.  The coverall figure includes many public pensions that can address any deficit with a moderate set of reforms and consistent funding and have plenty of time to close funding gaps and meet their promises to public employees and retirees.  However, there are about dozen large plans and many smaller plans that are so woefully underfunded that they no longer have the time or financial resources to bring their plans into balance without major reforms.  As these deeply troubled plans continue to pay benefits for retirees, they are virtually guaranteeing that today’s working public servants will get not getting anything close to a decent pension, and some retirees will lose a substantial amount of their benefits. 

In many of the most troubled states, beneficiaries are clinging to the hope that state constitutional protections will force legislatures and local governments to put in whatever funds are necessary to pay benefits.  However, state constitutions won’t save pension plans from fundamental reforms.  Rather, the constitutional provisions allow sufficient protection and negotiating leverage for beneficiaries to preserve a substantial portion of their pension benefits.  However, they must be prepared to negotiate.

Retirees and public employees have every right to be angry.  Legislators, actuaries, money managers, and pension trustees have been terrible stewards of public pension assets.  Over the years they’ve fiddled with the accounting standards to artificially shrink the long-term liability and, at times, limit funding obligations.  They’ve used unrealistically high investment assumptions so that the “magic” of the financial markets would painlessly fund pension plans, while grossly understating the liabilities.  And the money managers hired to achieve those “magic” returns failed to achieve those lofty targets.   Meanwhile trustees and legislators have tweaked the rules to allow some of the best compensated and most politically connected public employees to earn enhanced benefits at the expense of all of the other members.  There’s plenty of blame to spread across generations of politicians, investment professionals, and employee representations.  Yet assigning blame won’t solve the problem.

Moreover, a complete picture of the problem requires an admission that a significant part of the problem is due to modeling mistakes.  A pension plan is a complex series of cash flows spaced out over decades; funds come in from contributions and investment earnings, and they flow out as benefits are paid.  Those cash flows have to be estimated far into the future in order to figure out how much the employer and employee need to contribute each year to keep the pension functioning over the ensuing years.   The contributions are driven by financial models that are, in turn, dependent on a series of assumption, such as a payroll, salary increases, employee turn over, retirements, benefits, COLAs, age, and mortality. 

If a pension is out of balance and has an unfunded liability, no one expects employers or employees to contribute a huge lump sum in a single year to make up the shortfall.  Huge lump sum payments would create fiscal havoc.  Instead, pension plans are allowed to amortize the unfunded liability.  In other words, the necessary contributions are staggered over many years.  Unfortunately, the amortization periods have been lengthening over time as politicians and trustees tried to shrink the annual payments required to eliminate the unfunded liability.  Instead of making progress, many public pensions have fallen deeper into deficit.

Not surprisingly, many of the assumptions that drive pension math have turned out to be wrong (which isn’t unusual in any financial model) and haven’t been corrected.  These mistakes have added to the pension crisis.  Here’s where politics re-enters the picture.  In all too many states, political pressure on trustees and politicians has allowed modeling errors to persist, fester, and drive pension deficits to unmanageable levels.

Before looking at what a real reform plan might look like, we need to spend time examining proposed solutions that aren’t really solutions.   That’s tomorrow’s mission.

Tuesday, October 10, 2017

The road of broken promises ends here: Pro Bono Public Pensions

The road of broken promises ends here: Pro Bono Public Pensions

Some of America’s public pensions are in deep trouble.  Over the years I’ve written about them while pointing out the mistakes that led them to the edge of the abyss.   I’ve also critiqued various “reform” efforts that purported to address the problem but either left beneficiaries at enormous risk or taxpayers with a huge long-term liability. 

In many ways I’ve been as remiss as the pension professionals, public employee associations, actuaries, and politicians.  I haven’t been willing to propound a solution to the problem.  Why?  It’s very messy.  A solution to the pension crisis in states like Illinois, Kentucky, or Connecticut won’t come easily.  There isn’t one step that suddenly creates enough revenue, investment returns, or assets to fund the state’s pension obligations.   Moreover, there isn’t a solution that will be entirely satisfactory to any one constituency.   A real solution to the pension crisis is going to anger taxpayers, retirees, current public employees, and my old profession, money management – although money managers won’t actually suffer.

You probably don’t know Gordon Hamlin, and you might not think that a retired partner of a very fine Atlanta law firm would have answers to the pension crisis.  Gordon didn’t just retire from legal practice.   He set about studying the pension crisis in detail.  As a 2016 Fellow in Harvard’s Advanced Leadership Initiative he poured over every conceivable aspect of the problem from the arcane accounting practices to the complex legal issues.  He also dug deeply into a reform model that has been implemented in the province of New Brunswick, Canada and whose principles have been applied in the Netherlands.  Gordon concluded that the model in New Brunswick is a way forward because it equitably shares the risk of a traditional defined benefit plan between taxpayers and beneficiaries. I agree.

After speaking on the phone with Gordon numerous times and reading all sorts of briefs and presentations that Gordon sent my way, I finally agreed to let him buy me a sandwich.  Over a BLT and bag of chips, Gordon told me about Pro Bono Public Pensions, a non-profit he’d created to work with states to solve their pension problem.  Gordon’s business model has a unique attribute that separates it from any other expert, consultant, or organization that offers professional services or advice.  Pro Bono Public Pensions won’t accept a fee for its services.  At the end of our lunch, Gordon asked me to join the board of Pro Bono Public Pensions.

Over four decades I’ve listened to all sorts of business propositions, and I’ve never encountered a business plan quite like Gordon’s.  However, I also hadn’t met anyone so willing to confront the pension liability problem as honestly and energetically.    Moreover, I admired Gordon for his willingness to attack the pension liability problem in the states where it is most dire and where the politics are correspondingly difficult.

I didn’t agree to join the board immediately, but within a few days I decided I should lend my support.  Pro Bono Public Pensions is a worthy effort, and Gordon’s approach is the way forward for addressing public pension plans crisis.

In the next couple of days I want to discuss some of the failed and bogus efforts at public pension reform.  Borrowing heavily from Gordon’s work I want to lay out the case for a shared risk model.   Finally, I want to focus on his efforts in Kentucky, where all the relevant parties know they have a pension crisis on their hands, but the answers don’t come easily.

Tuesday, October 3, 2017

A letter to core supporters of the President

A letter to core supporters of the President

I’m not sure I can break through my bubble to reach Trump supporters and if this note reaches you, it may insult as you as well.    However, I think there are a number of you (as well as Trump opponents) who are in the process of being conned. 

Many of you have little use for a person like me.  I’m an aging white, overly educated, progressive living in a liberal enclave.  I have the financial resources and security that makes it easy for me to dismiss any real or alleged threats from immigrants, technological innovation, or international trade.  After all, I’m living in relative security. 

We share a love for this country, deep concern for our family and friends, and skepticism about the motives of our political leaders. 

Most of us, wherever we live or how much money we have, have been the victim of a high-pressure sales pitch.  Whether it’s shopping for a car, trying to get the cheapest cable television plan, consider a vacation time share, or purchase insurance, you’ve undoubtedly endured the same type of sales pitch as I have over the years.  You’ve heard the confident salesman who says:

Believe me, this is the best deal I can offer you if you are willing to do business with me today.  I know you like this car.  And look, and I shouldn’t be saying this, but we’re not going to make any money on this deal. I’m doing this because I know that you really need this.  So here’s what I’m going to do . . .

Three months later, you’ve got a bit of buyer’s remorse.  The car, cable plan, time share, or insurance plan isn’t exactly what you signed up for and the monthly payments are a lot more than you expected.  As American consumers we’ve all experienced this.

The president’s tax plan is a high-pressure sales pitch.  Here’s what Mr. Trump said in introducing the plan in Indianapolis:

We’re doing everything we can to reduce the tax burden on you and your family.  By eliminating tax breaks and loopholes, we will ensure that the benefits are focused on the middle class, the working men and women, not the highest-income earners.

Our framework includes our explicit commitment that tax reform will protect low-income and middle-income households, not the wealthy and well-connected.  They can call me all they want.  It’s not going to help.  I’m doing the right thing, and it’s not good for me.  Believe me.

Doesn’t it sound like the salesman trying to distract you with a rapid-fire monologue about the bells and whistles of a truck?  Before you’ve had time to consider the full financial implications of the transaction, you are sitting down with the credit guy signing up for lease or loan payments.
In many cases the truck is a far better deal than the President’s tax proposal.  True, you might have overpaid, you might have bought more features than you need, and you might have bought a truck that you don’t need quite yet, but at least you got something real.

To be fair, the President’s tax bill may put a couple hundred dollars in your pocket.  The increase in the standard deduction and the child and new dependent tax credit could lower your tax bill.  However, by the time the well-to-do (and that includes lots of Trump opponents) get their lower tax bracket on income, large decrease in their business tax rate, and elimination of all federal estate taxes, the folks who get their income from regular jobs and file 1040-EZ are going to be on the hook for even a higher proportion of federal spending.

I’m not asking you to reject President Trump.  He won your vote and he won the election. If you and I can’t unite in opposing this tax bill, we are both going to be hugely disappointed and bitter and our political leaders will probably incite us to become even more hostile toward one another.   I am begging you to resist the con job that is this tax bill.  

When we can stop this bill, may be we could grab a couple of beers and talk.