The Public Pension Problem?

The New York Times invited six contributors, including yours truly, to debate The Public Pension Problem:
It’s been a bad week for public workers. On Tuesday, in a ruling that has implications for other cities, a federal judge ruled that Detroit’s public employee pensions are not protected in a federal Chapter 9 bankruptcy. On that same day, the Illinois legislature passed a deal trimming retiree benefits and increasing state contributions, providing a template for other states to follow.
Amid all this, is the continuing refrain that Wall Street fat cats are responsible for “looting the pension funds.” Are government retirees being forced to pay for pension fund problems caused by bad investments? If so, what’s the solution?
Let me begin by thanking Susan Ellingwood, opinion editor at The New York Times, for inviting me to contribute my thoughts. She also did a great job editing my comment and finding the contributors.

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The six contributors discussing this topic are:
Ms. Gelinas writes, Wall Street Isn’t the Problem, Benefits Are:
As states and cities from California to Illinois to New York start to take public-sector pension costs seriously, defenders of generous benefits have taken up a new argument for keeping things as they are. They say that the problem isn’t guaranteed pensions and early-retirement ages. Rather, the problem is Wall Street. Public-pension fund fees are too high, and sucking money from retirees, they say. They’re right that is a problem – but it is not the main problem.

Earlier this week, a coalition of labor unions and civil-rights groups teamed up with Occupy Wall Street to point out that New York City pays far too much in public-pension fund fees. Their report notes that New York City’s public pension plans, which control $200.4 billion in assets, now pay $472.5 million in fees to money-management firms annually. They say that’s way too much.

That’s true – and it’s not news. Last year, I reported that the fees New York State pays also top half a billion dollars, up 54 percent from half a decade ago. Fees have gone up in fact because the state – along with other public-sector entities – has put more and more of public-pension fund assets into expensive investments run by hedge funds and private-equity funds. These deals aren’t only expenses. They pose other dangers, including opacity – it hard to know how much an investment in a hedge fund is worth, as it doesn’t trade publicly like a stock – as well as corruption.

But a much-need rethink in how New York City or State spends pension money won’t fix the problem.

Consider New York City again. Say the city cut the fees it pays by 60 percent – for a nearly $300 million savings. That’s something – but the city will spend $8.2 billion this year on pension contributions, and $8.5 billion a year by the mid-point of Mayor Bill de Blasio’s inaugural term.

The city must pay so much not largely because fees are so high, but because its pension benefits simply don’t make sense as people worldwide expect both to live and work longer.

A newly hired police officer, for example, can retire after 22 years with half-pay (often higher with disabilities). City taxpayers must support this retired officer or his surviving spouse likely for longer than the officer worked. Last year, the NYPD had more than 12,096 retirees younger than 55, making an average of nearly $43,000 in pension benefits. The city now pays more in public-safety benefits than in wages and salaries.

New York – and other municipalities as well as states – should certainly rein in payments to Wall Street. But eventually, it’s still going to have to rein in retirement benefits, too.
Dean Baker writes, Pay Retirees What They’ve Earned:
Cutting pension benefits amounts to taking away pay from workers after they already put in their work. If governments feel the need to take property, they should look for wealthy victims. But, of course, the Wall Street folks who bear much of the blame for the problem seem likely to get away unscathed.

Much of the underfunding dates to the 1990s stock bubble, when many pension managers made minimal contributions because the stock market run-up was financing their funds for them. The bond-rating agencies green-lighted this practice, effectively assuming the bubble would grow ever larger. (Some of us knew better.) Wall Street types engorged themselves on fees from these funds, taking money that could be used to pay retirees.

Once governments got in the habit of not making contributions, they found it hard to break when the bubble burst. Illinois and Chicago went a decade without making required contributions. The collapse of the housing bubble devastated state and local revenue, while increasing expenses, making the obligations harder to meet.

Still, in most cases, the unfunded liabilities are not nearly as large as has often been claimed and can still be met. For example, I've calculated that Chicago’s unfunded liabilities are around 0.6 percent of the value of future income over the next 30 years.The figure is comparable for the state of Illinois. These sums are hardly trivial, but presenting them in this light is not as scary as simply reporting that tens of billions of dollars are owed, as those pushing cuts are prone to do.

Taking care of these obligations could mean some increase in taxes, which is inconvenient, but this is money owed. As with the federal debt ceiling, another source of scare mongering, the place to deal with the problem is when the commitments are being made, not when it is time to pay up.

In the case of Detroit, there will be no choice but to have the state intervene as it already has in appointing a city manager. The city is a creation of the state. Under its constitution, which requires pensions be paid, it is difficult to see how the Michigan can avoid taking responsibility and paying the pension obligations.

The crucial point is that employees worked for these pensions. They are not a gift from the government; they were part of their pay package. Governments are not looking to seize properties that may have been sold at too low a price or to reclaim tax breaks and incentives to sports teams and other businesses that may have been too generous. Why do so many people on the political arena think it’s a good idea to take back the money that workers have already earned?

That says a great deal about politics in America today.
Eileen Norcross writes, A Reality Check on the Pension Crisis:
Judge Steven Rhodes’ ruling that Detroit may reduce pensions under Chapter 9 bankruptcy now means that all parties must face a hard mathematical reality with consequences for real people: The city cannot afford to pay the benefits it has promised.

Detroit’s unfunded pension liabilities are immense, at over $9 billion on a risk-free (guaranteed-to-be-paid) basis. Unfortunately, they were valued and funded incorrectly. For years, the city assumed it would earn 8 percent annually on plan assets, an uncertain expectation that did not match the certainty of pension payments.

This “asset-liability mismatch” means the plan took a gamble that didn’t pay off. Accounting tricks during boom years made the fund look flush giving the city the impression it could dole out "13th checks" for some employees.

Former Mayor Kwame Kilpatrick also engaged in “fancy financing” using pension bonds financed with interest rate swaps resulting in a $1.44 billion debt.

How does Detroit restructure public sector retirement in a “fair and equitable” manner for retirees and workers?

1. Stop the bleeding and close the defined-benefit system. Every day the defined-benefit plan is open, the liability grows.

2. Transition younger workers into a defined-contribution or private-annuity plan. They have more time to plan for retirement. Give them ownership over their retirement contributions.

3. Accurately value defined-benefit plans according to the likelihood of payment.

4. Invest the assets in a liability-matching portfolio. Do not rely on uncertain and volatile asset returns.

5. Current workers who have accrued benefits in the defined-benefit system should face higher retirement ages to collect full benefits.

6. Current retirees should bear the smallest burden. If it is necessary to trim their benefits, adjust future payments through cost of living adjustments, rather than cutting current payments.

Detroit’s story is a lesson for union leadership and for other cities. Accounting fiction and financial escapades produce the worst-case scenario for workers, retirees and residents. Toss the political rhetoric and face the real numbers before it’s too late: It’s the only way to ensure economic justice and retirement security for public-sector workers.
Connie M. Razza writes, Bring Financial Managers in House:
This past year, investment management fees on New York City pensions increased 28 percent. Over the past seven years, they have more than doubled to $472.5 million annually. The city pays very high fees even in years when the funds lose value.

These fees unduly burden the funds and add to the uncertainty with which our city's retired and current employees face the future. The rapid rise in pension fund fees is just one of many symptoms of our badly broken financial system, which fails to serve the broader economy and promote general prosperity. Instead, it promotes and exacerbates inequality.

As part of the New Day New York Coalition, the Center for Popular Democracy has proposed a sweeping solution. New York should create a highly skilled in-house financial management team for pension fund assets. Even with salaries high enough to attract top quality managers, the city would not pay the typical "2 percent of assets under management, plus 20 percent of profits" that hedge funds, private-equity firms and real-estate firms typically charge. The profit motive of in-house managers will be fully aligned with city employees and they will be better situated to ensure that investments are financially responsible, contributing to our broader economy and to the funds' bottom line. The creation of the in-house financial team would save the pension funds hundreds of millions of dollars a year.

As significant a change as this would be, it is an idea that the city's former chief investment officer has advocated, and that incoming city comptroller Scott Stringer has expressed interest in. Also, pension funds in Alaska, California, Wisconsin and Ontario, Canada, already do this, to varying degrees. All of these funds also rely on outside managers for some of their investments, but insourcing much of the pension investment management would give the city funds meaningful leverage when working with outside management firms.

Building an internal capacity to manage the pension fund assets of city workers is an important step toward rebalancing the city's relationship with Wall Street.
Andrew G. Biggs writes, Pension Cuts Must Be on the Table:
Public employee pensions pose increasing risks to state and local budgets. Pensions are bigger, and their investments riskier, than ever before. Both costs and risks must be brought under control. Modest benefit reductions, particularly for better-off retirees, should be on the table. This shouldn’t mean open season on public employees. But nationwide, public pensions are underfunded by $4 trillion or more, a figure that exceeds the explicit debt owed by cities and states. Many financially beleaguered cities are pushing the limits of “service insolvency,” in which rising pension and health costs force unacceptable reductions in basic services.

It’s easy to point to low average benefits for public employees, but these averages include workers who spent only a few years in government employment. In reality, public employee pensions are typically much – I repeat, much – more generous than those paid in the private sector. For instance, a full-career Detroit city employee would receive a traditional “defined-benefit” pension equal to two-thirds his final salary, for which he contributed nothing. Detroit workers could voluntarily contribute to a 401(k)-styled “defined-contribution” plan, on which the city guaranteed 7.9 percent annual returns even in bad times. In good times, both the defined-benefit and defined-contribution pensions received bonus payments. Add in Social Security, and it’s possible to earn more while retired than while working. It’s hard to argue that the typical Detroit taxpayer is doing as well.

The vast majority of public pension benefits owed should, and will, be paid. But in bankruptcy, nothing should be off the table. More important, cities and states need the right, which is taken for granted in the private sector, to alter the rate at which public employees earn future benefits. Reforms also should include greater risk-sharing between employers and employees. Wisconsin, for instance, bases cost of living adjustments, or COLAs, on plan performance, while Nevada splits all required contributions evenly between workers and the government. As unfortunate as Detroit’s circumstances may be, they start a conversation on how to make public pensions equitable and sustainable.
Finally, I write that Independent, Qualified Investment Boards Are Needed:
The main driver of public pension deficits isn't the financial crisis, it's decades of fiscal mismanagement. For years states willfully ignored their pension payments, borrowing money from public pension plans to create the illusion that they were balancing their budget every year.

To keep contributions down, stakeholders of public pension plans, including unions, deluded themselves into believing the pension rate-of-return fantasy -- a fantasy because it is based on the erroneous assumption that public pension funds will be able to attain their 8 percent investment bogey over a sustained period. With interest rates at historic lows, it's clear that discounting future liabilities using such rosy investment assumptions will only make matters worse.

These ridiculous investment targets have led to an even bigger problem, excessive risk taking among U.S. public pension funds that have allocated a large portion of their assets into alternative investments like private equity, real estate and hedge funds. In some cases, this approach is warranted and successful but in most cases, U.S. public pension funds are wasting billions in fees praying for an alternatives miracle that will never happen.

The legislative response to public pension deficits is predictable and shortsighted. Some reforms, like raising the retirement age and using career average earnings for determining pension benefits, are necessary as people are living longer.

Other reforms, however, are silly and promote long held myths on public pensions. In particular, shifting public sector workers into defined-contribution plans shifts retirement risk entirely onto workers, ensuring more pension poverty down the road.

Legislators need to understand that defined-benefit plans are superior to defined-contribution plans, and they must take measures to maintain public pensions and expand defined-benefit coverage to private sector workers. This will actually help reduce fiscal debt in the long-run as retirees earning predictable benefits will spend more money and pay higher taxes.

But there is a caveat to all this. U.S. pension reforms need to incorporate the shared risk model that has worked so well in the Netherlands. This way workers, retirees and plan sponsors will share the risk of the pension plan. Moreover, U.S. pension funds need to incorporate the same governance model that has allowed Canadian public pension funds to flourish. This means adopting independent investment boards that operate at arms-length from the government and compensating public pension fund managers more in line with what private sector fund managers receive.

Until U.S. public plans get the governance right by implementing independent and qualified investment boards and compensating their public pension fund managers properly, all other reforms are cosmetic and do nothing to slay the pension dragon.
Once more, I thank Susan Ellingwood, opinion editor at The New York Times, for inviting me to contribute my thoughts on this important topic.

If you want to add your thoughts, feel free to do so directly on The New York Times site after each comment. All you need to do is register.

Alternatively, if any of the experts that routinely read my blog want to add their comments here, just email me (LKolivakis@gmail.com) and I will edit this comment over the weekend to add a postscript.

Below, Fox Business New's Jeff Flock reports on how Detroit's chapter 9 bankruptcy ruling could impact public pensions across the United States.

Sadly, Detroit's cries of betrayal will be heard all over the U.S., including in Illinois, and even in Canada and elsewhere. The public pension problem is real but hardly insurmountable. It's time to implement sensible reforms, especially reforms on governance.  

Postscript: Please read my follow-up comment, More on the Public Pension Problem.