public employee pensions

The Politics of Public Pension Underfunding

by Ivan Osorio on May 23, 2011

in Economy, Employment, Labor

To date, the debate over public pensions has focused largely on accounting methods — how best to estimate the level of current funding needed to pay pension funds’ future obligations. That issue is crucial, but in the context of public policy, it needs to be understood in light of the political incentives that affect pensions.

It was good to see that topic discussed today at a panel debate on the underfunding of public pensions. The event, co-sponsored by the Manhattan Institute and the recently founded think tank E21 and held at the National Press Club, centered on the question of whether public pensions are in “crisis.” Andrew Biggs of the American Enterprise Institute and Josh Barro of the Manhattan Institute argued for the crisis scenario. Arguing the opposite case were Dean Baker of the Center for Economic and Policy Research and Elizabeth McNichol of the Center for Budget and Policy Priorities.

Interestingly, no one on the panel argued that public employee pensions face no problems at all. Baker and McNichol simply argued that the problems have been overstated and are relatively easily manageable. Yet this seemingly modest concession is significant.

During a discussion over compensation, everyone on the panel seemed to agree that back-loading of benefits — making them come due far in the future — is a problem. That creates a perverse incentive to shift costs onto future taxpayers, as Barro rightly noted.  Future taxpayers simply don’t have political clout today. Thus, the same public choice diffuse costs/concentrated benefits dynamic — which incentivizes politicians to transfer wealth from those who complain the least to those rent-seekers that lobbies the hardest — appears to create a ratchet effect toward ever increasing present-day benefits and unfunded future liabilities, when applied across time.

That seems like an intractable problem, but there is something that can be done: curb the political power of public sector unions by ending or seriously restricting government employee unions’ collective bargaining privileges. Government employee unions are the principal lobby for increasingly generous public employee compensation, and their ability to negotiate directly with government officials over the expenditure of government resources is a perk that no private party enjoys.

For more on public sector unions, see here.

New CBO Pension Report: Underfunding Could Be Higher

by Ivan Osorio on May 6, 2011

in Bailout Watch, Economy, Labor

That state and local governments  face serious pension funding problems isn’t a particularly controversial contention. However, the question of how much they’re underfunded by is much more contentious.

Last week, the Pew Center on the States released a report that estimates the nation’s total public pension underfunding at $1.26 trillion, based on the discount rate which  the Government Accounting Standards Board (GASB) allows fund managers to use in order to determine their level of contributions needed to meet future obligations. The Pew report is significant in that it acknowledges the arguments that the GASB-based estimate may be too low.

Now a new report by the Congressional Budget Office (CBO) follows suit, and goes further. It discusses in some detail the “fair-value approach” advocated by some GASB critics, and estimates what total pension underfunding would be using lower discount rates.

  • For assets, the fair value is what an investor would be willing to pay for them—that is, the current market value (or an estimate when market values are unavailable); it is not the averaged, or smoothed, market values that are reported under GASB guidelines.
  • For pension liabilities, the fair value can be thought of as what a private insurance company operating in a competitive market would charge to assume responsibility for those obligations.

In the case of state and local pension plans, the discount rate for future benefit payments using the fair-value approach is lower—and, therefore, the estimated present value of those payments is higher—than under the GASB approach. Under the fair-value approach, future cash flows are discounted at a rate that reflects their risk characteristics. Hence, for pension liabilities, the discount rate reflects the fact that the cash flows associated with accrued liabilities are fixed and carry little risk; it is very unlikely that the liabilities will not be honored. By contrast, under the GASB approach, the discount rate used for liabilities reflects the greater risk associated with pension funds’ assets. Under the fair-value approach, one way to approximate the discount rate applied to future benefit payments is by using the interest rate on municipal securities adjusted to remove the effect of tax deductibility): In 2010, the discount rate would have been about half as large as the median discount rate of 8 percent under the GASB guidelines. (For additional discussion of discount rates, see Box 1 on page 6.)

A study published last year that examined the sensitivity of estimates of underfunding to discount rates for pension plans in the Public Fund Survey illustrates the large difference between the GASB and fair-value approaches. Unfunded liabilities in 2009 amount to about $0.7 trillion when liabilities are discounted at 8 percent but total $2.2 trillion when liabilities are discounted at 5 percent and $2.9 trillion when they are discounted at 4 percent (see Table 1). Those unfunded liabilities, as calculated on a fair-value basis, indicate funded ratios of roughly 55 percent and less than 50 percent, respectively.

[click to continue…]

Faulty Public Pension Accounting: A Problem too Big to Ignore

by Ivan Osorio on April 28, 2011

in Economy, Employment, Labor, Regulation

One reason the ongoing debate over collective bargaining for government employees has been so loud is that the stakes are so high — for unionized government employees on one side and for taxpayers on the other.

For years, public sector collective bargaining enabled government employee unions, especially at the state and local level, to aggressively lobby for generous compensation in exchange for political support for the politicians who grant such largess.

Those politicians, seeking to avoid taxpayer wrath today, deferred many of the costlier elements of that compensation well into the future, including pensions. To make matters worse, states underfunded those pensions for years, and the accounting methods they used hid the funding gaps.

Today, however, much as the budget crises affecting state government around the country has brought public attention to the bad bargain for taxpayers that is public sector collective bargaining, state pension accounting standards face considerable public scrutiny, from across the ideological spectrum.

[click to continue…]

Transparency Bill Proposed Solution to Public Employee Pension Problems

by Kathryn Ciano on February 9, 2011

in Economy, Labor

At a House subcommittee meeting discussing one proposed solution for public employee pensions, a transparency bill designed to trace federal and state funds set aside to cover pension guarantees. Lawmakers and media types weigh in on taxes, Social Security, and how their interest groups are affected by pension cures.

Paul Ryan enters fresh from Bernanke’s hearing, to quote the Federal Reserve chair’s uncertainty as to when and how public employee pensions will be paid. This echoes Grover Norquist’s statement earlier in the same conference that everyone’s answer to the question of the day — Will public employees get the pensions promised them by their states? — is: We’re pretty sure.

Covering public employee pensions has become an enormous problem for states unable to cover even the going expense of running a government. California offered IOU’s to some employees this year, and state employees whose pensions are guaranteed by the state are subsisting on promises and guarantees, but many have not been paid. Arnold Schwarzenegger endorsed this transparency bill as he exited the office of governor, according to a presenting Ways and Means committee member.

Rep. Darrell Issa reminds the room that we will all pay for any failure. If one city or state fails, the entire country will bear the burden. Public employee pensions may not rise to the highest level on some conservative dockets, but as baby boomers retire, public budgets are braced to absorb the shock wave anticipated when the pension crisis hits.

As with every area of the economy, uncertainty quashes growth. As go public employees relying on a lifetime of pension pay-ins, so goes America, relying on receiving checks from social security, not IOU’s.

The Stealthy Public Pension Time Bomb

by Ivan Osorio on October 29, 2010

in Bailout Watch, Economy, Employment, Labor, Regulation

As state and local government budgets have come under increasing stress, greater public attention has come to focus on government employees’ compensation. This greater scrutiny has led to public anger over public employees’ generous compensation (along with their iron-clad job security). Naturally, this has put public employee unions and their allies on the defensive. Some have responded with publications that essentially retort, “It ain’t so!” In The American, Andrew Biggs of the American Enterprise Institute, responds to that defense. As he notes, a significant such study, by the Center on Wage and Employment Dynamics (CWED) at the University of California-Berkeley, makes an important miscalculation:

The basic problem with CWED’s treatment of benefits is that it assumes data showing what employers currently pay toward benefits is equal to what employees will actually receive. In the short-term, this assumption is fine, since many employee benefits are consumed today. But in the public sector, a large share of compensation is deferred to retirement in the form of pension benefits and retiree health benefits. The CWED study significantly underestimates the value of deferred benefits.

As many people are aware, public sector defined-benefit pension plans are significantly underfunded. Using private sector accounting standards, which is necessary to make apples-to-apples comparisons, the typical public pension is less than 50 percent funded. When pensions are underfunded, compensation from pensions is underestimated.

Thus, although the CWED study argues that California’s public sector employees receive pension benefits equal to 8.2 percent of their total compensation, that’s not exactly true. Their data actually shows that California public employers are paying 8.2 percent of employee compensation toward pensions, but that is only around half what employers should be paying. And since public pension benefits are guaranteed, that extra amount will be paid sooner or later. A good guess of true public pension compensation is to divide the reported pension contribution of 8.2 percent by the 50 percent funding level of California pensions, producing a value for promised pension benefits of 16 percent of compensation. This increases the 2 percent pay advantage that the CWED study already acknowledges to a public sector pay premium of around 10 percent.

So, in addition to threatening state and local government finances — and thus by extension taxpayers — public employee pension underfunding also partly obscures the real cost of public employee compensation. For government employee unions and the elected officials they support, this politically convenient, since they simply pass on the cost to future taxpayers, while mitigating current taxpayers’ wrath. For some insight into how they do this, it’s worth reading the study by Biggs and Eileen Norcross of the Mercatus Center (who’s also a former CEI Warren Brookes Journalism Fellow), on the public pension underfunding crisis, published by Mercatus. In a word, public pension managers have been overestimating investment returns for years. They focus on New Jersey as a case study.

The state reports that its pension systems are underfunded by $44.7 billion, when liabilities are discounted at the 8.25 percent annual return that New Jersey predicts it can achieve on funds’ investment portfolios.

However, when plan liabilities are calculated in a manner consistent with private sector accounting requirements, methods that economists almost universally agree are more appropriate, New Jersey’s unfunded benefit obligation rises to $173.9 billion. This amount is equivalent to 44 percent of the state’s current GDP and 328 percent of its current explicit government debt.

Such unrealistic investment return expectations lead to further underfunding. One necessary first step to alleviate this situation, Biggs and Norcross note, is honest accounting.

In addition to understating funding requirements, using a high discount rate to value public pension liabilities encourages plan managers to invest in higher risk portfolios in order to target the expected rate of return, producing bad incentives in the management of pension assets. Instead, financial theory suggests pensions should be discounted according to the lower risk (and lower return) Treasury bond rating of 3.5%.

Government employee unions are a formidable political force. However, the public pension underfunding problem is so large now that public support for reforms to get states out of the red finally has a good chance of carrying the day, as it did in Utah. As Utah State Senator Dan Liljenquist, who helped design and enact a major pension reform in his state noted recently at a Mercatus event (where Biggs and Norcross also presented): “This is not a conservative-versus-liberal issue, this is a reality issue.”

For more on public sector unions, see here and here.

For more on pensions, see here.

Around the Country with Public Sector Unions

by Ivan Osorio on August 10, 2010 · 1 comment

in Bailout Watch, Economy, Employment, Labor

It’s often a sign that a problem is turning into a crisis when the public outcry over it becomes ubiquitous. That seems to be the case with the stress that government employee compensation is placing on government budgets at all levels, as several news items today indicate.

In a front-page story, USA Today reports that federal employees earn far above their private sector counterparts, and that gap has widened considerably in recent years.

Federal workers have been awarded bigger average pay and benefit increases than private employees for nine years in a row. The compensation gap between federal and private workers has doubled in the past decade.

Federal civil servants earned average pay and benefits of $123,049 in 2009 while private workers made $61,051 in total compensation, according to the Bureau of Economic Analysis. The data are the latest available.

The federal compensation advantage has grown from $30,415 in 2000 to $61,998 last year.

Public employee unions say the compensation gap reflects the increasingly high level of skill and education required for most federal jobs and the government contracting out lower-paid jobs to the private sector in recent years.

However, as Reason‘s Nick Gillespie rightly notes, such touting of government employees’ education credentials “probably reflects credentialism run amok as a demonstrated need for specialized skills.”

Moreover, higher salaries are just the beginning. In addition to generous benefits, many government workers enjoy retirement benefits that most private sector workers can only dream of. Negotiated as part of collective bargaining agreements, lavish pensions allow union-friendly politicians to keep their organized labor supporters happy, while they get to kick the can down the road to their successors — when the bill comes due, it becomes the new office holders’ problem.

And how lavish can those pensions get? Take the city of Bell, California,  where, The Wall Street Journal notes in an editorial, “City Manager Robert Rizzo stepped down after news broke that he was making $800,000 a year to oversee the blue-collar town of 40,000.”  And he’s just the tip of the iceberg.

According to the California Foundation for Fiscal Responsibility, a nonprofit that advocates pension reform, Mr. Rizzo is hardly alone. The foundation lists 9,111 retired California government workers receiving pensions in excess of $100,000 a year. The top earner, one Bruce Malkenhorst, receives $510,000 a year for his tenure as city administrator of Vernon, California (population, 91). Not including health benefits.

These paydays are the inevitable result of the dominance of government unions in city and state politics. While most private workers have 401(k)-type plans that rise and fall in value with economic growth, unions negotiate guaranteed payouts that stay lucrative whether or not the cities can afford them. California Attorney General Jerry Brown is investigating the Bell episode, but he’d enhance his chances to become the next Governor if he proposed more ambitious pension reform.

That is bad enough, but making that situation even worse is the fact that those same politicians who negotiated those generous pensions have neglected to adequately fund them, while setting up rules that could be gamed to increase payouts — sometimes even beyond retirees’ former salaries. Now those states face huge financial shortfalls, which underfunded pension obligations are making far worse. As the Mercatus Center’s Eileen Norcross and Todd Zywicki note in The New York Daily News:

At 44, Hugo Tassone retired from the Yonkers police force with an annual pension of $101,333 – thanks to overtime pay he tacked on to his $74,000 salary. Tassone told The New York Times it was the pension he could collect after 20 years of service that attracted him to the job in the first place.

He’s not alone. In the last decade, half of the police and firefighters who retired in Yonkers collected pensions that exceeded their base pay, in (at least one case) by as much as 75%.

Don’t blame the officers. New York’s pension rules make it pay more to retire than to work.

[...]

But loopholes and gamesmanship aren’t the only reason why public pension systems nationwide face massive funding shortfalls. They are the result of a perfect storm of flawed accounting, which fueled unrealistic employee demands that were then underfunded by politicians. In plans across the country, during booming years of the late 1990s, many workers were promised retirement payouts that were “too good to be true” and, thus, impossible to make good on.

New York’s budget situation is bad. In California, it’s reached a point that Governor Arnold Schwarzenegger calls “unsustainable.” He lays out the numbers in a Los Angeles Times op ed:

We have $500 billion in government-employee pension debt alone, a mind-numbing figure that is six times the size of our entire state budget and 10 times the amount we spend on education.

[...]

We must also reform California’s pension system for government employees, whose costs to taxpayers for just one of our major pension funds have skyrocketed from $150 million a year a decade ago to almost $4 billion this year. Private-sector workers already struggle to pay for their own retirement. Now they are being forced to pay more and more for the government workers’ retirement, at the very time their own retirement accounts have declined. What is worse, in five years those pension costs will grow to well over $10 billion per year, and keep growing from there.

Fixing this will not be easy, but public attention turning to this crisis is a welcome first step.

For more on public sector unions, see here and here.

Barron’s on the Dire State of Public Employee Pensions

by Ivan Osorio on March 16, 2010

in Bailout Watch, Economy, Labor

The current issue of Barron’s highlights the crushing burden that employee pensions are putting on state and local governments around the nation. The situation is so dire that some dismaying-enough estimates fail to capture the entire scope of the problem. Barron’s writer Jonathan R. Laing cites a Pew Center of on the States study that finds that, “eight states — Connecticut, Illinois, Kansas, Kentucky, Massachusetts, Oklahoma, Rhode Island and West Virginia — lack funding for more than a third of their pension liabilities. Thirteen others are less than 80% funded.” That sounds bad, but it is a relatively optimistic estimate! As Laing notes:

The size of the legacy-pension hole is a matter of debate. The Pew report puts it at $452 billion. But the survey captured only about 85% of the universe and relied mostly on midyear 2008 numbers, missing much of the impact of the vicious bear market of 2008 and early 2009. That lopped about $1 trillion from public pension-fund asset values, driving down their total holdings to around $2.7 trillion.

Other observers think the eventual bill due on state pension funds will be multiples of the Pew number. Hedge-fund manager Orin Kramer, who is also chairman of the badly underfunded New Jersey retirement system, insists the gap is at least $2 trillion, if assets were recorded at market value and other pension-accounting practices common in Corporate America were adopted.

Finance professors Robert Novy-Marx at the University of Chicago and Joshua Rauh of Northwestern University asserted in a recent paper that the funding gap for state pension plans alone might exceed $3 trillion, in part because state funds are using an unrealistic long-term annual investment return of 8% to compute the present value of future payments to retirees, as is permitted in government standards for pension-fund accounting.

This establishes a “false equivalence” between pension liabilities and the likely investment outcomes of state investment portfolios, which are increasingly taking on more risk by beefing up their exposure to stocks, private-equity deals, hedge funds and real estate. Using a much lower expected return — say, one at least partially based on the riskless rate of return on government securities — would both properly and dramatically boost the present value of the pensions’ liabilities while decreasing their likely ability to meet them. The academic pair, using modern portfolio theory, claim that state funds, as currently configured, have only a one-in-20 chance of meeting their obligations 15 years out.

Of course, 15 years out, the politicians who helped to perpetuate this debacle will likely be out of office — which gives them an incentive to back load benefits in the form of pensions. By the time the bill comes due, it’ll be somebody else’s problem. So, while union-friendly office holders can’t give their public employee union supporters everything they ask for today, tomorrow is a different matter.

For more on public sector unions, see here and here.

FDIC Threatens Public Pensions

by Ivan Osorio on March 10, 2010

in Bailout Watch, Economy

The Federal Deposit Insurance Corporation (FDIC) is trying to get public pension funds to help prop up failed banks by buying into them, reports Bloomberg. Such a move would almost certainly run afoul of pension fund managers’ fiduciary duty, by investing in excessively risky assets. Indeed, the risks are obvious.

Oregon would invest in Community Bancorp LLC, a bank being formed by Sageview Capital LLC, according to the Oregon presentation. Sageview was founded by former Kohlberg Kravis Roberts & Co. executives Scott Stuart and Ned Gilhuly. Sageview is looking to raise about $1 billion from pension funds and similar investors, the presentation said.

While the structure makes sense, pension funds would be better off investing in existing banks, said Chris Whalen, managing director of Institutional Risk Analytics of Torrance, California. At those lenders, management will oversee details of buying failed lenders and save pension funds the time and effort needed to launch a new bank, he said.

“If they are really interested in playing this area, they should put their money into a larger bank that’s already playing here,” Whalen said. “If you look at the risk-reward and the distraction involved, it’s not worth it” to back a new bank, he said.

Investing in distressed banks doesn’t always pay off, as the U.S. Treasury Department learned with the Troubled Asset Relief Program. At least 60 lenders skipped some of their promised dividends to the TARP fund, according to SNL Financial, and a $2.33 billion stake in CIT Group Inc. was wiped out last year when the lender went bankrupt.

And who will then be on the hook when such investments go south?

FDIC guarantees may soften the risk of investing public pension money in distressed banks, Whalen said. When the FDIC sells a failed bank, it typically shares a portion of the loan losses.

This perfect storm of moral hazard and excessive risk cannot end well. Moreover, as former Labor Department official F. Vincent Vernuccio notes, some public pension funds already suffer from under-performance due to politicized investment strategies adopted by their managers.

[I]n June 2009, 41 signatories representing some of the nation’s largest public pension funds and others with approximately $1.4 trillion in assets wrote to the Securities and Exchange Commission, asking the agency “to improve disclosure of climate change-related risks, and material environmental, social and governance risks, in securities filings.” California State Treasurer Bill Lockyer, who serves on the governing boards of the California Public Employees’ Retirement System (CalPERS) and the California State Teachers’ Retirement System (CalSTRS), put climate change on par with protecting retirement funds, saying, “Pension fundsprotect workers’ retirement benefits, and they need to ensure their portfolios reflect the risks and benefits related to climate change.”

Lockyer’s endorsement of using pension funds for anything other than retirement security is particularly brazen considering the huge losses that CalPERS and CalSTRS have sustained in recent years due to PTI investments. In 2000, then-California State Treasurer Philip Angelides launched his “Double Bottom Line” initiative to adopt certain social and tobacco-free investment policies—including using the pension funds in CalPERS and CalSTRS for local economic investments. The divestment of tobacco was a costly mistake. CalSTRS revealed that its tobacco investment ban lost the plan $1 billion in gains, and in 2008 conceded that they “could no longer justify” avoiding tobacco stocks.

For more on public employee pensions, see here and here.

For more on pension fund activism, see here and here.

Eliot Spitzer Wants your Pension

by Ivan Osorio on October 14, 2009

in Economy, Labor, Politics as Usual, Regulation

Today, Slate features a rant by disgraced former New York Governor Eliot Spitzer that includes distortions and falsehoods so blatant that they wouldn’t merit a response if they didn’t come from so loud a megaphone.

Spitzer is miffed at the U.S. Chamber of Commerce for opposing the major expansions of government power currently being proposed in Washington.The Chamber, he says, has a “right to be wrong” (wrong in Spitzer’s universe apparently being anything that opposes the expansion of government), but it doesn’t have a right to do it with “our money.”

“Our” money? Yes, according to Spitzer, the publicly held companies that are members of the Chamber have an obligation to promote a liberal agenda — or at least not oppose it — because that’s what shareholders want. What he bases this belief on is hard to fathom. Has he polled a substantial sample of all (or a least a substantial majority of) America’s publicly held companies? Public company shareholders are a diverse lot; to ascribe uniform political views to them as whole is absurd, to put it mildly.

But even if a majority of shareholders of a majority of companies were left-leaning, all responsible shareholders share the same goal, independently of political views: Increasing shareholder value. Spitzer claims that, “It is corporate leadership, though its support of the chamber, that has injected politics into the corporations that we own.” Yet its not support of politics that seems to irk Spitzer so much, but support of policies he doesn’t favor.

“So what should be done?” he asks.  He wants “public pension funds [to] pressure the board to drop the chamber membership. If one activist state comptroller begins to build this coalition, the other state pension funds will follow.” Somehow, in Spitzer’s universe, this isn’t playing politics.

Moreover, Spitzer’s claim that institutional investors have shown a “passive, permissive attitude toward the management” is blatantly untrue, as a casual look at the board of the environmental activist investment fund Ceres makes clear. Ceres lists as Co-Chair none other than the CEO of the California Public Employee Retirement System. Ceres describes itself as “a national network of investors, environmental organizations and other public interest groups working with companies and investors to address sustainability challenges such as global climate change.”

This brazen hypocrisy is merely annoying, but it’s Spitzer’s substantive recommendation that is really harmful. California’s state employee retirement funds provide a good example. Last year, the California State Teachers’ Retirement System reversed its politically correct no-tobacco-stocks policy after it acknowledged that the tobacco ban had cost the plan $1 billion in lost gains.

In addition, many union pension funds today are severely underfunded, largely as a result of politicized investment strategies. The AFL-CIO’s 2008 Key Votes Survey actually boasts that, “The AFL-CIO and leading institutional investors continue to work with President Obama, Senate Banking Committee Chairman Chris Dodd, and House Committee Chairman Barney Frank to pass landmark ‘say on pay’ bill” and that, “in 2008, the AFL-CIO Office of Investment, working with leaders of the Interfarith Council on Corporate Responsibility (ICCR), successfully drafted and presented a new shareholder proposal on health care reform.”

The only logical connection either of these efforts could have to the AFL-CIO fulfilling its fiduciary duty in ensuring that the companies in which its pension funds own shares are being well run is that the AFL-CIO’s fund managers believe themselves to be so incompetent to the task that they simply cannot do it without a federal law helping them along.

And it is that kind of activism that Spitzer wants more of. Responsible shareholders should be thankful that he no longer has the power to force it on them.

For more on the politicization of pension funds, see here and here.