Download The Spectre of Mortgage Fraud: A PRIMER

Public Sector Pensions 101:
The Hidden Taxpayer ‘Put’
“If a taxpayer’s personal portfolio underperforms, he or she can cut back on their
expenditures. But if the government’s pension portfolio underperforms, the taxpayer
will be asked to pay to the government the difference between what the government
promised to public employees and the resources that are left to meet those
obligations”.”
Professor Joshua Rauh, Northwestern University
February 14th, 2011 statement to Subcommittee on Courts, Commercial, and Administrative Law
“The Role of Public Employee Pensions in Contributing to State Insolvency and the Possibility of a State
Bankruptcy Chapter”
NEW JERSEY TEA PARTY COALITION
Are We Against Pensions?
Of course not; we just don’t want to be lied to about the true cost
pensions to taxpayers
Public Sector Pension Underfunding:
Really, Really Boring but Actually Quite Dangerous
•
Pension liabilities for states and local governments are 40%
understated nationally through near-fraudulent accounting
– Real unfunded accrued liabilities are many times higher than reported
– This means that total state and local government debt is much higher than
bonded debt-- and a pension-muni bond collision is coming
– Pension reform efforts to date focus on current employees only and not the
accrued liability (Battle of Madison just the beginning)
– The accrued pension liability is too large and can’t be paid
•
•
•
Municipal bond ratings are based on faulty data and willful
misperception, and are wrong
The municipal bond market is straining to downplay the problem and
lull retail investors, and generally in deep denial that a problem exist
The players--pension boards, legislators, financial managers, rating
agencies, and state judges--are seriously conflicted
Public Sector Pension Underfunding:
Really, Really Boring but Actually Quite Dangerous
•
Pension liabilities for states and local governments are 40%
understated nationally through near-fraudulent accounting
– Real unfunded accrued liabilities are many times higher than reported
– This means that total state and local government debt is much higher than
bonded debt-- and a pension-muni bond collision is coming
– Pension reform efforts to date focus on current employees only and not the
accrued liability (Battle of Madison just the beginning)
– The accrued pension liability is too large and can’t be paid
•
•
•
Municipal government bond ratings are based on faulty data and willful
misperception, and are wrong
The municipal bond market is straining to downplay the problem and
lull retail investors, and generally in deep denial that a problem exists
The players--pension boards, legislators, financial managers, rating
agencies, and state judges--are seriously conflicted
Why Do We Care?
I don’t think of the long-term budget fight as being between Democrats and Republicans or
between rich and poor. I look at it as a fight between people with funded retirements and
unfunded retirements.
If I have saved enough to support my lifestyle in retirement, then I have a funded
retirement. If my neighbor who teaches in public school wants to support a similar lifestyle
based on her pension, then she has a retirement that is somewhat unfunded. That is, as of
now, her pension plan has only about 50¢ for every $1 of promised benefits. Social
Security and Medicare also are unfunded. Their trust funds consist of government bonds. If
I took care of my own retirement the same way, the drawer where I keep statements from
mutual funds that I own would instead be filled with IOUs from myself. More important, the
actuarial shortfall in Social Security and Medicare, like that in my neighbor’s pension plan,
is very large.
Down the road, someone is going to get the shaft. It could be my neighbor, it could be me,
or it could be both of us. That is, people who are relying on the unfunded systems--public
sector pensions, Social Security, and Medicare--might find their benefits cut. Or people
who are relying on personal savings could wind up having those savings taxed away in
order to address the shortfalls in the public systems. Or all of us could have our savings
eroded by inflation, from which we may not be able to protect ourselves.
Arnold Kling, April 2011
Why Do We Care, Once Again?
• Entitlements: political promises that be taken back
– Social Security: $12 trillion?
• 1935 benefits began at age 65, vs life expectancy of 58-62 (now 78-81)
– Medicaid/Medicare: $80 trillion?
• Death panels and rationing
• Debt: the rules are decided by the lender
– Total US private wealth: $49 trillion
– Federal debt: $14.3 trillion as of…what time is it?
– Municipal Bonds: $2.6 trillion
– Reported unfunded public sector pension liability: $1.3 trillion
• Real unfunded liability: $3 trillion or more
• Public pensions are not a distant future problem
– Pension costs now encroaching on essential services
• 20-30% of general budgets in some cases
– About ten state pensions are within a decade of going bust
– And we still haven’t dealt with OPEB entitlements
Does This Look Like a Smoking Gun?
(Hint: lying about the true liability)
Source: Official Statement, State of Illinois General Obligation Bonds,
Taxable Series February 2011
How About This?
(They also lie about the assets)
17. On June 29, 2001, the State legislature approved legislation (P.L. 2001, c. 133) that,
effective November 1, 2001, increased retirement benefits for employees and retirees
enrolled in TPAF and PERS by 9.09 percent. In order to fund the enhanced benefits,
without increased costs to the State or taxpayers, the legislation revalued TPAF and
PERS assets to reflect their full market value as of June 30, 1999, near the height of the
bull market.13 Bond offering documents did not disclose the retroactive mark-to-market
revaluation of the pension assets under the 2001 legislation until March 2003 or the
reason for the reevaluation. More specifically, bond offering documents did not disclose
that the State used the market value as of June 30, 1999 in order to make it appear
that the State could afford the benefit improvements.
13. In the actuarial valuations as of June 30, 1999 for TPAF and PERS, the actuarial value of assets was replaced with the market value of assets.
Subsequent actuarial valuations, including actuarial valuations as of June 30, 2000 and June 30, 2001, applied the five-year smoothing method.
Source: Securities and Exchange Commission Administrative Proceeding re State of New Jersey
File No. 3-14009 Release No. 9135, August 18, 2010
Some Points of Reference
•
Defined Benefit Plans (vs. 401 k Defined Contribution)
–
Contractual obligation is at least legally equivalent to bonded debt
•
•
–
–
–
•
Dollar-certain future annuity
Obligation to pay much stronger than Social Security or Medicaid/Medicare
OPEBs--health benefits--are a separate category
State and local plans not governed by ERISA (1974)
–
–
–
•
Same actuaries use different assumed-return standards
Private plans in better shape, though ERISA put taxpayers on the hook via PBGC
Not all public workers covered by Social Security
Most public sector employees covered through 220+ state wide plans
•
•
•
Even more protected under some state constitutions (IL, NY, HA)
In past cases of muni bond default, pensions not affected
Range in size from $500 mm to over $150 bil
About 19.8 million state and local government employees (2.7 m Fed civ, 153 m total US)
Muni bond market very disaggregated compared to corporate bonds
–
–
–
–
50,000 issuers from states to local districts; many security types (GO, revenue, etc)
Illiquid, ‘buy and hold’ market
30% institutional, but 70% held by individuals directly or through mutual funds
‘Munis never default’
•
Oh yeah?
Some Major Conflicts of Interest
• Most statewide pensions were 100%+ funded in 2000
– Same poor accounting but risks obscured by dot-com run-up
– Instead of building reserves, legislators promptly increased pension benefits
– The trading of pension benefits for votes is obvious in retrospect
• Who sits on the boards of public pensions and decides
investments, discount rates, benefits?
– Legislators (pension recipients)
– State and local treasurers (pension recipients)
– State and local employees and union members (pension recipients)
• State judges have their own state pensions
– Will they recuse themselves when the inevitable legal fights begin?
• Rating agencies paid by advisors, bankers, issuers
• Actuaries hired and paid by pension boards
– The same actuaries apply more conservative practices for ERISA plans
How Does a DB Pension Work?
•Defined Benefit pensions are fundamentally simple
–Future, dollar-certain benefits are earned during a working career (pension
liability)
–Employer/employee contributions are made to a pension trust fund (invested
assets)
–The combination of contributions and trust fund investment earnings should
cover the future benefit payments (assets = liability)
•The actuarial forecasting of the pension liability can be complex
–Actuarial variables include mortality of both retiree and spouse; also
•retirement age;
•salary growth;
• inflation
–Another key variable is the assumed rate of return on the invested assets, or the
discount rate
Future Pension Payments Comprise a Bundle
of Many Annuities
2010
2020
2030
2040
2050
2060
2080
Fireman, 25
retires at 50
Teacher, 45
retires at 60
Accountant, 65
already retired
Ex-employee, 35
retires at 55
DPW operator, 75
already retired
Because retirement systems have been around
for decades and are full of baby boomers, the
duration or mid-point of future benefit streams for
both public and private plans is 12-15 years--not 30!
(I.e., the problem is imminent)
Present Value, Future Value:
The Fundamental Principle of Finance
• Time value of money is expressed as an interest rate
PV
2011
FV
15 years
2026
$31.52
8.00%
$100
$56.13
4.25%
$100
• Rate of return is correlated to risk
•Higher return = higher risk
Pension Accounting:
Merely Misleading, or More Institutional Fraud?
•
The actuarial complexities are real, but they can obscure
blatantly mismatched risk/return assumptions
– The pension liability is mandatory; it must be paid
• Therefore, asset investment should be conservative and low in risk
• This means contributions should be conservatively ample
– Typical 8% ‘discount rate’ creates inappropriate market risk
• Asset/liability risk intentionally mismatched to understate
current contributions required to fund the pension trust fund
• Effectively forces a put on taxpayers to cover the future shortfall
– 5-12 year ‘actuarial smoothing’ can overstate asset value and hide
recent market declines (NJ SEC)
• This accounting allows politicians to buy votes with benefits and
hide the real cost
Is the Discount Rate Important?
Benefits Paid Out in Retirement
Benefits Earned During Working Career
25
Employee’s Age
40
Annually Required Contribution (ARC) to Pension Fund
Pension Fund Assets Build Over Time
62
80
Is the Discount Rate Important?
Benefits Paid Out in Retirement
Benefits Earned During Working Career
25
Employee’s Age
40
62
80
Future Value of
Benefit Stream
Discount Rate
Present Value of Future Benefit
Stream
Annually Required Contribution (ARC) to Pension Fund
Pension Fund Assets Build Over Time
Discount rate determines how much has to be
set aside during working career from employer/
employee contributions for investment to ensure
adequate funds to pay future benefits
Is the Discount Rate Important?
Benefits Paid Out in Retirement
Benefits Earned During Working Career
25
Employee’s Age
40
62
80
Future Value of
Benefit Stream
Discount Rate
Present Value of Future Benefit
Stream
Annually Required Contribution (ARC) to Pension Fund
Pension Fund Assets Build Over Time
Discount rate determines how much has to be
set aside during working career from employer/
employee contributions for investment to ensure
adequate funds to pay future benefits
High discount rate assumes more
investment earnings, requires lower
contributions (but more risk!)
Low discount rate assumes less
investment earnings, requires more
contributions (less future risk to
taxpayers, politicians restricted)
Is the Pension Funded or Under-funded?
Benefits Earned During Working Career
Benefits Paid Out in Retirement
PV of future benefits earned
to date = Accrued Liability
Discount Rate
+$
-$
FV of
Benefits
If at any valuation date invested assets are
greater than the Accrued Liability, the plan
is fully funded or better
If at any valuation date invested assets (past
contributions) are less than the Accrued Liability
the plan is underfunded
Today
Use fair market value, not ‘smoothed’ values
What if the Assumption is Bad?
• The pension plan’s actuarial report shows the funding level
based on the assumed discount rate
– Most public sector plans now officially funded at 80% or less, even
with absurdly high discount rates
• Since the discount rate is too high--as it usually is in public sector
pensions, where 8.0% is common--the plan’s underfunded
situation is actually much worse
– Guess who gets stuck covering the shortfall?
• Since we know the average duration of the pension liability is 15
years, it’s not hard to calculate a more realistic funded level
using a more conservative interest rate--such as the 15 year
Treasury (4.25%)
And Now for the Really Bad News
(remember that taxpayer put?)
($ millions)
Unfunded Pension Liability
State
Connecticut
Bonded Debt
$
25,000
General
Revenues
$
20,491
2010
population
3,574,097
Reported
$
25,188
$
Real
61,259
debt and real
debt
bonded debt debt, real UFL
UFL
increase
per cap
per cap
$
86,259
3.45 $
6,995 $
24,134
Illinois
$
33,528
$
32,162
12,830,632
$
138,794
$
242,436
$
275,964
8.23 $
2,613
$
21,508
Nevada
$
2,933
$
7,649
2,700,551
$
8,748
$
31,407
$
34,340
11.71 $
1,086
$
12,716
New York
$
45,871
$
125,917
19,378,100
$
(1,128)
$
102,874
$
148,745
3.24 $
2,367
$
7,676
North Carolina $
8,096
$
39,734
9,535,483
$
2,512
$
43,594
$
51,690
6.38 $
849
$
5,421
3,725,789
$
24,000
$
42,000
$
105,000
1.67 $
16,909
$
28,182
*
Puerto Rico
$
63,000
$
8,000
New Jersey
$
44,917
$
45,575
8,791,894
$
49,174
$
154,348
$
199,265
4.44 $
5,109
$
22,665
Tennessee
$
1,700
$
22,800
6,346,105
$
8,200
$
25,200
$
26,900
15.82 $
268
$
4,239
*Reported UFPL FV’d 15 years at plan discount rate;
PV’d back at 4.25% (15 yr Treasury)
Source: State CAFRs,
Actuarial reports
And Now for the Really Bad News
(remember that taxpayer put?)
($ millions)
Unfunded Pension Liability
State
Connecticut
Bonded Debt
$
25,000
General
Revenues
$
20,491
2010
population
3,574,097
Reported
$
25,188
$
Real
61,259
debt and real
debt
bonded debt debt, real UFL
UFL
increase
per cap
per cap
$
86,259
3.45 $
6,995 $
24,134
Illinois
$
33,528
$
32,162
12,830,632
$
138,794
$
242,436
$
275,964
8.23 $
2,613
$
21,508
Nevada
$
2,933
$
7,649
2,700,551
$
8,748
$
31,407
$
34,340
11.71 $
1,086
$
12,716
New York
$
45,871
$
125,917
19,378,100
$
(1,128)
$
102,874
$
148,745
3.24 $
2,367
$
7,676
North Carolina $
8,096
$
39,734
9,535,483
$
2,512
$
43,594
$
51,690
6.38 $
849
$
5,421
3,725,789
$
24,000
$
42,000
$
105,000
1.67 $
16,909
$
28,182
*
Puerto Rico
$
63,000
$
8,000
New Jersey
$
44,917
$
45,575
8,791,894
$
49,174
$
154,348
$
199,265
4.44 $
5,109
$
22,665
Tennessee
$
1,700
$
22,800
6,346,105
$
8,200
$
25,200
$
26,900
15.82 $
268
$
4,239
*Reported UFPL FV’d 15 years at plan discount rate;
PV’d back at 4.25% (15 yr Treasury)
Source: State CAFRs,
Actuarial reports
And Now for the Really Bad News
(remember that taxpayer put?)
($ millions)
Unfunded Pension Liability
State
Connecticut
Bonded Debt
$
25,000
General
Revenues
$
20,491
2010
population
3,574,097
Reported
$
25,188
$
Real
61,259
debt and real
debt
bonded debt debt, real UFL
UFL
increase
per cap
per cap
$
86,259
3.45 $
6,995 $
24,134
Illinois
$
33,528
$
32,162
12,830,632
$
138,794
$
242,436
$
275,964
8.23 $
2,613
$
21,508
Nevada
$
2,933
$
7,649
2,700,551
$
8,748
$
31,407
$
34,340
11.71 $
1,086
$
12,716
New York
$
45,871
$
125,917
19,378,100
$
(1,128)
$
102,874
$
148,745
3.24 $
2,367
$
7,676
North Carolina $
8,096
$
39,734
9,535,483
$
2,512
$
43,594
$
51,690
6.38 $
849
$
5,421
3,725,789
$
24,000
$
42,000
$
105,000
1.67 $
16,909
$
28,182
*
Puerto Rico
$
63,000
$
8,000
New Jersey
$
44,917
$
45,575
8,791,894
$
49,174
$
154,348
$
199,265
4.44 $
5,109
$
22,665
Tennessee
$
1,700
$
22,800
6,346,105
$
8,200
$
25,200
$
26,900
15.82 $
268
$
4,239
*Reported UFPL FV’d 15 years at plan discount rate;
PV’d back at 4.25% (15 yr Treasury)
Source: State CAFRs,
Actuarial reports
How Does This End?
(hint: probably not well)
•State and local government revenue ‘pie’ can’t increase
•Economic activity not growing so revenues stay flat
•Tax rates can’t increase given high unemployment, foreclosures
•Caterpillar, Sears threatening to leave Illinois
•Blue states already losing population
•Pension funding claims higher and higher share of annual budgets
•Public sector layoffs, service cuts result, but with no cut in taxes
•Economic ‘death spiral’ as ranks of unemployed swell
•Unions forced to choose between active and retired workers
•Government will get increasingly desperate as ‘Kick the Can’ finally
runs out of time
•Hyper-inflation to pay debt and pension with devalued dollars
• personal savings destroyed
•IRAs/401ks forced into US Treasuries when no one else wants them
•State and local bankruptcies, defaults, as leadership fails