The usual suspects, part 2

A previous post (Eat, drink, and be merry for tomorrow our pension may die) addressed the city of Stockton's foolish decision to finance its pension debt with bonds.  This New York Times article by Mary Williams Walsh (How a Plan to Help City Pay Pensions Backfired) details how Stockton was assisted in this debacle by Wall Street investment bank Lehman Brothers.   For those who already blame Wall Street for the public pension crisis, this article will serve as a convenient morality play in which evil Wall Street, represented by the now-defunct Lehman Brothers, leads the naive politicians of Stockton down the path of ruin.

The situation in Stockton is a mess with taxpayers, city employees, and retirees left to watch the spectacle of the city government, CalPERS, bond insurers, and other creditors fight it out in court over who gets paid, who gets stiffed, and who gets stuck with the tab.  Lehman Brothers would be involved in this battle as well if it had not gone bankrupt, but Lehman Brothers does serve a purpose by lingering in the background as a ready-made scapegoat.  This allows the Stockton city council, CalPERS, and bond insurers a way to mitigate their poor choices and lack of foresight by utilizing the it's-all-Wall-Street's-fault excuse.

For many people Wall Street occupies the same economic environment as the much-derided "middleman" in the retail industry.  The consumer has been led to believe that the middleman is a superfluous entity whose only purpose in the supply chain is to take his cut and raise final costs.  However, the middleman does provide a service to manufacturers who want to move their goods quickly and retailers who only want to carry enough inventory to match their sales.  If Target or Safeway tried to operate their business like Costco, they would need buildings that dwarfed your typical Costco.

Wall Street exists to facilitate transactions that transfer risk between parties.  Market makers, insurers, investment banks, currency and commodities traders, and brokerages all link up parties willing to buy and sell risk.  This is no different than when a homeowner buys insurance; he is simply transferring the risk of catastrophic loss to the insurer for an annual fee.  The financial system is supposed to price risk based on the likelihood of default, and products more likely to default have higher interest rates.  The problem that will always exist is the danger that risk is miscalculated or that the parties do not understand the true risk of the product they have bought or sold.  This is not to say that there is not fraud or unethical behavior on Wall Street.  In the documentary Enron: The Smartest Guys in the Room, some Enron traders gloated to coworkers when they made a trade that they knew would end badly for the unsuspecting buyer.  How prevalent that type of attitude is on Wall Street would have to be answered by an insider, but regardless, a market for risk-trading exists and Wall Street profits by making that market work.

This post is not meant to be a explanation or history of the Great Recession, and there are several good books like Gretchen Morgenson's Reckless Endangerment,Bethany McLean and Joe Nocera's All the Devils Are Here,Edward Conard's Unintended Consequences,and Michael Lewis' The Big Shortthat do a great job of explaining what happened.  For the city of Stockton, Mr. Lewis' book has the most cogent passage.  He writes about a trader named Danny Moses whose question to any Wall Street firm that tried to sell him on a supposedly risk-free trade was, "I appreciate this, but I just want to know one thing: How are you going to f*** me?"  For Mr. Moses this was not a rhetorical question, and he demanded an honest answer and would trade only if he was told the truth.

Ms. Walsh's article tells how the Stockton city council sensed that the pension bond idea was too good to be true, and one council member even professed ignorance about the bond market. Lehman Brothers eventually sold them on the bond proposal in 2007, but with how much skepticism, willing suspension of disbelief, and unanswered questions from the city council is not detailed in the article.

So how much is Lehman Brothers to blame?  They appear as Harold Hill-like characters selling a dream to gullible townsfolk, but the product actually succeeded in its purpose of transferring risk.  Stockton transferred risk to bondholders and then insured the bonds.  The insurer of the bonds will have to reimburse bondholders for their principal, but the insurer has filed a claim against the city in bankruptcy court.  Depending on how the bankruptcy judge rules, Stockton may get out of this debt at a discount or even scot-free.  This was not how it was supposed to work, but it may turn out to be a good deal for the city after all.

The overarching question is the culpability of Wall Street in the public pension crisis.  The criticism that Wall Street created bad products like mortgage-backed securities and credit default swaps that were destined to crash the market is valid, though bond rating agencies, government regulators, government-sponsored entities like Fannie Mae and Freddie Mac, and institutional investors also share some of the blame.  However, the market has since recovered, and yet, many public pensions are still in bad financial shape.  As convenient as it is to blame Lehman Brothers for some of Stockton's financial problems, the trouble started long before Lehman Brothers ever entered the picture.  The awarding of generous retirement benefits with unrealistic expectations of how they were to be funded is the real reason Stockton is bankrupt.  And so it goes for the public pension crisis.  Even if Wall Street may have helped crash the market, the seeds of the public pension crisis were sown long before the crash.

The next post will cover the last of the usual suspects that get blamed for the public pension crisis: public employee unions.

The usual suspects, part 1

“I do not believe that the solution to our problem is simply to elect the right people. The important thing is to establish a political climate of opinion which will make it politically profitable for the wrong people to do the right thing. Unless it is politically profitable for the wrong people to do the right thing, the right people will not do the right thing either, or if they try, they will shortly be out of office.”

      Milton Friedman, Nobel Prize-winning economist

For public employee unions seeking to find someone to blame for the public pension crisis, there are always the standard issue villains: Wall Street and politicians. For advocates of small government, the villains are public employee unions and politicians.  At least both sides have one villain they can both agree upon.  David Crane in his editorial on September 15, 2012 (Pension problems not the fault of employees) lays blame for the public pension crisis squarely on politicians.  He takes politicians to task for promising benefits but failing to adequately fund them.

Based on his background, Mr. Crane is obviously no naif when it comes to government or California politics.  However, he is missing the most fundamental problems with politicians: they deal in immediate benefits but deferred and diffused costs.  Politicians can immediately reward constituencies or special interest groups through laws and regulations but hide the true cost by deferring it to the future or diffusing it over a large number of taxpayers.  One group can receive something now while those that have to pay for it are unaware of the true cost because it will not hit until the future.  This cost can also be spread out over a large enough number of taxpayers that it is not readily apparent, but the small costs will accumulate over time and steadily increase the taxpayers' burden.

Those who receive the immediate benefits have a very strong incentive to get politicians to take their side and will use whatever resources they have to accomplish this.  Taxpayers, unfortunately, are given a misleading picture of what this is doing to the long-term financial health of the government and its ability to provide necessary services.

Mr. Crane may be correct that politicians are at fault. He writes that pensions and retiree health benefits are simply forms of deferred compensation that were promised by California's politicians but not adequately funded.  But this is just another product of the system in which politicians exist, and the system usually works fine until all those deferred and diffused costs become so great that they can not and will not be paid.  Then it breaks down and you have a situation like the public pension crisis.

Milton Friedman had a better understanding of the situation and why politicians themselves are not the real problem.

PSPRS members: A dozen more reasons to be concerned about your pension

The Government Accounting Standards Board (GASB) issued two new rules that will dramatically affect public employee pensions.  Released on June 25, 2012, GASB Statements Nos. 67 and 68 will change how pensions like PSPRS have to report their financial condition.  This key passage come from GASB's "plain language" article (New GASB Pension Statements to Bring About Major Improvements in Financial Reporting):

To the extent that a pension plan's net position and projected contributions associated with active and inactive employees, including retirees, is expected to fully cover projected benefit payments for those individuals, the long-term expected rate of return will be used.  If there comes a point in the projections when plan net position and contributions related to active and inactive employees is no longer projected to be greater than or equal to projected benefit payments related to those employees and administrative expenses, then from that point forward a government would be required to discount the projected benefit payments using a municipal borrowing rate--a tax-exempt, high quality (an average rating of AA/Aa or higher, including equivalent ratings) 20-year general obligation bond index rate.

That's supposed to be "plain language"?  Here is a clearer explanation from Andrew Biggs of the American Enterprise Institute (The Accounting Trick that Will Haunt Public Pensions):

Under GASB' current accounting standards, state and local pensions "discount" their future benefit liabilities using the assumed rate of return on pension's assets, typically 8 percent. Discounting calculates the present value of a future payment by subtracting interest each year, something like compound interest in reverse.

In response to criticism, GASB in June proposed amended rules. Under the new standards, the current 8 percent discount rate could be applied to benefits only through the years in which the plan's assets are expected to last. Liabilities occurring in years after plan assets would be exhausted must be valued using a lower municipal bond rate.

What this means for PSPRS is that it can only use its expected rate of return on a portion of its liabilities.  Using the lower rate on the other portion will increase PSPRS' total liability and decrease its funded ratio.  We can see how much lower in this Wall Street Journal article (Is Your Pension Underfunded?).  These figures were for fiscal year 2010, but if this same 12% decrease were applied to the fiscal year 2011 funded ratio, PSPRS would have a funded ratio under 50%.  The new GASB rules will go into effect over the next two years.

The only good thing to take away from the Wall Street Journal article is that, at least, we aren't teachers in Chicago.

The folly of the DROP, part three

For those who may remain unconvinced that the Deferred Retirement Option Plan (DROP) was a shortsighted and ill-conceived plan, here are some other points:

1. The DROP existed for barely a decade before it was eliminated.  That is hardly a ringing endorsement of its financial genius.  Unfortunately, it will continue to harm PSPRS until the last of those grandfathered in finally leave the job.
2. Though touted as a cost-neutral or even money-saving program, the DROP was only created for a small group of public safety personnel.  If it was so great, other departments would have created their own versions of the DROP.
3. It creates a two-class system among PSPRS members.

To illustrate the last point, consider a new hire with no access to the DROP and an individual entering the DROP today with a very modest $3,000/month retirement benefit.  The employee who enters the DROP today, using the minimum interest rate of 2%, will receive a DROP payment after five years of $189,457.  At the current 4.4% interest rate, he would leave with $201,662.  This lump sum payment can then be rolled over into another tax-deferred account like an IRA or 457(b).

The new hire is ineligible for the DROP, but she can be extremely frugal and put away the current maximum $17,000 per year into her 457(b).  If she made regular monthly deposits of $1,417/month and earned a 4.4% interest rate, compounded monthly, it would take her over 9 years to save up about the same amount as the employee earning only 2% in the DROP.

The employee who entered the DROP would do nothing more than fill out some paperwork five years before he would have retired anyway.  But the new hire would have to make enormous sacrifices to achieve the same end.  She and her family would suffer, all while taking on the added burdens of working longer and paying more into PSPRS.  This is the folly of the DROP, personified.

The folly of the DROP, part two

The most compelling argument for the Deferred Retirement Option Plan (DROP) is that it is a win-win proposition for employees and employers.  The DROP allows an employee to "retire" out of PSPRS but continue working for up to five more years.  The employee's monthly retirement payments accumulate tax-free while in the DROP and are paid out with interest when the employee finally leaves the job.  The final lump sum payout to the employee can be hundreds of thousands of dollars.  It proves to be such an attractive idea because it contradicts the old adage that there is no such thing as a free lunch.  Is it really possible to create a program that earns PSPRS members a large end-of-career bonus and save taxpayers money?

Of course not. Many years ago Fram had a commercial that highlighted the importance of preventive maintenance through the use of its oil filters.  Mechanics would contrast the cost of regular oil changes versus the expense of rebuilding an engine.  They would end the commercial by saying, "You can pay me now or pay me later."  This sums up the problems with the DROP.

The DROP was sold to politicians as a money-saving measure because, while an employee is in the DROP, the employer does not have to contribute anything to PSPRS for that employee.  This can save an employer thousands of dollars a year for just one employee and free up money for other purposes.  If hundreds of employees are in the DROP, the savings can be in the millions.  So far, so good--sounds like a great idea.

The problems begin when we consider that an employee enters the DROP at his highest earning years.  When both the employer and the employee should be making their greatest contribution to PSPRS, they both pay nothing.  Furthermore, those in the DROP were guaranteed an interest rate as high as 9% on their accumulated retirement payments.  This interest was paid even in years when PSPRS suffered huge losses on it investment portfolio.  The DROP not only starves PSPRS of funding but can rob principal from PSPRS when investment returns are bad.

That should be enough to make the DROP unworkable, but it gets worse.  Employees have a fixed contribution rate, which limits their liability.  Taxpayers, however, have an open-ended commitment to PSPRS.  After employees have paid their fixed contribution, taxpayers must pick up whatever else is needed to make up for shortfalls in PSPRS.  Taxpayers never received any true savings and just deferred costs they could have paid in the past (during a better economy) until now.  "You can pay me now, or you can pay me later."

Politicians look only to the next election, so of course, they approved the DROP.  It freed up money they could spend immediately at the expense of the future.  Those who pitched this to politicians selfishly helped themselves to a huge windfall.  While this was supposed to benefit taxpayers by saving money and retaining experienced personnel, taxpayers ended with nothing but debt.  Somebody won with the DROP, but it certainly wasn't the taxpayer.

PSPRS pension debate primer

My union local emailed me this link to a rebuttal written by Professional Fire Fighters of Arizona (PFFA) President Tim Hill (Hill: Robb fails to mention some important facts on public safety pensions).  It responds to Robert Robb's August 10, 2012 piece in the Arizona Republic (Public pension funds are ticking time bomb).  Here are some important facts that Mr. Hill did not mention in his piece:

1. The S&P 500 index hits its all-time high of 1,565.15 on October 9, 2007 and closed at 676.53 on March 9, 2009.  It closed at 1,429.08 yesterday (September 10, 2012).  This is 90% of the all-time high, but a 211% increase over the market low during the most recent recession. Markets and returns can and do fluctuate.
2. PSPRS' funding ratio was 126.9% on June 30, 2001.  It was 61.9% on June 30, 2011 and may have dropped below 60% at the fiscal year end on June 30, 2012. The funding ratio measures the ability of PSPRS to meet its obligations.
3. Employers (i.e. taxpayers) paid a contribution rate of 20.11% vs. 7.65% for employees in fiscal year (FY) 2010-11.  This employer rate is estimated to increase to 27.18% vs. 9.55% for employees in FY 2012-13.
4. Employers (i.e. taxpayers) contributed $44,518,693 to PSPRS in FY 2001-02.  In FY 2010-11, they contributed $273,824,144.  (Note: taxpayers also contribute to PSPRS through a fire insurance premium tax.  This tax is not included in the figures above.)
5. Employees contributed $62,486,725 to PSPRS in FY 2001-02.  In FY 2010-11, they contributed $99,262,271.
6. The average PSPRS pension in FY 2001-02 was $30,759.  In FY 2010-11, it was $47,739.
7. There were 15,557 active members (current employees) vs. 5,989 retirees in PSPRS as of FY year end June, 30, 2002.  As of FY year end June 30, 2011, there were 18,638 active members vs. 9,522 retirees.
8. As of FY 2001-02, there were 645 in the DROP.  As of FY 2010-11, there were 1,419 in the DROP.  Those in the DROP do not pay into PSPRS nor does the employer contribute anything toward those in the DROP.
9. Taxpayers are constitutionally bound to fund PSPRS.  This leaves taxpayers with virtually unlimited liability to PSPRS, and they are left to make the greater sacrifice to keep PSPRS funded.
10. $40,000 a year may not seem like a lot, but if you were to enter the DROP today with a $40,000 ($3,333/month) annual pension, you will walk away with  $224,000 five years later.   Also, $40,000 is the average pension.  When this average is calculated, it includes smaller pensions taken 15, 20, and more years ago as well lower surviving spouse pensions, so it is likely pensions being taken today are much higher.
11. Anyone hired on or after January 1, 2012 will have to work longer, pay more, and receive fewer benefits.  They will get no DROP.  They will pay for the excesses of those hired before them.
12. Pension reforms are threatened in the courts and the legislature.  For those hired before January 1, 2012, this may eventually return PSPRS to the status quo before SB 1609.
13. PSPRS has large investments in hedge funds and private equity firms.  

Readers can reach their own conclusions based on these additional facts.  They are relevant and need to be considered by anyone who wants to seriously engage in debates over PSPRS.