Hidden Pension Fiasco May Foment
Another $1 Trillion Bailout
March 3 (Bloomberg) -- The Chicago Transit
Authority retirement plan had a $1.5 billion hole in its stash of
assets in 2007. At the height of a four-year bull market, it didnft have
enough cash on hand to pay its retirees through 2013, meaning it was
underfunded to the tune of 62 percent.
The CTA, which manages the second-largest public transit system in the
U.S., had to hope for a huge contribution from the Illinois state
legislature. That wasnft going to happen.
Then the authority found an answer.
gWefve identified the problem and a solution,h said CTA Chairman Carole
Brown on April 16, 2007. The agency decided to raise money from a bond
sale.
A year later, it asked Illinois Auditor General William
Holland to research its plan. The state hired an actuary, did a study
and, on July 17, concluded that the sale of bonds would most likely result
in a loss of taxpayersf money.
Thirteen days after that, the CTA ignored the warning and issued $1.9
billion in bonds. Before the year ended, the pension fund was paying out
more to bondholders than it was earning on its new influx of money.
Instead of closing its funding gap, the CTA was falling further behind.
Public pension funds across the U.S. are hiding the size of a crisis
thatfs been looming for years. Retirement plans play accounting games with
numbers, giving the illusion that the funds are healthy.
The paper alchemy gives governors and legislators the easy choice to
contribute too little or nothing to the funds, year after year.
30 Percent Shortfall
The misleading numbers posted by retirement fund administrators help
mask this reality: Public pensions in the U.S. had total liabilities of
$2.9 trillion as of Dec. 16, according to the Center for Retirement Research
at Boston College. Their total assets are about 30 percent less than that,
at $2 trillion.
With stock market losses this year, public pensions in the U.S. are now
underfunded by more than $1 trillion.
That lack of funds explains why dozens of retirement plans in the U.S.
have issued more than $50 billion in pension obligation bonds during the
past 25 years -- more than half of them since 1997 -- public records show.
The quick fix for pension funds becomes a future albatross for
taxpayers.
In the CTA deal, the fund borrowed $1.9 billion by promising to pay
bondholders a 6.8 percent return. The proceeds of the bond sale, held in a
money market fund, earned 2 percent -- 70 percent less than what the fund
was paying for the loan.
The public gets nothing from pension bonds -- other than a chance to at
least temporarily avoid paying for higher pension fund contributions.
Pension bonds portend the possibility of steep tax increases.
eVery Riskyf
By law, states must guarantee public pension fund debts.
gWhat appears to be a riskless strategy is actually very risky,h says
David
Zion, director of accounting research for New York-based Credit Suisse
Holdings USA Inc. gIf the returns on the pension bond-financed assets
donft exceed the cost of servicing the debt, the taxpayers bear the
brunt.h
With the recession that started in December 2007, cities and states are
running huge deficits, which theyfre closing by cutting services and
firing employees. The economic downturn gives state legislatures another
reason to cut back on funding pensions.
Government retirement plans nationwide donft calculate their shortfalls
based on market values of their assets and liabilities, says Orin
Kramer, chairman of the New Jersey State Investment Council, which
oversees that statefs pension fund.
Paper Over Losses
Fund accountants resort to a grab bag of tricks to get by. They set
unrealistically high expected rates of return to reduce governmentsf
annual contributions. And they use smoothing techniques to paper over
investment reverses so they make losing years look like winners.
Accountants do that by averaging gains and losses, usually over a
five-year period -- sometimes for as long as 15 years of investment
returns.
That means actual results of any one year arenft used to calculate how
much a state legislature contributes, which can delay governments catching
up with losses for more than a decade.
This ruse can pass the buck to future taxpayers, who will pay for the
retirement benefits of todayfs government workers.
gThere are accounting gimmicks in pension land which create economic
fictions and which disguise the severity of the real problem,h Kramer
says. gUnfortunately, pension board members donft have much of an appetite
for disclosing inconvenient truths.h
Calpersf Numbers
The Teacher Retirement System
of Texas, the seventh-largest public pension fund in the U.S., reports
each year that its expected rate of return is 8 percent. Public records
show the fund has had an average return of 2.6 percent during the past 10
years.
The nationfs largest public pension fund, California Public Employeesf
Retirement System, has been reporting an expected rate of return of 7.75
percent for the past eight years, and 8 percent before that, according to
Calpers spokesman Clark
McKinley.
Its annual return during the decade from Dec. 31, 1998, to Dec. 31,
2008, has been 3.32 percent, and last year, when markets tanked, it lost
27 percent.
eItfs Pitifulf
gItfs pitiful, isnft it?h says Frederick
gShadh Rowe, a member of the Texas Pension Review Board, which
monitors state and local government pension funds. gMy experience has been
that pension funds misfire from every direction. They overstate expected
returns and understate future costs. The combination is debilitating over
time.h
Rowe, 62, is chairman of Greenbrier Partners, a private investment firm
he founded in Dallas 24 years ago.
Texas teacher retirement fund spokesman Howard
Goldman and Calpersfs McKinley declined to comment on Rowefs views.
Most public pension funds, like the one in Chicago, were already
treading water before the 2008 stock market crash. Now theyfre closer to
sinking.
State government pension fund assets in the U.S. fell 30 percent in the
14 months ended on Dec. 16, losing $900 billion, according to the Center
for Retirement Research.
Fund managers donft have many options for increasing assets. They need
adequate funding from state legislatures, which in many cases they donft
get. Beyond that, theyfre at the mercy of financial markets.
Easy Money
Typically, public pension funds put 60 percent of their assets in
stocks, 30 percent in fixed income, 5 percent in real estate and the rest
in riskier investments such as hedge funds and commodities.
That mix requires the nonbond assets to earn double-digit gains in
order to reach expected rates of return.
The easiest way for retirement plans to increase cash is to issue
pension obligation bonds. For the funds, that means borrowing money at no
risk -- because the bonds are backed by taxpayers.
A government retirement plan canft go bankrupt, even if itfs insolvent;
state treasuries must put up the money if a fund runs dry.
What for retirement plans in the U.S. has been a simple solution --
issuing $50 billion in pension bonds --has become a growing headache for
the public.
eWhere Did The Money Go?f
gWhen the actuary is finished with his magic, where did the money go?h
asks Jeremy
Gold, who was one of the first actuaries to work for a Wall Street
firm when he joined Morgan Stanley in 1985.
The answer, he says, is that future taxpayers may cover what fund
administrators had hoped to get from investment returns.
For investors, these debt sales are similar to ordinary municipal
bonds. Because both forms of debt are ultimately backed by taxpayers,
credit rating firms give them high grades for safety. The difference for
bondholders in states is that pension bonds arenft tax-exempt.
General obligation bonds are typically used to pay for construction of
schools, hospitals and other public works; pension bonds just fund needy
retirement plans. For that reason, Congress decided in 1986 that pension
bond income should be subject to federal income taxes.
Government officials say they issue pension bonds believing that their
fund managers can earn more money from investing the proceeds than what
they have to spend in interest payments to bondholders.
eRisk Is Minimalf
The government of Puerto Rico borrowed $2.9 billion through pension
bonds in 2008, betting that it could reap annual returns of 8.5 percent
investing the money, while paying its bondholders 6.5 percent.
gThe risk is minimal,h says Jorge Irizarry, who was chairman of the
Employees Retirement System of Puerto Rico from August 2007 through
December 2008.
A political appointee, he departed after his party lost the
governorship in November. Before working for Puerto Rico, Irizarry was an
executive on the island at PaineWebber Group Inc., now UBS Puerto Rico,
from 1986 to 1998.
So far, Puerto Ricofs wager isnft paying off. The 8.5 percent expected
rate of return has instead been a loss of more than $200 million,
according to a Dec. 12 presentation by fund administrators to legislators.
eTurned Against Usf
gIt was an arbitrage transaction, and the market has turned against
us,h says Carlos
Garcia, former president of Banco Santander Puerto Rico, who replaced
Irizarry as chairman of the pension fund in January. gI donft know if the
benefits intended will be realized.h
Actuaries consistently permit public pension funds to report
artificially high expected rates of return -- most often 8 percent and as
much as 8.75 percent. Thatfs more than the 6.9 percent billionaire
investor Warren
Buffett sets for his Omaha, Nebraska-based Berkshire Hathaway Inc.fs
pension fund.
gPublic pension promises are huge and, in many cases, funding is
woefully inadequate,h Buffett wrote in his 2008 letter to shareholders.
gBecause the fuse on this time bomb is long, politicians flinch from
inflicting tax pain, given that the problems will only become apparent
long after these officials have departed.h
Determining how much expected rates of return should be isnft
complicated, says Rowe, who oversees Texas pension funds.
gWhy do they choose high expected rates of return?h he says. gThe only
reason is to sneak through promising a lot to pensioners -- which means
worrying about it later. Itfs madness.h
The Rules
The Governmental Accounting
Standards Board, a nonprofit group that provides guidance for
accountants, has rules for financial reporting by public pension funds.
A study commissioned by the U.S. Senate Finance Committee, released on
July 10, 2008, found that GASB guidelines could be meaningless.
gGASB operates independently and has no authority to enforce the use of
its standards,h the report said. Each state sets its own rules. The GASB
rules donft mention pension bonds.
Illinois sold the largest pension bond issue ever, $10 billion in 2003,
to shore up its state pension funds. In 2007, former Governor Rod
Blagojevich proposed an even larger, $16 billion pension bond issue,
as the statefs unfunded pension liability exceeded $40 billion.
The legislature impeached Blagojevich in January after he allegedly
sought bribes in return for filling President Barack
Obamafs vacant U.S. Senate seat.
Ignoring Advice
When the Chicago Transit Authority decided to issue debt in 2008, it
did its own calculations.
The CTA concluded it could borrow $1.9 billion, paying an interest rate
of 6 percent to bondholders, and invest the proceeds to receive its
expected rate of return of 8.75 percent. Such an annual return would add
$52 million a year to bolster the fund.
The CTA chose to ignore not only Illinoisfs auditor general but also
its own actuarial firm, Detroit-based Gabriel Roeder Smith & Co. The
company had determined there was just a 30 percent chance of earning 8.75
percent.
gWe executed the best transaction we could, given the legislative and
political restraints,h says CTA Chairman Brown, who is also co-head of
municipal finance at Chicago-based Mesirow Financial
Inc.
Credit Crunch
Since the bond sale, the authority has held the money as cash, earning
2 percent. And, with the credit crunch forcing municipal bond interest
rates up to attract buyers, the CTA wasnft able to sell bonds with a 6
percent return.
A team of underwriters, including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan
Stanley, sold the CTA bonds in August 2008, at a yield of 6.8 percent, so
the fund had to pay bondholders more than it had expected.
gThere is negative arbitrage,h Brown says. gItfs better than having
dumped the money into the equity market.h
The one group that benefits from the pension bond sales is the CTAfs
retirement plan members. The authority is responsible for contributing
more than twice as much to the fund as its employees. Thus the retirees
are virtually certain to enjoy pension contribution savings from the
pension bonds, the auditor generalfs report says.
Puerto Rico Mistakes
Neither workers nor the government are thrilled with the public pension
system in Puerto Rico. As of 2005, the Caribbean islandfs government
pension, with 278,000 participants, had assets that totaled just 19
percent of its long-term liabilities. That made it less funded than any
state retirement fund in the U.S., public records show.
Puerto Ricofs pension system is a model for common mistakes made by
public funds across the U.S.
Puerto Rico, a U.S. commonwealth with a population of 4 million, has
underfunded its main public pension fund since 1951 to save cash.
The island, whose capital building in Old San Juan is as close to the
turquoise ocean waves as are the tourists taking photos on the edge of the
beach, is far from being a financial paradise.
The legislature has repeatedly ignored annual suggested contributions
calculated by its own actuaries, according to the Employees Retirement
Systemfs records.
Boosting Benefits
Puerto Ricofs legislature raised pension benefits without funding the
increased expense 30 years ago. Edmund Garza, the retirement systemfs
administrator from 1992 to 1996, says pensions were boosted from 45
percent of average salary to 75 percent after 30 years of employee
service.
gThey didnft prepare a detailed actuarial analysis to see the financial
impact of this decision, but definitely it was huge,h Garza, 47, says.
The government skipped nearly $2 billion in contributions urged by its
actuaries from 2000 to e05, according to fund records. The pension system
continued a course toward insolvency as it paid out more in benefits than
it took in.
By 2005, the Employees Retirement System had $12.3 billion of pension
obligations with just $2.3 billion of assets. Puerto Rico itself has a
BBB- credit rating, one notch above junk, from Standard & Poorfs.
gWe are very near bankruptcy,h says economist Jose Villamil, speaking
of the commonwealth. He is founder of Estudios Tecnicos Inc., a San
Juan-based economics consulting firm. gThe budget is out of control; the
treasury is in sad shape.h
eContinue to Deterioratef
In 2007, the actuary for the Puerto Rico fund, Hector Gaitan of Buck
Consultants LLC, recommended that the legislature make an annual
contribution of $564 million.
gThe financial status of the System will continue to deteriorate,h
Gaitan said in a Feb. 12, 2007, letter to the pension board that urged a
boost in commonwealth contributions.
The legislature ignored Gaitanfs warning. It chose to put $398 million
into the pension fund. Just months after Gaitan suggested bigger
government contributions to the retirement system, the pension board
dismissed Gaitan and his firm.
gThose comments may have gotten us in trouble,h says Gaitan, seated at
his desk in a small cramped office in a San Juan business park landscaped
with palm trees. gWe were terminated shortly thereafter.h
Irizarry, who chaired the fundfs board until Dec. 31, declined to say
why the board dismissed Gaitan.
Outdated Mortality Tables
Gaitan says the retirement systemfs underfunding may actually be an
additional $1 billion or more than the fund reports, because the board
relies on outdated mortality tables based on 1960s statistics to compute
its future obligations. The shorter life spans in those outdated tables
reduce the apparent size of the fundfs liabilities.
The legislature has taken one step to improve pension funding -- on the
backs of employees hired after Dec. 31, 1999. New employees are denied
fixed annual pensions. They must self- fund their retirement accounts.
The legislature diverts 9.275 percent of salary pension contributions
for new workers to help scrape together the money needed to provide
pensions for pre-2000 employees. By not making pension payments to
employees hired after 1999, the pension fund will cut future liabilities.
The states of Alaska and Michigan, like Puerto Rico, have eliminated
traditional public pension funds for new employees in the past 12 years.
Ana Reyes, an attorney in Puerto Rico, decided to take a job with the
city of Caguas in 2008 so she could lock into a government pension.
eMy Insurancef
gI wanted to have a good life when I get old,h Reyes, 33, says. gThat
was my insurance.h
Reyes, who lives in the islandfs Central Mountain Range 20 miles (32
kilometers) south of San Juan, says she didnft know that new employees get
no retirement payments funded by the government.
gIf Ifd known this, I might have made a different career decision,h
says Reyes, who is the mother of a 2-year-old girl. gWhen I started here,
they didnft explain that.h
Even states that have had fully funded pensions --such as New Jersey in
the 1990s -- now have retirement plans with fewer assets than future
liabilities and arenft moving to plug the gaps.
Jon Corzine
New Jersey Governor Jon
Corzine, a former co-chief executive officer of Goldman Sachs, has
proposed allowing government pension funds to put off half their pension
contributions because of the statefs growing deficit during the recession.
Corzinefs suggestion follows a recent New Jersey pension track record
of mistakes. When the statefs pensions were healthy in the 1990s, the
state legislature eliminated nearly all of its annual pension
contributions for almost a decade, while adding $4.6 billion of benefits.
New Jersey sold $2.75 billion of pension bonds in July 1997.
Then-Governor Christine
Todd Whitman said at the time that the bonds would save taxpayers $47
billion and make the system fully funded.
gYoufd be crazy not to have done this,h Whitman said in a Bloomberg
News interview in June 1997. gItfs not a gimmick. This is an ongoing
benefit to taxpayers.h
Whitmanfs prediction hasnft held up. While the state pays pension
bondholders a fixed 7.64 percent interest rate, the fund has earned 4.8
percent annualized since the bond sale, according to Tom Bell, spokesman
for the New Jersey Treasury Department.
eOutrageous Gimmickf
New Jerseyfs pension bonds havenft saved taxpayers $47 billion. To
date, the state has lost more than $500 million on those bonds, according
to state records.
gGovernor Whitman came up with this outrageous gimmick in order to give
people tax cuts,h says Kramer, chairman of the board that oversees New
Jersey state pension funds.
As the global economic crisis deepens, public pension funds will lose
more money. The solution shouldnft be more accounting tricks, Kramer says.
gVirtually every pension system has suffered losses in excess of 20
percent since they created the last set of artificial numbers,h he says.
The best step forward would be for states to negotiate benefits down,
increase pension contributions and reduce the expected rate of return,
Texas pension oversight board member Rowe says.
Public pension funds have to stop pushing the costs of retirement
benefits for current workers into the future, actuary Gold says.
gYoufre putting a bigger burden on your children,h he says. gIt amounts
to a transfer from tomorrowfs taxpayers to todayfs employees.h
For Related News and Information:
To contact the reporter on this story: David
Evans in Los Angeles at davidevans@bloomberg.net
Last Updated: March 3, 2009 01:00 EST