Archive for the ‘Pension Crisis’ Category

In a recent news release, State Treasurer John Chiang said:  “…the Governor and I are partnering on a fiscally prudent plan to buy down our pension debt using what Albert Einstein once called ‘the eighth wonder of the world,’ compound interest. ”

It’s not Albert Einstein he should be crediting, but Bernie Madoff.

The plan calls for shifting $6B from the state’s short-term investment pool, where it earns less than a point, to Calpers, where it could conceivably earn 7% (the most recent 20-year average).  The difference in earnings could generate $11B over the next 20 years for the financially challenged fund.

The math is theoretically correct, but it is a classic example of papering over a problem.

Just as Madoff used cash from recent investors to pay established clients, Chiang is shortchanging the needs of the rest of the state by denying access to these monies for general purposes.

He is also ignoring the risks of shifting funds from a risk-free pool to a highly volatile investment fund.  As I have stated before, the world economy has undergone major structural change over the last few decades.  Increased competition, which has been generally good for consumers, has also heightened investment risk.  Chiang should know that past performance is no indicator of future returns, especially when the past has little resemblance to the present. Whipsawing is a more appropriate description of Calpers performance in more contemporary times.

Rather than coming to grips with the real problem, that is, insufficient employee contributions to cover very generous benefits, Chiang wants to play a shell game. Yes, even assuming the 5.1% rate for the most recent 10 years, more cash would be generated, but any improvement in returns is lost to the general fund.

Chiang should be considering altering the investment strategy of the short-term pool.  A targeted rate of 1.5 points (about one-third more than  the current return) could be accomplished without undue exposure to additional risk. It would be much safer than allowing Calpers to roll the dice and pray we do not have a major economic crisis.

But regardless, he is re-purposing cash and locking it up at a time when the state has other pressing needs.

Once the $6B is transferred to Calpers, it becomes political capital benefiting only one segment of the state’s population – public employees.

But then, they are who Brown and Chiang represent.

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Both the New York Times and LA times have recently published informative articles about the status of public pensions, particularly Calpers. LA Times’ Jack Dolan and James Koren have provided sober analysis in recent weeks.

The reporters have echoed the same concerns I, Jack Humphreville, respected members of academia and many in other publications have been sounding for years – concerns over the diminishing sustainability of the defined benefit plans that almost every politician at the state and local government levels have ignored. A few, including Governor Brown and former Governor Schwarzenegger, have attempted modest reforms and failed, because of the death-grip public unions have on our elected officials.

The NY Times article, by Mary Williams Walsh, is particularly interesting because it reads like a case study. For all intents and purposes, it is one. It deals with a small fund managed by Calpers. Since this particular fund is so small, it is easier for readers to wrap their heads around the math. But it is the same math behind every other defined benefit plan, large and small. Just as a lab experiment on a single cancerous cell can speak volumes about the greater disease, so can this case shed light on the cancer of public pensions.

Basically, the problem boils down to using aggressive favorable assumptions to gauge the financial health of plans, plans which are required to fully guarantee the promises made to their members. The assumptions have masked the weakness of the underlying numbers.

The important difference between a market vs actuarial approach to funding defined benefit plans is critical, as the article suggests. As the small pension unit in the article learned, Calpers charged them the market rate to liquidate the plan, which was a sum far greater than the actuarial value Calpers uses to assess the health of any plan.

Quite a shock to the participants who assumed things were just peachy.

Calpers wants it both ways: use the blue-sky view for public disclosure, but penalize participants based on reality. It’s called “having your cake and eating it too” (a few of my colleagues at Citywatch know how much I detest that expression, but it applies here).

The truth is, Calpers should not be hanging its hat on one approach vs the other. A range of values needs to be shared with the public, and funding should be based on at least a blend of outcomes.

That means either taxpayers fork over more money, or the participating employees contribute more. The taxpayers are already covering too much, not to mention bearing the risk if there are insufficient funds to pay participants.

How much more participants should pay is arguable, but it would cause some degree of pain in any event – manageable pain.

In the private sector, typical employees pay 6.2% for SSA retirement and contribute at least 6% into a 401K. State employees contribute anywhere from 5% to 11.5% of their salaries. Pretty good compared to the 12.2% absorbed by their counterparts. Safety workers are at the higher end, but can retire much earlier and collect up to 90% of their salaries.

A private-sector worker would pay $1 million to purchase an annuity comparable to an average CalPERS’ benefit starting at age 60. A state employee earning an average of $100,000 and contributing 10% would pay in $300,000 over 30 years in gross terms. Obviously, discounting the amount would lower it considerably.

That’s a pretty large gap. In any event, Calpers would still be a good deal for employees if their contribution rates doubled.

And why not?

Investors pay more, in the form of a lower yield, for less exposure to risk. Why shouldn’t public employees pay a premium for what is a risk-free, lifetime benefit?

The system is not going to collapse tomorrow. It’s similar to a sinking ship, which takes on water but stays afloat….that is until buoyancy is lost.

When that happens, it goes down faster than the Edmond Fitzgerald.

Time to start pumping and sealing the leak.

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The Los Angeles Times reported that CALPERS incurred its worst rate of return since 2009.

One year does not make or break the pension fund. Two years of low returns in a row hurt, but alone are not enough to register as a crisis.

What is telling is the average rate over the last 10-20 years has fallen well below the assumed rate of return of 7.5%, which is a major factor in determining the long-term funding of the retirement plan.

The rates reported were as follows:
7.03% over the last 20 years
Less than 6% over 10-15 years (Bloomberg reported 5.1% over the last 10 years).

LACERS has not published its updated rates yet, but almost all would expect a similar set of results. The fund was in negative territory for the year as of March 2016, which will drag down the average rates over the 10-20 year period. LACERS’ 20 year return will probably be treading close to the 7.5% earnings assumption, while those for the 10-15 year range will miss the mark by a significant margin.That range was already well below the assumed rate as of last fiscal year.

What’s so special about the 10-20 year range?

It is what I refer to as the relevant range.

Think of it like comparing baseball players from different eras. Hard to decide who was the greater slugger – Babe Ruth or Hank Aaron – because they played under markedly different conditions and levels of competition.

Comparing investment returns rooted in the years prior to 20-30 years ago is like going through a time warp. The world economy has changed drastically since then due to globalization. As I pointed out in an article several years go, the United States is no longer the lone 800-pound gorilla in the market. As competition has increased, so has investment risk.

Relying on more recent returns as a predictive gauge has even greater risk, since one extraordinary year will skew the results.

Assuming a rate much beyond a very conservative level is playing with fire in an age where markets whipsaw in response to both rational and irrational reasons. Public employee pension managers are under pressure to hit artificially high rate assumptions that they willfully incur more pronounced risks.

Bad timing can kill you. It could also deliver one-off major gains, but who wants to take a Las Vegas approach to investing funds underlying a guaranteed payout?

Public retirement funds are probably not going to collapse. Instead, they will require higher contributions to assure retiree benefits are covered.

The additional cash will have to come from either greater employee contributions and/or the taxpayers. In case you haven’t noticed, the ballots are always filled with tax measures, utility rates are tracking upwards and the costs of government services has steadily increased. We do not need another bill to pay.

In a city like Los Angeles, where the taxpayer contributions have grown from 10% of the general fund to 20% in ten years, the ability to provide basic services will diminish.

It’s what I have repeatedly referred to as virtual bankruptcy, a slow and painful path for the public.

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As I pointed out in Monday’s edition of Citywatch, the City of Los Angeles booked a $7.6 billion adjustment to recognize the unfunded pension liability owed to the beneficiaries of its public pension programs. It is an admission that the residents and stakeholders of the city are on the hook for very generous retirement benefits offered to municipal employees. For the record, the adjustment does not cover exposure to virtually free health benefits.

Anyone who follows the city’s finances expected this. All of our elected officials have been expecting this.

I got around to reading the Comprehensive Annual Financial Report, which was issued on February 5th, on last Saturday, February 27th. I wrote and published my article about the very significant adjustment on February 28th. Citywatch picked it up on the 29th….and still beat the city’s press release by a day! I thought I was slow.

It is common- in the interest of transparency – to disclose material adjustments to an entity’s financial position in sufficient detail to stakeholders, whether they are shareholders, investors or, in the case of a governmental unit, taxpayers and others who pays fees for public services. Such disclosures should be timely, too. Almost a full month after the financial statements were released is not timely.

However, worse than the poor timeliness, was the lack of sufficient detail.

The nature of the disclosure was simply that it was mandatory. The Governmental Accounting Standards Board (GASB) issued pronouncement 68 requiring that unfunded pension liabilities be included in the face of the financial statements, identified as Net Pension Liability. The statements, cover letter and subsequent, but late, press release did not offer any explanation as to why GASB issued the new reporting requirement, that it was necessary to emphasize the impact defined benefit plans had on governments’ long-term resources.

Furthermore, the treatment on the financial statements is still not as transparent as it should. According to a white paper issued by California Committee on Municipal Accounting (a joint committee comprised of representatives of the League of California Cities and the California Society of Certified Public Accountants) the Unfunded Pension Liabilities will become a new liability on the Statement of Net Position, appropriately named “Net Pension Liability.”

I challenge anyone to find a line in the CAFR’s Statement of Financial Position that states “Net Pension Liability.”

Instead, you will find “Non-Current Liabilities due in more than one year.”

Only if you compared that line with last year’s CAFR could you determine the impact on the liabilities. So, the most significant, long-term liability is buried. You must dig much further by diving into the notes to get a sense of what occurred – that is simply what GASB 68 was trying to avoid.

As I mentioned, the press release is short on details.

But it also obfuscates the result by aggregating the impact on a city-wide basis instead of the operating segments.

If you break it out by segments, the Government Activities segment took the brunt of the adjustment, putting its equity in negative territory. This is the segment responsible for core services residents depend on for quality of life. It includes public safety, recreation and transportation, among others.

No where is there a discussion of how the Net Pension Liability is likely to grow. City contributions to retirement plans as a percentage of payroll has been growing steadily (see my previous article). That is a reflection of the increasing burden the retirement plans are having on the budget.

Ron Galperin is the best controller Los Angeles as ever had – by far.

If the city elections were held tomorrow, he would have my vote.

However, this all demonstrates how strong the influence politics has on the Office of Controller. No one wants to risk raising awareness over this controversial and costly problem, because doing so could create tensions with the powerful public unions many of our elected officials depend on for their re-election campaigns.

Galperin may not be a beneficiary of such support, but he must work with city officials who are.

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Did you see it?

Can’t blame you if you missed it. It is sad when only numbers geeks take notice – nothing wrong with being a numbers geek, though, because they are a rare breed in City Hall.

As reported in the Comprehensive Annual Financial Report (CAFR)for FY June 30, 2015, issued by the City Controller on February 5, 2016, the equity of the City of Los Angeles took a hit to the tune of $7.6 billion, perhaps the most significant single adjustment ever recorded in its history. Most of the adjustment ($6.7B) fell on the Government Activities segment of the balance sheet. That segment went from positive territory of $5.1B to a negative ($.5B).

The adjustment was required under Statement 68 issued by the the Government Accounting Standards Board (GASB). 68 required government entities to recognize unfunded pension liabilities in the body of the financial statements instead of buried in the footnotes.

There was no discussion as to the background and reasoning behind it, nor the ramification – moving the liability from the hypothetical realm to the real world.

It would have been worse had the earnings rate assumption for pension assets been more realistic – say somewhere around 6.5% instead of 7.5%.

As revolutionary as Statement 68 was by requiring recognition of the net pension liability, it failed to rein in the discretion cities have in setting the earnings rate. Only the worst of the worst government pension plans would be subject to the application of a low risk-free rate. Please read my earlier article on the subject.

City Hall likes to suppress controversial news. Encouraging open debate over a delicate political issue, such as public pensions, creates tension.

To be fair, though, most people would not understand the nature of an unfunded liability, but it’s not complicated when you think about it. The liability is not much different than a negative amortization loan – and more than a few people wrestled with one during the mortgage meltdown.

Your loan balance grows faster than the value of the house because the variable interest rate runs higher than the one used to calculate the monthly payment. The balance grows to the point where refinancing is impossible and selling the home requires a short sale.

We are seeing a version of that scenario playing out in the city’s finances. Employer contributions as a percentage of payroll has steadily grown from 19.9% in 2006 to 36.5% in 2015 for Police and Fire, and 14.2% to 20.8% for civilian employees (LACERS) – Source: 2015 CAFR.

Controller Ron Galperin has done an unprecedented job of educating the public about the city’s finances. I particularly like his Community Financial Report, sort of a CAFR-light for the vast majority of the population with no times to review the 400 pages of the mother document.

The CFR covers the $7.6B as a one-liner on page 6.

Ron, whose public outreach should be a model for other officials to follow, needs to take this issue on the road and encourage an open discussion as to what it means to the city’s long-term capability of delivering cost-effective services.

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I wrote an article in January 2014. It covered the ever-increasing human life span in this country (if not most of the developed world) and what it meant to projecting post-retirement benefit costs.

A recent report by CNBC cites the projections of respected financial advisers regarding life spans and retirement planning.

“The first person to reach age 150 has already been born,” exclaimed Ric Edelman,chairman and CEO of Edelman Financial Services.

Obviously, while 150 will be the exception rather than the norm, 120 is within the reach of anyone under 40 with decent health care and a semi-active lifestyle. The number of people making it to their 90s tripled between 1980 and 2010; it is expected to quadruple between 2010 and 2050.

No complaints about living longer, assuming we can avoid undue pain and suffering, but think of the effect on Social Security and public pensions, both defined benefit plans.

Governments are thinking about it. They are just not doing anything about it.

California, Los Angeles and all other cities in the state will face dire consequences as pension and healthcare contributions will have to be increased mush faster than revenue growth to just stay above water. There is only so much the taxpayers will be able to afford. For that matter, we are already contributing too much while public employees provide too little.

In a city like Los Angeles, for every year a retiree lives beyond mortality expectations, the combined cost of health and pension costs could easily exceed $100,000 per year. A thousand retirees exceeding actuarial estimates of life expectancy would cost the city $100 million extra per year.

A court decision that exposes public pension benefits to cuts from municipal bankruptcy will undoubtedly loom larger in the years to come.

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Death and Pensions

My first accounting job after college was with a retirement trust operated by a trade association for its members.

Defined benefit plans were common for both the private and public sectors in those days.

Each plan underwent a required periodic actuarial review, as happens today. My functions as a staff accountant included providing data to the actuaries and supporting their work by pre-analyzing each individual plan.

I recall a conversation with one of the actuaries concerning the life expectancy assumptions he applied: a 30-year old white male could be expected to live to around 70, about 77 for a white female and somewhat less for all others. This was back in the early seventies.

I asked if he had considered a higher age since the trend clearly pointed to longer and longer life spans.

He agreed that would be an appropriate consideration, but he had to base his assumptions primarily on actual historical data. However, he reminded me that with each subsequent review, the life expectancy would be pushed upward.

Regardless, the life expectancy assumptions he used would tend to trail probable future experience. The actuary did not believe there would be a significant variance in the funding. Employees and employers would be willing to contribute more to secure the future stream of benefits.

What reminded me of this long-ago conversation was an editorial in the Los Angeles Daily News written by Daniel Borenstein, a columnist with the Contra Costa Times who has a Masters in Public Policy from Cal Berkeley.

Mr. Borenstein criticized Calpers for understating life expectancies for its retirees, effectively hiding the true cost of funding the retirement plan.

“Given constant advancements in medical science…the California Public Employees’ Retirement System hasn’t previously factored future mortality improvements into actuarial calculations. As a result, it has not collected enough money to pay pensions when workers retire.”

“Currently, CalPers studies the mortality data for its members every four years and from that projects how long retirees will live and receive benefits. But those numbers don’t account for the expectation that people will live longer in the future; it only considers how long they’ve lived in the past.”

That was deja vu for me. I truly hope our elected officials at the state and local levels read the article. Along with public union leaders, they are living in denial regarding the stability of public pension plans everywhere in California.

But how serious is this understatement? Remember, the actuary I dealt with did not think the variance was significant.

Well, times have changed since the seventies.

Consider this: deaths per 100,000 have dropped by 32% and 45% for middle-aged persons since then (female and male, respectively). All that in a span of 40 years. Using a simple average, that is one point per year. A compound rate would be a little higher. This trend is much higher than the historical data we relied on in the seventies. That means the rate of underfunding has been running higher than my former employer’s actuary ever imagined.

While a percentage point per year may sound harmless, the cumulative effect between actuarial adjustments could easily amount to 4% or 5% underfunding. That’s very serious since we are dealing with billions in accrued benefits.

Who will fund the shortfall?

The responsibility should fall mostly on the participants, but most of our politicians, including the Los Angeles City Council and our State Senators and Assembly Members, do not have the stomach to bargain in earnest with the public unions on whom they depend for campaign contributions.

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