The POLICEPAY Crew (L to R) Matt, Ron, and Charles
Why 100% Under-Funding Of Pensions Is Best For Everyone
By: Ron York, President
POLICEPAY.NET
One of the most common statements made by politicians about government is:
“We are leaving our children and grandchildren saddled with huge pension debts that will be impossible to pay.”
First, let me respond to that statement. So what? It will never have to be paid. It is not as if someone is going to show up at the front door demanding payment. Oh, the people owed today will be paid, but new people will take their place. The total debt will increase along with the growth in gross domestic product, but so will everything else, including wages. If we were talking about a non-governmental entity, we might be concerned that there would be a day that it would cease to exist. If that occurred, the debt would have to be paid. Governments are perpetual entities. Even the City of Vallejo is not going out of business. It will continue to operate with business as usual.
Debt has a negative connotation in our society. There are seminars on how to become debt free, which are very similar to weight loss programs. What is debt? Debt is another form of equity, equity that has less risk than proprietary equity, but less reward potential also. Equity is a claim against an asset. If you have a home worth $100,000, with no mortgage, you have equity in the house of $100,000. If you have a mortgage of $75,000, your equity is $25,000. What happened to the rest of the equity? It is now equity owned by the mortgage company. Just keep in mind that debt is just equity, not a dreaded disease. Debt is debt, regardless of its form. Assets are assets, regardless of their form.
I want a new car. I am off to the dealership.
| Current Amounts | Pay Cash | Get A Car Loan | Take Out A 2nd Mortgage |
Cash | $50,000 | $25,000 | $50,000 | $50,000 |
Old Car | $5,000 |
|
|
|
New Car |
| $30,000 | $30,000 | $30,000 |
Home | $250,000 | $250,000 | $250,000 | $250,000 |
Car Loan |
|
| ($25,000) |
|
Mortgage | ($150,000) | ($150,000) | ($150,000) | ($175,000) |
Equity | $155,000 | $155,000 | $155,000 | $155,000 |
The table above shows the options available to a person that wants to trade his old car in for a new car. The new car costs $30,000 and the old car is worth $5,000. Let us assume the interest rates on the mortgage, cash savings, and a potential car loan are equal. This keeps arbitrage out of the equation. The first column is where this fellow is before he heads off to the car dealership. The next three columns are his three purchase options. Notice that his equity position is the same in all four columns. With the first and third options he is driving a car that is paid off, but is he in any better of a financial position? To purchase the new car he has to give up his money or take on debt.
I am the mayor and I have a large pension liability. What should I do?
| Current Amounts | Use Cash | Use Bonds | Reduce Assets |
Cash | $150,000,000 | $50,000,000 | $150,000,000 | $150,000,000 |
Fixed Assets | $300,000,000 | $300,000,000 | $300,000,000 | $200,000,000 |
Pension Liability | ($100,000,000) | $0 | $0 | $0 |
Bonds Payable | ($150,000,000) | ($150,000,000) | ($250,000,000) | ($150,000,000) |
Equity | $200,000,000 | $200,000,000 | $200,000,000 | $200,000,000 |
The mayor has six options:
- Do nothing
- Use cash
- Sell bonds
- Reduce assets
- Raise taxes
- Cut expenditures
How does he reduce assets? This is accomplished by replacing assets at a slower rate than they are being depleted. Even if he uses his cash or sells more bonds, he will eventually be tempted to move into buying fewer assets. Money to purchase assets is diverted to either replenish cash or pay off the bonds. Some of you are thinking that raising taxes or cutting expenditures are the best options. What if he cannot raise taxes? Even if he can raise taxes, it is a poison pill in politics. Making substantial cuts in expenditures is virtually impossible. Most cities choose to reduce assets through asset attrition. In the short-term, it is the least painful. Eventually, there is an asset crisis – everything is old and worn out. It is then that bonds are sold and the inventory of capital assets is replenished. That is, if he can pull it off.
Case Study – California and Proposition 13 (Prop 13)
On June 6, 1978, California citizens voted to adopt a constitutional amendment that put restrictions on real estate tax rates. This was a revolt by California citizens led by Howard Jarvis and Paul Gann. As with every political action, there were consequences. About this same time, the move to start pre-funding public employees’ retirement systems took hold. Prior to then, most systems were on a pay-as-you-go basis or greatly under-funded. Essentially, cities and counties began making double payments. This large increase in expenditures combined with a cap on taxing ability led to local governments scrambling to close the cash flow gap. Selling bonds to liquidate their pension liability was not possible because of the annual debt service needed. Left with only one option, to reduce expenditures, local governments chose the route that caused the least pain – reducing capital expenditures.
It took nearly twenty years to fully fund the pension plans, causing a severe decline in the quality and quantity of capital assets. Especially hard hit were the California public school systems. Once considered as the state with the best school systems, California schools were consumed with mediocrity. A similar effect was seen in city governments. Where was all that money that would have been spent on capital assets? Was it in the bank accounts of retirees? No, it is residing at California Public Employees’ Retirement Systems (CALPERS) – in perpetuity. It is not going to be spent. The fund balance is just going to grow. At first, the question might have been “who moved my cheese?” Thirty years later, this piece of mouse cheese has become Mt. Everest with $250,000,000,000 worth of cash, stock, bonds, and real estate. That is billions, one-quarter of a trillion dollars. To make matters worse, CALPERS evolved from being a grandfatherly caretaker and conduit into a non-profit Carl Icahn that flexes its muscles financially and politically.
Where would California be today if the pension plans had been left on the pay-as-you-go basis? All of the money permanently parked at CALPERS would be in streets and school buildings. People on city councils and school boards would have an understanding of annual pension costs and would be able to comprehend presentations that estimate future cash flow, because pay-as-you-go is simple, consistent and easy to understand. Instead, they are stuck with the dreaded “black box” – the actuarial study. We would be hard pressed to find ten city council or school board members in the entire State of California that understand what happens inside that intimidating “black box.” Like a pagan god, the actuarial study shows up annually at governing board meetings, causing anxiety and fear in the hearts of everyone. The actuary, like a grim reaper, unveils the amount that must be stuffed into the ‘black box” this year to satisfy this vengeful god of finance and mortality. It might be ecstasy (zero) or sudden death (40% of payroll). Whose sudden death? Your pension benefits. They come under severe attack. With pay-as-you-go, the annual funding of pension obligations would be as boring as driving across the desert, instead of being as frightening as a trip down “Elm Street.”
Why would we want to pre-fund pension obligations? Why would we want enough money in a bank account that someone else controls, to liquidate the entire pension obligation? Remember, debt is debt. Substitute “bonds payable” for “pension obligation.” Is it sinking in? Why don’t we pass a rule that requires cities to have enough money in a bank account that someone else controls to fully liquidate the bonds? It is like that old remark about conservative banks. “If I met all the requirements that the bank wants, I would not need to borrow the money.” Debt is debt. There is no good or bad debt.
I advocate spending down the funds and then going back to a pay-as-you-go system. There is just one problem. How do we make employees secure? The bankruptcy petition by the City of Vallejo shows that it is possible to “jerk the rug” on agreements with employees. I do not have the solution to that problem. Unfortunately, the mistake made with pensions is about to be committed with retiree health insurance plans. The same misguided application of simple, personal household finance to a command economy, governmental function is being heralded again. Go ahead and worship “financial accounting conservatism” and send all your money to an entity that you have no control over and sit back and watch your money be used to control your decisions and behavior.
