Tuesday, May 15, 2012

The Pension Wars - 2012

A long series of mistakes and bad decisions have brought us to the pension wars of 2012..  While there have been many blunders, by employees and employers, six stand out as major:

  • Granting retro-active benefits
  • Employers not making full contributions
  • Loop holes that permit spiking of pension benefits
  • Failure to educate constituents of the rationale for public pensions
  • Moving from pay-as-you-go to prepayment of pension benefits
  • Tying employer contributions to equity and real estate markets 

There is a general public perception that pension benefits are no longer affordable.  This perception has caused some cities and counties to call for a reduction of benefits and more contributions by employees.  Some are proposing the complete elimination of pensions.  Is this perception correct?  No, but it has become the conventional wisdom among political leaders and the press, leading to a critical mass of citizens that are calling for drastic change.  There are seven false, but deeply held believes, that are sustaining the “We can no longer afford public pensions” perception:

  • The United States Economy is in the grip of a severe recession
  • Local governments are going bankrupt
  • Local Governments are required to prepay pension benefits
  • Accounting rules dictate what a local government must contribute to pension plans
  • Pension obligations will soon collapse local governments
  • Major changes in pensions are inescapable
  • Employee unions are leading local governments to the abyss

Just what is the truth?

  • The United States recession ended nearly three years ago
  • Local governments are reporting all time record high revenue
  • Cities and counties do not have to prepay pension benefits
  • Accounting rules do not apply to funding of pension benefits
  • Employer pension contribution rates are cyclical – we are at the high point today
  • Left as is, pension plans and local governments will both be okay
  • Local governments are not laying down to pacify employee unions 

Granting of retroactive benefits, spiking of pensions, and below cost contributions by employers are mistakes and should not be repeated.  These three may be irresponsible, but they are not the real issue at the moment.  The number one cause is the false belief that pension benefits must be paid in advance and that the Governmental Accounting Standards Board's rules mandate how the advance funding must be paid.  In an attempt to promote an accounting dogma, “the matching concept”, while not having the fortitude to fully embrace it, the Governmental Accounting Standards Board created a beast that now seeks to destroy public pensions.

Here is how the beast works.  Each year an actuarial firm comes in and determines how much the local government is “on the hook” for pension benefits.  That number is then compared with the value of all the pension plan's assets.  If the assets are less than the total liability, the local government has to pony up the difference.  If the assets are more than the total liability, the employer puts nothing in the pension plan.  In order to get the best returns on their assets, pension plans invest in the stock and real estate markets.  Selling this program to cities and counties was very hard  So, to make it more palatable, smoothing devices were added to soften the blow.  Below is a quick summary of  “The Saga of An Accounting Debacle.”

GASB Rolls Out A New Elixir
Soon after its creation in 1984, the Governmental Accounting Standards Board (GASB) began to commandeer the accounting rules for  financial report presentation of public pensions.  GASB, abetted by the bond rating firms, allowed the false perception that it had the authority and power to tell local governments how they must fund their pension plans.  GASB has no such authority.  A reader of GASB's proclamations could easily infer just the opposite when confronted with the  terms used by GASB – ARC (Annual REQUIRED Contribution)  and NPO (Net Pension OBLIGATION).  I do not read those terms as voluntary suggestions, but they are.  GASB has implied authority to impose it's rules on the financial presentation (financial statements) by local governments.  Even that implied authority is contingent on a local government's acquiescence.  Any or all local governments can tell GASB to go fly a kite.

However, the bond rating companies,  Moody's, Standards and Poor, and Fitch, will threaten any non-consenting government with a poor credit rating.  Just like GASB, this trio has no legal authority and must also rely on bullying to enforce its requirements.  Once great analyzers of municipal financial statements, the trio has succumb to accounting dogma and a rote paint-by-the-numbers methodology.

When pushed into the corner, both GASB and the bond raters will admit that they do not have any legal authority to force their desires on local governments.  Apparently, there is no need for such authority.  Like sheep, cities and counties have obediently surrendered.

Sales of GASB's Elixir Goes Vertical
Starting with statement number five (GASB 5) and subsequent declarations (GASB 25 and GASB 27), GASB embarked on a half-hearted effort to implement accrual accounting for local government pension liability, but lost its courage and fell back to an “accrual lite” doctrine.  As has been a long time tenet of accounting, “professional judgment” was given rather broad latitude, as long as the fundamental dogma was embraced by local governments.  Methodologies for calculating pension liabilities and the value of plan assets were a smorgasbord, but all had one thing in common – they were divorced from economic reality.  It seems that true economic accounting was a little hard to stomach – ergo, “accrual lite” was articulated.  Proudly, mark-to-market accounting was rolled out for asset values, but to accommodate “market sissies”, a safety net was created.  Any gains or losses that were over or below the project returns were allowed to be amortized over five years.

In an effort to ease the pain for governments who had not recognized their entire pension liability, an amnesty program was devised by GASB – the undisclosed “sins” could be amortized over thirty years.

True believers of accrual accounting would have required a “prior period adjustment' and restatement of the last ten financial reports for the entire pension liability. Five year smoothing of earning variances?  Are you out of your mind?  Everything goes on the earnings statement – immediately. I believe accrual accounting for local governments is stupid, but if it must be accrual, then bring it on and dump watered down accrual.

Local Government Leaders Become Inebriated By GASB's Elixir
The local bean counters dutifully went along with the program, as might be expected, but the real coup came when local officials began to believe that the GASB reporting rules were also the funding rules.  Combined with muscle from the bond raters, this misconception came alive.  So alive, that every two-bit hack that had a journalistic outlet began to preach the lie as if it were the gospel.

Local officials became intoxicated by GASB just in time to benefit from its clumsy arrangement.  With the new rules came the pension contribution roller-coaster.   This exciting new ride was driven by the equity markets – where pensions put their money, causing employer contribution rates to have wild swings.  Cities and counties got the faith just at the point where the “Big Dipper” was at a peak, allowing most to reduce or completely eliminate their current annual contribution to the pension plan.  But, when the the big dip came, along with outrageous contribution rates, the new converts began heaving their undigested lunches onto the people below.  Paying little or nothing to their pension plans must have seemed like heaven, but the inevitable, contribution rates in the forty to fifty percent range, were undeniable hell.  The proper reaction would have been to stay off the roller-coaster, but these hung-over leaders opted to dynamite the entire amusement park.

The Power and Destruction of Leverage
There are certain relationships that are very important to this discussion.  Look at this example

Actuarial Accrued Liability (AAL)

Actuarial Value of Assets (AVA)

Unfunded Liability (UAAL)

Annual Covered Payroll (ACP)

Annual Required Contribution (ARC)

Relationship of Actuarial Value of Assets (AVA) and Annual Cover Payroll (ACP)

$1,897,740,077 Divided By $367,639,226 Equals  5.16

Annual Required Contribution As A Percentage of Covered Payroll

$70,969,666 Divided By $367,639,226 Equals  19.3%

If the ARC is based on a 8.5% return on assets, a 1% negative variance on investment earnings would cause the employer's contribution to go up to 24.46%.  A 1% positive variance would lower the employer's contribution rate to 14.14%.  Any positive variance of 3.74% or more would allow the city to contribute nothing.  But, but look at what happens when the return on investments is a negative 5%, which causes a negative variance of 13.5% .  The employer rate goes to 88.96%.  With a five year smoothing, the final rate would be about 37%, if there are no carry overs from prior years.  The five year smoothing would require a positive variance of 18.7% to bring the employer's contribution rate down to zero.  Several bad years or several good years could easily get the employer's rate up to 50% or down to 0%.

The purpose of this is to show how a small change in the earnings rate causes a large change in the contribution rate.  It should be obvious to anyone that the current accounting rules (not funding rules) allow large swings in the contribution rate.

More Bad News – The Numbers Are Phony

The numbers we have been discussing are as phony as a three dollar bill.  Actuarial Accrued Liability is not the real liability.  The methodology used to get that number is called “Entry Age Normal”.  It is method that tries to pay homage to “the matching concept”, by trying to smooth the incremental increases each year.  It requires a projection to estimate what an employee's wages will be in the future. A set of odds, much like a tote board, are developed to cover the various scenarios that are possible.  This ranges from the employee being run over by a truck this afternoon to him living to be 100.

The correct way to calculate the liability would be to determine the amount that would be owed to each employee if he quit on the measurement date.  This obvious methodology was rejected by GASB.

Thanks to five year smoothing, the asset values in the example are overstated by about $165,000,000.  That is not exactly chump change.

Even More Bad News – Nobody Is Interested In The Truth
Very few people are interested in listening.  The movement to impair or destroy public pensions has turn into a cult with its own flat earth theory.  They love it because it supports their view of the world.  And as rabid devotees of their economic believes are prepared to fight to the last man, Just like Davy Crockett.

So what is the truth about public pensions:

  • GASB rules are not funding rules
  • The average police or fire pension requires total annual funding of 20% - 25% of payroll
  • Public pensions are NOT required to use mark-to-market accounting for funding
  • Public pensions are payroll reduction programs that provide deferred compensation
  • Even pay-as-you-go pension plans are healthy
  • Pension liabilities are the same as bond debt, which is 100% pay-as-you-go
  • Only pensions and retiree insurance have had pre-funding imposed on them
  • No home mortgage loan requires pre-funding for its retirement
  • No corporate loan requires pre-funding for its retirement
  • No credible case has ever been made for treating pension liability differently from other debt
  • No other entity is required to assume that it is going out of business every single year 
  • No other entity has been subjected to such insane accounting rules
  • Only pension plans and retiree insurance have been held to such a high threshold

There Is Still More To Come

All that sanctimonious talk about the virtues and correctness of GASB pension rules?  Oh, it is soon going to the ash can.  There's a “New GASB In Town.”  GASB has a new Pension Project in the works.  We already know what it will say.  With GASB, the review process is more of a coronation than a debate.  Dissonant opinion are quickly dispatched.  There are actually some good things in the new order, but one stealthy provision is a real poison pill – the discount rate used to calculate present value.  For many years a discount rate of 8% has been used by most actuaries.  This has proven to be an accurate assumption over the long run, but the accountants think that it is too high.  The attack advances by dividing calculations into two groups – funded amounts and unfunded amounts.  The argument is that the pension fund cannot earn the 8% on the money if it does not have it.  On the surface, that appears to be a valid argument, but a closer examination exposes it for the snake oil that it is.  What is actual value of a debt?  It is the amount that a creditor would accept as payment in full.  If the employer paid the balance due, the pension plan would have the money to earn the 8%.

GASB's plan is to tie discount rates to municipal bond rates – translation: lower rate which will create larger pension liabilities.  Pretending that nothing has changed, cities and counties will respond with self-righteous indignation to the skyrocketing pension costs.

What do I see ahead?  I am recklessly pessimistic.  As equity and real estate prices improve, the size of pension liabilities will start to shrink, but don't think that will deter the opposition.  One thing that has been learned over recent years  is that truth does not matter.  Today it is simplistic slogans and trite cliches, unrestrained by a truth test, that carry the day.  If your pension plan is under attack, forget about winning with the facts and reason.  You will lose.  There is only one thing that can save you now – raw politics.  If you unable or unwilling to twist some arms and call in some chips, you're toast.

Forget about winning a referendum – you can't win.  There are two pension referendum votes on pensions coming up soon in California.  Look for a complete thrashing of employees.  Worked into a frenzy by Tea Party propaganda, the public has taken on a lynch mob mentality toward public pensions.  Today, the vote that counts is the city council's or the county commission.  This is the only place that you have any chance of winning a vote.