by Jonathan Rochford, via Zero Hedge:
The recent blow-up of the Dallas Police and Fire Pension System was entirely predictable.The combination of overpriced financial markets, inadequate contributions and overly generous pension promises mean dozens of US local and state government pension plans will end up in the same situation.
The recent blow-up of the Dallas Police and Fire Pension System was entirely predictable. Whilst it is tempting to blame unusual circumstances for the recent lock-up of redemptions and likely substantial reductions to pensions for those still in the fund, many other American pension funds are heading down the same road. The combination of overpriced financial markets, inadequate contributions and overly generous pension promises mean dozens of US local and state government pension plans will end up in the same situation. The simple maths and political factors at play mean what happened at GM, Chrysler, Detroit and now Dallas will happen nationwide in the coming decade. So, what’s happened in Dallas and why will it happen elsewhere?
Background to the Dallas Pension Fiasco
The Dallas pension scheme has been underfunded for many years with the situation accelerating recently. As the table below shows, as at 1 January 2016 the pension plan had $2.68 billion of assets (AVA) against $5.95 billion of liabilities (AAL), making the funding ratio (AVA/AAL) a mere 45.1%. Despite equity markets recovering strongly over the last seven years, the value of the assets has fallen at the same time as the value of the liabilities has grown rapidly. The story of how such a seemingly odd outcome could occur dates back to decisions made long before the financial crisis.
Source: Dallas Police and Fire Pension System
In the late 1990’s, returns in financial markets had been strong for years leading many to believe that exceptional returns would continue. In this environment, the board that ran the Dallas plan decided that more generous pension terms could be offered to employees and that these could be funded by the higher expected returns without needing greater contributions from the Dallas municipality and its taxpayers. Exceptionally generous terms were introduced including the now notorious DROP accounts and inflated assumptions for cost of living adjustments (COLA). These changes meant that pension liabilities were guaranteed to skyrocket in future years, whilst there was no guarantee that investment returns and inflation levels would also be high. Dallas police and fire personnel were being offered the equivalent of a free lunch and they took full advantage.
In the 2000’s the pension plan made some unusual investment decisions. A disproportionate amount of plan assets were invested in illiquid and exotic alternative investments. When the financial crisis struck these assets didn’t decline as much as the assets of other pension plans. However, this was merely a deferral of the inevitable write downs which came in the last two years after a change in management.
Throughout 2016 the pension board, the municipality and the State government bickered over who was responsible and who should pay to fix the mess. The State government blamed the municipality for the poor investment decisions. The municipality blamed the State government for creating a system that it could not control but was supposed to be responsible for. It also blamed the pension board for the overly generous changes they implemented. The pension board recognised the huge problem but offered only minor concessions arguing that plan participants were entitled to be paid in full in all circumstances. They asked the municipality for a one-off addition of $1.1 billion, equivalent to almost one year’s general fund revenue for the municipality.
As the funding ratio plummeted during 2016, plan participants became concerned that their generous pension entitlements might not be met. In other pension plans the employer might increase its contributions when these circumstances occurred, but in Dallas the municipality was already paying close to the legislative maximum. Police officers with high balances retired in record numbers, pulling out $500 million in four months in late 2016. Those who withdrew received 100% of what was owed, with those remaining seeing their position as measured by the funding ratio deteriorate further.
In November, when faced with $154 million of redemption requests and dwindling liquid assets, the pension board suspended redemptions. The funding ratio is now estimated to be around 36% with assets forecast to be exhausted in a decade. Litigation has begun with some plan participants suing to see their redemption requests honoured. The municipality has indicated it wants to claw back some of the generous benefits accrued since the changes in the 1990’s, though this is likely to only impact those who didn’t redeemed. The State has begun a criminal investigation. Everyone is looking to blame someone else, but not everyone has accepted that drastic pension cuts are inevitable.
The Interplay of Political Decisions and Financial Reality
The factors that led to Dallas pension fiasco are all too common. Politicians and their administrations often make decisions that are politically beneficial without taking into account financial reality. A generous pension scheme keeps workers and their unions onside, helping the politicians win re-election. However, the bill for the generosity is deferred beyond the current political generation, with unrealistic assumptions of future returns enabling the problem to be obscured. As financial markets tend to go up the escalator and down the elevator it is not until a market crash that the unrealistic return assumptions are exposed and the funding ratio collapses.
This is when a second political reality kicks in. In the case of Dallas, there are just under 10,000 participants in the pension plan compared to 1.258 million residents in the municipality. Plan participants therefore make up less than 1% of the population. If the Dallas municipality chose to fully fund the pension plan it would be require an enormous increase in taxes from the entire population in order to fund overly generous pensions for a very small minority of the population. For current politicians, it is far easier to blame the previous politicians and the pension board for the mess and see pensions for a select group cut by half or more than it is to sell a massive tax increase.
The legal position remains murky and it will take some time to clear up. The municipality is paying 37.5% of employee benefits into the pension plan, the maximum amount required by state law. Without a change in state legislation, it seems likely that the pension plan will have to bear almost all of the financial pain through pension reductions. If state legislation was changed to increase the burden on the municipality years of litigation could ensue with the potential for the municipality to declare bankruptcy as a strategic response. The appointment of an administrator during bankruptcy could see services reduced and/or taxes increased, but pension cuts would be all but a certainty.
Dallas Isn’t the First and Won’t be the Last
It’s tempting to see the generous pension structure and bad investment decisions in Dallas as making it a special case. Detroit was seen by many as a special case when it went into bankruptcy in 2013 as it had seen its population fall by 25% in a decade. This depopulation left a smaller population base trying to fund the debt and pensions obligations incurred when the population was much larger. Growing debt and pension obligations are signs of what is to come for many local and state governments who have been living beyond their means for decades.
As well as building up pension obligations many US governments have been accruing explicit debt. The two are intertwined, with some governments issuing debt to make payments into their pension plans, often to close the underfunding gap. This is very much a short-term measure, as whether it is pension contributions or debt repayments both will either require high taxes and/or lower spending on government services in the future in order for these payments to be met.
Pew Charitable Trusts research estimates a $1.5 trillion pension funding gap for the states alone, with Kentucky, New Jersey, Illinois, Pennsylvania and California going backwards at a rapid rate. Using a wider range of fiscal health measures the Mercatus Center has the five worst states as Kentucky, Illinois, New Jersey, Massachusetts and Connecticut. The table below shows the five state pension plans in Illinois, with an average funded ratio of just 37.6%.
Source: Illinois Commission on Government Forecasting and Accountability
For cities, Chicago is likely to be the next Detroit with the city and its school system both showing signs of financial distress. Chicago is trying to stem the bleeding with a grab bag of tax and other revenue increases but in the long term this makes the overall position worse.
Default is Almost Inevitable as the Weak get Weaker
The problem for Chicago and others trying to pay their debt and pension obligations by raising taxes is that this makes them unattractive destinations for businesses and workers. Growth covers many sins, as growth creates more jobs and drags more people into the area. This increases the tax base and lessens the burden from previous commitments on those already there. Well managed, low tax jurisdictions benefit from a positive feedback loop.
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