The Looming Municipal Pension Crisis

Gary North’s REALITY CHECK
September 21, 2004

On September 17, the “New York Times” ran an article, “Budget Use of Pensions Sows Trouble in San Diego.”  It was a nice piece of journalism.  We are going to see similar stories like this one over the next 20 years.

San Diego is caught in a financial bind, facing the possibility of a bankruptcy filing, largely because of a $1.2 billion shortfall in its pension fund for municipal workers. For years the city has spent money from illusory pension fund earnings, according to the authors of a new report released yesterday.

The purposes of pensions differ, according to the viewpoint of particular interest groups.  The main groups are these: employees, employers, and trade union officials.  When we consider public pension programs, we add a fourth group: taxpayers.

EMPLOYEES

Employees decide to take tax-free income during the period in which they are in higher income tax brackets than they are likely to be after they retire.  They are allowed to do this by the tax authorities when their income comes in the form of pension fund contributions, which includes matching funds from the employer.

These employees could be paid this money in wages.  They choose to invest it, meaning that they choose to have a third party invest it: the company’s pension fund managers.  If an independent third party organization manages this fund, its managers have no strong incentive to use the money for purposes other than capital growth.  If, however, the company runs the fund, it is tempted to use this money for other purposes.  One such purpose: buy the company’s publicly traded stock, so as to raise the share price, so as to increase the value of the stock options of senior management, who sell their shares when they see trouble coming.  Call it the Enron strategy.

The employees assume that the pension fund managers are acting as their economic and legal representatives — as trustees, in other words.  But when there are millions or even billions of dollars involved, this assumption becomes increasingly naive, unless the fund’s management can be held personally accountable in a civil court if the decision-makers use the funds in ways unsuitable for third-party trustees.

This gets us back to the “New York Times” story.  When government-run pension funds are involved, the courts are not empowered to enforce trusteeship laws that apply to private pension funds.  To review: “For years the city has spent money from illusory pension fund earnings, according to the authors of a new report released yesterday.”  Here is the legal problem:

Cities are not held to the same standards of disclosure  that corporations are when they issue stocks and bonds.  The only relevant provisions of the federal securities  laws are broad prohibitions of significant omissions  and misstatements. Until now, the S.E.C. has never  brought an enforcement action over a city’s pension  disclosures, Mr. Maco said.

The legal system gives special exemptions to politicians and bureaucrats.  This is because the legal system is run by politicians and bureaucrats.  It is not in their personal self- interest to enforce the judicial principle of equality before the law.

EMPLOYERS

Employers use pension funds to compensate employees in ways that encourage the employees to forego wage raises.  The employer’s investment in the pension fund is a form of an implied promise: “I’ll see to it that you are taken care of in your old age if you will hold down your demands for immediate compensation.”  Whenever you hear this offer, think of a carnival barker with a top hat and a pointing stick: “Tell ya what I’m gonna do.”  (For those readers who are too young to remember a carnival barker, think of Bill Clinton, a tear visible, assuring us, “I feel your pain.”)

The pension fund came of age in the post-World War II era. Employers were ready to pay workers minimal pension fund contributions, which were going to compound over time.  This cut the companies’ immediate expenses.  It freed up money for other purposes, such as bonuses for senior managers.

What corporations have done, cities have done.  They have used the money that would have gone into wages to pay for immediate benefits.

This is borrowing from each worker in the name of his future retirement.  He was given hope.  The trouble is, you can’t eat hope.

The problem, it turns out, is that corporations and cities have used paper increases in their pension fund portfolio returns to justify a reduction in quarterly pension fund contributions. This has freed up even more money for other uses.

At the core of San Diego’s troubles, according to the  report, is its use, year after year, of pension fund  earnings that exceeded projections to pay for a variety  of local projects, including expenses associated with  playing host to the 1996 Republican National Convention  and paying health insurance premiums for retired  teachers and firefighters.

This is sometimes called borrowing from Peter to pay Paul. The two apostles would probably not appreciate this use of their names.  It sounds crooked.

Yet the practice, which the authors called dangerous,  is sanctioned by law in California and other places and  is commonplace among cities that offer pensions to  their workers. The findings raise the possibility that  other communities will face similar financial  disasters.

Possibility, indeed!  I call it probability — high probability.  The temptation to use the money to buy votes is just too great.

But actuarial projections are long-term averages, and  when the above-average earnings are used in a good  year, that does not leave any money to offset the  inevitable bad year.

This was not a problem from 1982 to 2000.  High returns seemed to justify reduced funding.  The stock market boom, which was stimulated by the fall in long-term interest rates, gave pension fund managers the best of both worlds: rising stock equity and rising bond equity.  The market price of long-term bonds is inverse to the rate of interest of the particular bond. When rates fall, market price rises.

Instead of steadily putting aside so much money per employee per quarter, San Diego skipped payments when its pension fund portfolio rose in value.  San Diego is not alone.  The same approach was taken by all American savers.  This is a major reason why the savings rate fell in the 1990s.  People decided to let the market make them rich in their old age.  They reduced their savings rate and bought consumer goods.  It was “free money.”

The idea that a pension fund provides “free money” that  a city can spend is “dangerous and widely misused,”  said the report, which was commissioned in February by  the mayor of San Diego in an effort to identify flaws  in the city’s financial reporting procedures and to  recommend corrections. Many local governments harness  illusory pension money as San Diego did, the authors  said.

“This was not something done by stealth. This was not  unique to San Diego,” said Richard Carl Sauer, a former  official of the Securities and Exchange Commission and  now a partner in the Washington office of the law firm  of Vinson & Elkins. “Any number of municipalities have  used surplus earnings to cover budget items.”

UNION OFFICIALS

Union officials want victories.  Victories are what justify their continued election.  Like every other good, the lower the cost of victories, the more will be demanded.

Low-cost victories were obtainable for decades by going the pension-fund route.  Union officials could point to the establishment of a corporate pension fund for workers, and then tell the members, “See?  We have forced management to capitulate.”  Management played along.  “Please, don’t throw us in the pension-fund briar patch!”

Management went along with labor union officials because it was cheaper than either risking a strike or paying higher wages. It was a mutually beneficial deal.  Management kept more money inside the corporation, and union leaders were able to look like hard bargainers.  Each group stayed employed.

This joint strategy has continued in municipal government under post-1960 conditions, in which American trade union membership has fallen everywhere except in government jobs. Trade unions have become less and less powerful in the United States.  Employment has moved to states that have outlawed compulsory union membership.  Also, white collar workers are more independent and therefore more difficult to organize.  The computer revolution has put pressure on all workers not to join a union by increasing their efficiency but also by making them replaceable.

The unions do not want to go on strike.  Ever since Reagan broke the strike of the Professional Air Transport Controllers Organization (PATCO) in 1981, government unions have preferred to avoid strikes.  This makes them more willing to accept low-cost victories.

TAXPAYERS

Everyone wants a good deal.  This includes taxpayers.  They want to get more subsidized goodies out of local governments. This is why they consent to official pension fund promises.  It’s so easy to make a promise.  Payment is always way in the future. The future can somehow take care of itself.

Voters look at pension fund obligations in the same way that they look at Social Security/Medicare obligations.  They expect the tax fairy to show up monthly and put a pension check under the pillow of retired ex-employees.

They are unconcerned with the future property tax implications of these present promises.  After all, if things get tight, they can just pass the equivalent of Proposition 13, which capped California property taxes.  That will force the tax fairy to show up.

The fact that the pension funds’ legal obligations are large and growing doesn’t bother voters.  Social Security and Medicare obligations are also growing.  Who cares?  Not the typical voter. There is always a way out.  Something will turn up.

IT’S SO EASY WHEN YOU KNOW HOW

There is really nothing to this procedure.  It’s the Enron solution.  Juggle the figures.  Make economically improbable assumptions regarding future rates of return.  Cook the books. Nobody will notice.

Mr. Sauer and the new report’s other author, Paul S.  Maco, said they were not aware of any single source of  detailed information on the handling of state and local  pension funds. Therefore, they said, it was impossible  to predict how many other localities might end up in  San Diego’s situation.

“One thing that is fair to say is that part of the  story in San Diego is that people were not taking a  very close look,” said Mr. Maco, a former S.E.C. lawyer  who oversaw the agency’s work on Orange County, which  declared bankruptcy in 1994. He, too, is now a partner  with Vinson & Elkins in Washington, specializing in  securities law and public finance.

“If there’s one message that comes from this,” he said,  “it’s that cities should take a very close look at the  status of their obligation to fund their pension  system.”

You might imagine that the accountants would be blowing continual whistles.  But if there is one sure thing in this life, it is this: accountants do not blow whistles.  Instead, they insert verbiage at the end of their reports.  The old rule of investing is not widely understood: “The longer the accounting firm’s qualification at the end of the report, the less risky a short sale.”

Though San Diego’s troubles are thought to have been  brewing for more than two decades, their severity was  not widely understood until recently. For many of the  years when the city was setting the stage for its  current problems, it was winning awards for the quality  of its financial reports and being given high ratings  by credit agencies.

HURRICANES

The hurricanes that have hit Florida this summer have created havoc for municipalities and huge losses for property insurance companies.  They are nothing compared to the financial hurricanes that the pension fund system will create.  This applies to all third-party managed pension funds, but especially municipal and state funds.

Most people wait until the last 24 hours to go to the store and stock up on water, food, Sterno, and similar post-hurricane items.  This pattern is unbreakable until two hurricanes hit and the third is on the way.

The same phenomenon applies to economic hurricanes.  These little ones come by, and everyone else thinks, “It can’t happen here.”  But it can.  The same motivation and the same accounting assumptions apply in other cities.  But no one monitors this, so the public doesn’t know.  That’s how city managers prefer it.

CONCLUSION

You are going to pay, one way or the other.  Either you will pay as a retired city worker or else you will pay as a taxpayer. The promises have been made for decades.  They have accumulated. That is, they have compounded.

Voters have faith.  This faith is going to be paid off in funny money.  “In God we trust,” it says on Federal Reserve Notes.  That’s a warning.  Treat it as such.