Playing the pension game
Two national stories yesterday shed light on the foolishness that’s taking place on the fringes of the public pension world. The first story, from the Los Angeles Times, is about pension obligation bonds – a classic tale of fancy, Wall Street-devised products that promised more than they could deliver. The second story, from the New York Times, is about a scheme, dreamed up in an ivory tower, of having state government pension plans take over responsibility for the pensions of corporate retirees. The mind reels at the complexity and difficulty of this idea.
Nathaniel Popper of the LA Times does an excellent job of describing the speculative risks that state and local governments take by borrowing in the bond markets to fund their contributions to their pension plans. Pension obligation bonds are a form of interest-rate arbitrage: a municipal issuer borrows at, say, 4 percent and invests these funds in its actively managed pension plan. The hope is that the funds will earn higher rates of return, usually from investments in the stock markets. It’s basically a way of borrowing to speculate, but since Congress won’t allow municipalities to do that using tax-exempt bonds, a new approach was developed. The LA Times says:
Congress made it illegal in 1986 to issue normal tax-exempt municipal bonds for this type of speculation, but municipalities and their outside advisors realized they could get around this by issuing taxable bonds, like corporations. These bonds come with higher interest rates, but many local government officials have believed they could earn enough from investments to come out on top.
So pension obligation bonds lose the advantage of having a municipal tax exemption and instead pay higher, taxable rates. Is the strategy good enough for state and local governments to overcome the costs? The LA Times recounts the horrifying experience of the state of Illinois:
In Illinois, the state has struggled even to make the ongoing payments to the [pension] fund, much less make up the shortfall. For the last two years the state has issued billions of dollars of pension bonds just to pay the immediate contribution to the pension fund.
The state will shell out $1.6 billion – or 5% of the state’s entire annual budget – just to pay off the interest on its pension bonds issued over the last decade, according to the Illinois Civic Federation. The bonds were issued with the hope of increasing the funding level of the pension fund, but that level has actually dropped.
The whole basis of the vast fixed-income market is to borrow short and lend long, so POBs make sense – at least, on the surface. But public pension funds move slowly. They aren’t managed aggressively and are often dependent on the whims of the governor and legislature. There is no magic formula for state and local governments to ease their pension woes. Pension obligation bonds just look like fancy speculation with public funds.
Next, the New York Times detailed an unrealistic plan from professor Teresa Ghilarducci, a labor economist at the New School for Social Research, in an article entitled “New Ideas on Pensions: Use States.” Ghilarducci’s plan is based on the premise that private companies have a hard time running or establishing pension funds for their employees. To remedy that, state or local pension plans could step in.
Currently, states do an uneven job of managing pension funds (see map). Texas, Colorado and Pennsylvania have achieved reasonably good returns over the last decade, but other states like Florida, Georgia and New York have lagged behind. The results of Ghilarducci’s plan would be mixed, depending on the state where a company was located. Critics, of course, would point to the severe sustainability issues that many state and local governments have with their own plans. Illinois, for instance, is only funded at about 45 percent of its liabilities. Ghilarducci’s solution would be for the nearly broke federal pension guaranty agency to stand behind these publicly administered private pension plans. The NY Times says:
The federal government’s Pension Benefit Guaranty Corporation could guarantee the benefits, something it does not do for public pensions or 401(k) plans.
“All we really need is an orderly exit from single-employer pensions to another platform,” Ms. Ghilarducci said. “And that’s either the states or the federal government, because those are the only entities designed to last in perpetuity.”
Ms. Ghilarducci floated her idea in Washington but found little interest. When she tried the states, she got a toehold, especially in states led by Democratic governors or legislatures.
I agree that current models for retiree income support are no longer as useful as they once were. But bringing in the government does nothing to raise the chances for guaranteed benefits. Let’s keep governments focused on simple goals. Managing retirement assets for private workers is not that simple.