Archive for category Budget

Why PERA’s Cumulative Returns Matter

PERA’s unfunded liability often comes into sharper after a year of low returns.  Its detractors point to last year’s 1.5% return, for instance, as evidence that PERA’s expected rate of return is too optimistic (it is).  Its defenders argue that a single year’s returns are less important than the long-term (they are).  They then point to a time frame, say, the last 7 years, where PERA has averaged 9.7%.

But it’s not just average returns that matter.  It’s cumulative returns, and there, even a couple of bad years can wreak havoc on a defined benefit plan.

Let’s look at PERA’s returns since 1990:

A few really bad years to start off the century, and we all remember 2008.  But aside from that, mostly above expected, and a few years slightly below expected.  If you had invested $100 in PERA Mutual Fund in 1990 and let it sit for a quarter century, you’d be about where you should be, based on each year’s expected rate of return.  Most years, you’re even ahead of the game, before the dot-com burst and the housing bubble burst bring you back to earth.

But of course, you don’t put $100 in in 1990 and let it sit.  You put $100 in every year.  Instead of looking at this from the perspective of each year going forward, let’s choose the perspective of 2015 looking back at each year.  That is, for each year where you’ve invested $100, let’s see how you end up in 2015.

For $100 invested in 1990, you’d expect to have about $800, and we already know that that’s what you’ve got.  For $100 invested in 2000, though, you’d expect that to be worth $355 today, but it’s only appreciated to $228.  That’s because in January 2000, you invested before the bad years of 2000-2002.  So money invested in every year from 1995-2003 is worth less now than PERA’s expected return would project.  In fact, there are only a few years where the cumulative return through 2015 is better than expected, because 2000-2002 and 2008 wipe out all the gains beyond expectations.

Not surprisingly, this means that your PERA Mutual Fund is short of expectations in 2015, by just over 9%.  You’d expect to have just over $9000, but instead you’re just under $8200.

Naturally, PERA’s actual situation is much more complex than this.  But the point remains – it’s not enough to do as well as you’d expect over a long period of time, even in the absence of required annual payouts.   In order to keep the plan solvent, you need to do better than that.

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PERA Admits Problem – Blames Legislature

Could people be catching on to the shell game / ponzi scheme that is Colorado’s public pension system?  If the Denver Post can start running critical articles, then anything’s possible.

Yesterday (“‘Alarm bells’ raised: PERA stability again under scrutiny“), the Post noted that even PERA is admitting that it’s going to take longer to reach fully-funded status than had been previously estimated.

Wow!  Who could have predicted this?  It’s a shame nobody’s been around to tell them this might happen.

PERA is paying particular attention to the Judicial Fund, which is projected never to crash and burn, but never to achieve fully-funded status.  It’s like a pension version of Purgatorio.  We’ve been here before with larger funds, and indeed, the Denver Public Schools Fund also has an infinite amortization period.

The Judicial Fund is tiny. The DPS fund isn’t huge itself.  The state could easily just pay these pensions out of current cash.

The State and School Funds, however, are gigantic by comparison, and have the potential to crush state and school budgets.  Their amortization periods are now around 45 years, and headed in the wrong direction.  The amortization period varies wildly with relatively small shifts in return because we’re operating so close to the margin. It’s not the 10 year shift itself that’s worrisome, it’s the fact that we’re so close to infinity to begin with.

PERA with good amortization. A small difference in the funded level doesn’t change the date much.  This is ok, as long as you don’t drift too far off center.

PERA with bad amortization. A small difference in returns sends you first to the brink, and then spinning off into space, helpless, never able to retire.  You just don’t want to be operating in this region.

PERA, like most public pensions, relies on “time diversification,” or the idea that over the long term, average expected returns are the best guide to what will happen.  But they’re not the best guide to what the risk is to the fund, the retirees, and the citizens of the state.  The paradox is that even as average returns converge, where you end up at the end of 30 or 40 years spreads out.

It’s like the pension version of “gas expands to fill the available space.”  Imagine if I brought a canister of chlorine gas into the room and took the top off of it.  Sure, the center point would stay the same, but pretty quickly we’d be all DIA murals.

In the same way, the expected returns converge to the mean, but the number of things that can happen, the number of different balances you can end up with, grows, and therefore so does the risk of one of those balances being negative.

PERA itself has acknowledged this.  Its own study in 2015 showed a better than 1-in-6 chance that the School and State Funds would crash and burn sometime in the next 30 years, based solely on variations in expected returns:

When PERA runs into trouble, it will likely be because of low investment returns.  The state will then likely try to come to the taxpayers to bail it out.  It may even be forced to do so by the courts.,

The problem is, the taxpayers have their retirement money in mostly the same places of PERA, and will have also been seeing low returns on their own retirement portfolios.  Basically, the state will be demanding money from people who don’t have it, in order to honor promises they didn’t make.

As a taxpayer, I’m mad.  But I’d also be mad if I were in the legislature.  Here’s PERA Executive Director Greg Smith:

“You all put together a 30-year plan to recover from that,” Smith told lawmakers. “We’re six years in, and we’re behind. And we’re going to go and talk about how can we get back on track for what that plan was.”

“You all?”  Yes, that’s true.  The Legislature had to vote on the plan.  But it was informed by PERA’s Board, who not only backed SB1, but also had a huge part in drafting it and commenting on its provisions.  Every year, every time the question has come up, PERA’s Smith has said that things were just fine.  Every time anyone proposed changes to make it more robust – better reporting, small tinkering at the edges, larger more substantive improvements – PERA’s Smith has been there with his merry band of union and retiree groups arguing against them.

This is Exhibit A of why we need to move to a defined contribution plan and take these decisions out of the hands of elected officials.  Legislators aren’t (all) dumb, but they’re not specialists, and they rely on experts like Smith to inform them about what needs to be done.  But Smith and PERA as a whole have a vested interest in telling them that everything is fine, or that more money from taxpayers will fix the problem.

Moving to a 401(k)-style plan, or even a cash balance plan, would help insulate everyone from the politics here.

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Podcast Experiment

One of my fondest desires has been to produce a This American Life or RadioLab, only for free-market and conservative ideas.  Thanks to Stacy Petty, I’ve actually been given a chance to do this.

In one of his own podcast interviews, Dan Carlin of Hardcore History fame says that his goal has been to produce, for radio, a long-form edition of what a newspaper column would look like.  That’s kind of what I’m aiming for here, as well.  Edited, polished, but also using the illustrative and mood-setting background sound that radio give you, but newspapers don’t.

It’s unclear exactly what the format will be going forward, but here’s the first attempt, discussing PERA, the forthcoming State Auditor’s report on an early warning system, and small planes.  It runs 10:30, but I’m hoping to bring future editions in at exactly 10:00.

 

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Colorado to Pay for Drunken Artists Colonies

In what has to be one of the worst misappropriations of public funds since that study about why lesbians are fat, Colorado is going to sponsor “affordable housing” (sic) for artists in rural communities:

Gov. John Hickenlooper announced the plan Monday at an artists’ community in Loveland. The governor says that the state will help sponsor a $50 million plan to create artist housing in nine rural communities, starting with Trinidad.

Why should Denver have all the bad public art?

The housing will have income caps. Artists who qualify for housing can’t make more than 60 percent of their area’s median income.

Well, at least we have some standards.

Private foundations are joining the effort. A state spokeswoman says it’s not clear how much of the $50 million will be paid by the government.

How about $0?  Does $0 work for you?

The program will have a generous definition of “artist.” The program will accept architects, filmmakers – even beer and liquor makers.

Gotta get those creative juices flowing somehow.

The argument we hear from the Democrats all the time is, “We need to have a conversation about what we want the government to do, and then fund it appropriately.” This is the sort of nonsense you get when you start from that end of the deal.  Of course when you start by asking, “What is it you want?” you end up with a wish list like me in a book store.  The phrasing completely hides the fact that you’re actually making choices – either about what the government will do with its limited resources, or with what you can do with your own.

Try ph
rasing it differently: “We need to decide how much we really want to pay for government, and then use that money appropriately.”  Aha, now it’s clear that there’s only so much money to go around, and if you want to spend your own money on this sort of thing, you’ll be paying for it before you fund your food, your mortgage, your kids’ education, and your retirement.

Naturally, the Democrats hate that part of the conversation, so much so that they try, every step of the way, not to let you have it.  They want to have the “What do you want us to do for you?” part of the discussion, and then, once you’ve committed to buying Pierre the Failed Art Student his rent and bitters, tell you how much it costs.  And when you decide maybe your dental bill is more important, they want to insist that, no, we’ve already decided that IPAs for Pierre are in the budget, and it’s no fair going back on that and changing the deal on poor Pierre, once he’s pulled up stakes and moved to Ouray.

It’s the main reason they hate TABOR so much.  Unless it’s a really good budget year, and the government just happens to have money sitting around burning a hole in its pocket, TABOR makes them actually ask you whether or not you want to pay for Pierre’s studio loft.

The next time someone comes up with a harebrained idea like this, the first question should be: “Instead of what?”

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As Colorado’s Pensions Add Risk, California Seeks to Reduce It

Even as Colorado’s state public pensions seek to add risk to their portfolio, California CalPERS is seeking to reduce risk and volatility in its own plan.  In doing so, it sends up a flare for other pension plans.  It also confirms one of the key assertions of defined benefit plan critics: the aggressive return assumptions, combined with permissive discount rate assertions, in US public pension plans incentivize those plans to chase those returns, and add risk in doing so.

In a piece I wrote back in March for Watchdog Arena, I noted that Colorado PERA’s Board of Trustees had voted to shift several percentage points of investment from stocks and bonds into riskier alternative assets and real estate.  This portfolio isn’t necessarily out of line with the majority of US public pension asset allocations, but it does represent adding risk – and therefore volatility – in an attempt to increase returns.

Yesterday, Pensions and Investments reported that CalPERS is looking at reducing its expected 7.5% rate of return to as low as 6.5%.  Doing so, the plan says, would allow it to shift its investments out of stocks and alternative assets into more predictable, less volatile bonds.

“It is essential that we do this,” said California Controller Betty T. Yee in an interview with P&I. Ms. Yee added that if CalPERS does not reduce volatility, it could jeopardize its ability to pay retirees in the future….

Ms. Eason said lowering the rate of return would also enable officials to build a portfolio less vulnerable to market swings. The current 7.5% rate of return has a 12% volatility rate. Reducing the rate to 7%, as one scenario does, would translate to a 10% volatility rate. A 6.5% rate of return would equate to a volatility level of 8.5%, she said.

In doing so, CalPERS doesn’t implicitly accept the critics’ assertions – it explicitly accepts them.  They would lower the expected rate of return specifically so they could “safely” move assets into less risky (albeit less remunerative) investments.  Public pension officials in the US have long denied a linkage between the two, so it will be interesting to see how they react to this admission.

By most measures, CalPERS is better funded that Colorado PERA, although not particularly well-funded.  It admits to a funding level of 77%, compared to PERA’s claimed funding level of 62%.  These claims both discount the pension liabilities at 7.5%, the assumed rate of return.  Lowering CalPERS’s expected rate of return to 6.5% would, correspondingly, lower its funded level by lowering its discount rate.  A study by State Budget Solutions, however, using the states’ cost of borrowing as the discount rate, placed the funding levels at 39% and 32%, respectively.

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PERA’s 2014 CAFR – Situation Normal…

Colorado PERA released its 2014 Comprehensive Annual Financial Report on Tuesday, and there were no real surprises, which isn’t to say it was particularly good news for the state’s retirees, government employees, or taxpayers.  For the most part, it showed more of what we already knew: a system in trouble, and unlikely to earn its way out of that trouble any time soon, if ever.

The rate of return on investment was 5.7%, which is 1.8% short of the expected rate of return of 7.5%.  PERA will no doubt point to the fact that it met the benchmark return, but all that means is that the funds weren’t grossly mismanaged.  The net result is that the unfunded liability, as acknowledged by PERA, climbed from $23.3 billion to $24.6 billion.

In reality, the future liability should be discounted not at the expected rate of return – an accounting gimmick that is only available to US public pensions – but by the borrowing cost of the governments involved.  In this case, that would mean a discount rate of about 4.5%.  Running that out 15 years, we end up with an eye-popping unfunded liability of $60 billion.  A 30-year window raises it to an almost unimaginable $116 billion.  That’s the unfunded liability – the promises made for which we have no money.

Overall, the funding levels fell to 64.2% from 65.2%, but the two biggest funds are much worse off than that.  The State Fund’s funding level slipped to 59.8%, the School Fund to 62.8%.  These calculations are done using the market value of the assets, rather than the smoothed actuarial value, as they have in the past.  That actually makes the funding levels look better, as the investments age out the miserable 2011 investment year, but it gets the direction right, and funds can only spend and invest actual dollars, not smoothed ones.

The amortization periods – how long it would take to get to full funding – also ballooned to 45 years for the State Fund, and 48 years for the School fund, after accounting for the future increases in the AED and SAED supplemental payments.  PERA rightly points out that these numbers don’t account for the decrease in benefits for future hires, which probably shorten the amortization periods by a few years.

I’ll have a lot more to say about this, but the short version is that there’s nothing to be cheerful about here.  PERA will claim that everything is still on track to be fully-funded decades hence, but then, PERA always thinks nothing’s wrong right up until the point that they come to the legislature for more money.

Photo Credit: Todd Shepherd & Complete Colorado

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Media 101

When the PERA Pension Obligation Bond story was in its death throes, the Denver Post was writing a story about the political, rather than the financial angle, of the bill and its failure in committee.  Treasurer Walker Stapleton had testified in favor of the bill in the House Finance Committee, although most of his testimony was of a technical nature.

At the time Post reporter John Frank called me, I had not yet heard Stapleton’s comments on the Mike Rosen Show, where he appeared to try to walk back his support for the bill.  There’s no reason to rehash the controversy here, and that’s not the point of the post.

The point is this: Franks paraphrased what Stapleton had said, and asked me to comment on his on-air statements. I asked him to quote them to me.  He quoted to me a couple of sentences, and I was brought up short.  But this was a radio talk show, and Mike Rosen is one of the best interviewers around.  The actual on-air back-and-forth was much longer than that.

So I paused, said that, even though I had just asked him to quote Stapleton to me, I really would need to hear the whole thing before I could comment. And I went on to say something Franks probably already knew – that there were legislators without pension funding expertise who had probably been swayed by Walker’s support, and by the fact that the Republican Treasurer, Democrat Governor, and “impartial” PERA Board were all in favor of the deal.

Later, after thinking about it, I came back with what I expressed as a possible interpretation of what Frank had quoted me, didn’t offer an opinion on it, and suggested he go back and listen to the whole interview with that idea in mind.

Reporters often count on people liking to talk, and liking to talk to reporters specifically, because they may get to see their names in print.  But you don’t have to answer a question if you don’t want to, and you don’t have to offer an opinion when the only information you’re getting is from the reporter.

I doubt Frank was purposely trying to do a hatchet job on Walker, but there was no reason to fall into the trap of trying to offer an opinion based on an interpretation of one small piece of the story.

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PERA’s Pension Obligation Bonds Are a Bad Idea

This is an extended version of the OpEd that appeared in the Greeley Tribune.

Last week, Colorado legislators considered – and rejected – a plan of dubious legality to shore up the state’s public pensions.

The result of a difficult three-way negotiation among Governor Hickenlooper, Treasurer Stapleton, and PERA, the plan would have circumvented the state Constitution’s limits against issuing general obligation debt without a vote of the people, for gains that would have been largely illusory.

Worse, the changes could have encouraged future legislatures to repeat mistakes that put teachers’ and state employees’ retirements at risk in the first place, while making real reforms more difficult.

HB15-1388 would have authorized the State Treasurer to direct the Colorado Housing and Finance Authority (CHFA) to issue up to $10 billion in bonds on the state’s credit. The proceeds would have been deposited into PERA’s State and School funds, and invested with the rest of PERA’s assets. The investment returns theoretically would shorten PERA’s time to full funding.

The bonds’ interest was to be funded by the supplemental payments that the state and school districts pay into PERA (the AED and SAED), with PERA paying back the principal when the bonds matured.  The AED and SAED payments are taxpayer contributions established in 2004 and 2006 to stabilize PERA’s finances.  They are escalating percentages of employee salaries.

The complex web of relationships was needed to avoid state constitutional limits on issuing debt. The bill’s language laid out the legal arguments for why the restrictions didn’t apply. Supporters claimed they were revenue bonds that would not obligate general tax dollars, and purported that CHFA is not a state agency.

Passing the buck to the courts, HB 1388 would have required a binding judicial ruling certifying the scheme’s legality before the bonds could have been issued.

Make no mistake: The debt would have been on the state’s credit, and shown up on the state’s balance sheet. These are not revenue bonds; they would have been funded only by general tax revenue.

Whether or not the game of hide-the-pea satisfied the courts, it violated the spirit and purpose of constitutional provisions designed to prevent the legislature from indebting citizens into a long-term fiscal bind. The many state bankruptcies of the 1840s were still fresh in the people’s minds in 1876, when the Constitution was drafted. Those concerns are no less valid now.

The bonds wouldn’t have shown up in PERA’s financial report, except in the footnotes. With no single, authoritative document laying out the full financial picture associated with funding the state’s public pensions, PERA would look better-funded than it was.

Risk-averse legislators could have justified avoiding the difficult decisions needed to provide real retirement security for Colorado’s teachers and state employees. Future legislatures might have been tempted to repeat the mistakes that put that security at risk in the first place. While a full legal analysis awaits, tying the AED and the SAED explicitly to a bonded debt might have complicated any attempts at more sustainable reform.

A comprehensive study by the Center for Retirement Research found that the misuse and mistiming of pension obligation bonds have punished numerous states and municipalities over the last 20 years. The Government Finance Officers Association recommends against their use.

To their credit, the bill’s architects studied past failures and tried to mitigate the risks to Colorado and its schools. The annual interest on the bonds could have been no larger than two-thirds of each year’s anticipated AED and SAED, with a minimum 2 percent spread between the bond interest rate and PERA’s anticipated rate of return. Statutory contributions to PERA – inadequate though they are – would have remained intact, and bond proceeds would have been unavailable for diversion to other spending.

Still, the deal entailed significant risk. Proponents misleadingly argued that it refinanced 7.5 percent debt at 4.5 percent. In an actual refinance, the original obligation is paid off. Here, the pension obligation would have remained, with Colorado taking on additional debt.

Even PERA’s claim that its current debt should be discounted at 7.5 percent is based on an accounting gimmick only available to US public pensions – and no other pensions in the world.  (Not coincidentally, without the discipline of correct accounting, US public pensions are also the worst-funded public pensions in the world.)

As contractual promises, they should be discounted at the same interest rate as the bonds.  PERA would just be adding 4.5 percent debt to the true 4.5 percent debt of its current contractual obligations, improving its situation only marginally.

The proposal’s safeguards would not have changed the fact that proponents were seeking to close the funding gap by taking on additional debt and risk.

While the governor and the treasurer are to be credited for taking PERA’s underfunding seriously, HB 1388 was the wrong answer to the problem.

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PERA Benefits Among Most Generous in the Country

Late last week, the redoubtable Andrew Biggs of the American Enterprise Institute published a state-by-state comparison of full-career public pension retirement benefits, in that organization’s monthly Economic Perspectives.  While news of PERA’s long-term fiscal problems won’t be a surprise to anyone reading this blog, it may come as a surprise to learn that Colorado ranks among the most generous states when it comes to that measure.

In nominal dollars, Colorado ranks fourth in the country, at just over $60,000 for an employee who spends his entire career in the state civil service.  The $60,420 per annum figure ranks just behind California and Alaska, and considerably behind Nevada’s $64,000.  When adjusted for the states’ relative cost of living, as calculated by the Council for Community and Economic Research, Colorado jumps well past both California and Alaska, into 2nd place.

Biggs also noted that the present value of these benefits can create “pension millionaires,” whose benefits exceed $1 million in today’s money.  When Colorado’s benefit is compounded at the maximum 2.0% COLA, and then discounted using a 3.5% risk-free discount rate, the total comes in at $1.25 million in 2014 dollars, assuming the beneficiary retires at 60 and lives to 82.5 years of age.

As Biggs points out, the need to stay for an entire career in order to collect benefits, at the same time that they forego Social Security benefits for those years, is a serious disincentive to retaining qualified and motivated public employees.  Those who leave – or arrive – in the middle of their career get shortchanged the most, since vesting and benefits are not proportional to the years served.

The problem here isn’t that workers are greedy, or that these benefits themselves are unsustainable.  It’s that the results are unfair to the majority of workers, who find their own benefits shortchanged in order to fund the retirements of full-career public servants.  A conversion to a defined contribution plan, where workers are always fully vested in their own contributions would help to solve this problem, and be much fairer to the majority of workers who do not spend their entire careers with the government.

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Act Now to Ensure a Solvent Colorado Public Employee Pension Plan

My introductory at-bat in the Independence Institute’s lineup at the Greeley Tribune:

The assumption of a 7.5 percent return masks considerable risk and volatility. Although catastrophic market years such as 2008 have historically been rare, smaller routine losses are to be expected. Those losses can force an already-underfunded system to eat its seed corn by paying benefits out of assets that should be earning returns.

As a result, considerable risk exists that in the future, the state will still need to cut benefits to those who are already retired, to raise taxes, to cut services, or all three.

There is a way out.

I suggest three reforms that would help solve the problem.  We’re no longer in a budget crisis.  The Democrats’ passion for spending every last dime that comes in on new programs that will cry poor in the next recession may fix that.  In the meantime, though, now would be a good time to fix this.

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