Archive for category PERA
Budget Lessons from the Old Dominion
Posted by Joshua Sharf in Budget, Colorado Politics, HD-6 2010, PERA on August 31st, 2010
This, from the Wall Street Journal, describes how Virginia managed to close its budget gap:
Here’s something you don’t see often these days: a government running a budget surplus. Governor Robert McDonnell announced last week that Virginia closed fiscal 2010 some $400 million in the black. That’s a radically improved financial picture from a year ago when the state faced a $4.2 billion two-year budget hole.
The usual suspects—the big business lobbies, the Washington Post—thought a major tax increase was needed. So did the previous Governor, Democrat Tim Kaine, who proposed a $2 billion tax hike before he left town, on top of two major Virginia tax increases in the previous eight years.
Mr. McDonnell has proved otherwise. The newly elected Republican put a freeze on hiring and took the knife even to such politically sensitive programs as school aid, police and Medicaid to cut hundreds of millions of dollars. Total state spending has been reset more or less to 2007 levels. If Congress were to do that, the federal deficit could fall by more than $900 billion, or two-thirds.
It’s true that Richmond used too many budget tricks to make the surplus appear larger than it really is. Sales tax payments were accelerated by one month to count in 2010 rather than 2011. Several hundred million dollars were borrowed from the public-employee pension reserve—money the Governor promises to repay by 2013. Most fiscal experts think the real surplus is closer to $87 million. But given the lousy economy, Virginia’s budget achievement is laudable. (Emphasis added)
Virginia does biennial budgeting, so they’ve passed their FY11 and FY12 budgets already. Virginia’s general fund is about $15.5 billion, and its total budget is about $38 billion, so either way, it’s about twice Colorado’s. Virginia was facing a $4.2 billion deficit over two years, so it was also roughly proportional to the $1 billion hole we face in FY11-12.
We could begin with a meaningful hiring freeze ourselves. Despite the Democrats’ claim of a hiring freeze, the Bureau of Labor Statistics tells a different story:
It also makes the urgency of converting PERA from a defined-benefit to a defined-contribution plan even more plain. (For the basics on public pensions, see this primer.)
In the past, I’ve posted on the difficulty of forecasting, how despite the best intentions and best information, the folks at Legislative Council have a hard time seeing revenue crises before they hit. Bloomberg has a fine posting on why this is so:
How do economists fare when it comes to real forecasting, to predicting GDP growth and inflation one year out? About as good as a coin toss, according to Bryan’s research. Less than half the economists did better than the “naive” forecast, which is based on no understanding of the economy and merely assumes next year’s outcome will be the same as this year’s. It’s what you’d expect if the results were purely random….
I want to hear a plausible scenario, based on what we know and what we expect, for how things are going to play out in the U.S. and on the global stage. Getting the number right is a job for an accountant. Putting that number in the context of a larger trend is a job for an economist.
We don’t know when revenue will recover, and we don’t know when the next drop will hit. As a result, we need to be careful not to build in additional structural spending when times are good.
Unfortunately, we’ve already used up all those gimmicks that make the Virginia surplus look larger than it is. For us, it’s going to be even more painful, which means it’s going to call for a seriousness that’s been lacking. It’s going to call for the guts to make difficult cuts, and the courage to defend them before the voters – even in odd-numbered years.
The Wrong Way on Pensions
Posted by Joshua Sharf in PERA on August 24th, 2010
Via this morning’s Denver Post:
The city and the fire department union were at odds over how pension benefits are paid. The city wanted to continue the current pension plan, similar to a 401(k).
The union wanted to have the Fire and Police Pension Association of Colorado take over management of its pensions. The city feared losing control of the pension process.
An outside arbitrator recently sided with the fire union.
But this month, the City Council rejected that recommendation, which would have forced the issue onto the November ballot.
…The resolution passed by an 8-2 vote. Another matter to put the issue before voters in November was tabled indefinitely, killing it.
This is a terrible development, taking one, relatively small public pension (although not to the people of Aurora) entirely in the wrong direction.
PERA is underfunded by at least $20 billion. It’s underfunded because it’s a defined benefit plan, and because politicians have traditionally found it easier to vote new benefits, listening to rosy return estimates and aggressive discounting. There is enormous default risk associated with these pensions, and it’s sad to see the City of Aurora going down the same path with its firemens’ pension.
Discount That Optimism
Posted by Joshua Sharf in Colorado Politics, Finance, PERA on July 28th, 2010
On Sunday night’s Backbone Business, we discussed the problems with (mostly) public pensions. PERA, Colorado’s Public Employee Retirement Administration, is not exempt from these issues.
The biggest issue with public pensions is that, for some reason, they’re allowed to game the number that describes how much money they need to have in hand in order to cover future expenses.
We should always discount future cash flows according to the required rate of return of the project. In this case, the project, a government guarantee, should be discounted at the same rate as comparable government bonds. Corporate pensions, a company guarantee, discount at a rate equivalent to a basket of highly-rated corporate bonds, since that closely matches their obligation.
The economic reason for this is that a lower interest rate is associated with lower risk. If you discount at a lower rate, it implies a higher level of safety, and therefore, creates an obligation to have more money on hand to cover those expenses. Since the level of risk associated with a state pension is the same as the level of risk associated with a government bond, they should be discounted at the same rate. Otherwise you have equivalent risks paying different returns which creates all sorts of arbitrage opportunities.
The problem is that government pensions are allowed to discount at the expected rate of return of their investments, in effect presenting a risky investment as though it were a sound one, and therefore underfunding the plan.
Currently, PERA takes full advantage of this loophole, and discounts its obligations at 8%, the expected return on its investments. Needless to say, despite whatever reforms were passed in the last session, it’s not enough, and the taxpayers are going to be left holding the bag.
Eventually, we are going to have to transition to a defined contribution plan, and with the unfunded obligation growing rather than shrinking, the sooner we make that decision, the less painful it will be.
PERA Nears A Deal – UPDATED
Posted by Joshua Sharf in Budget, Colorado Politics, Finance, PERA on January 8th, 2010
The Denver Post is reporting that negotiators are nearing a deal on PERA, the generous defined-benefit plan that most state workers have benefited from over the years:
The major changes to the Public Employees’ Retirement Association include increasing employee and employer contributions by 2 percent and reducing cost-of-living increases for current retirees from 3.5 percent this year, capping them at 2 percent….
Several issues remain to be resolved, most revolving around age of retirement and years of service needed to get full benefits, but both men said those issues could be resolved by the time lawmakers convene for their 120-day session next week….
So let’s assume that accounting for the government worked the same as accounting for a private pension. In fact, in this case, there’s no good reason why it shouldn’t. Basically, the plan has assets and obligations, but both of those change over time. So the inputs to the model are 1) Actuarial Assessments, and 2) Interest Rate Assessments.
Actuarial assessments include things like Years of Service, Age of Retirement, Years of Benefits, Salary Increases (due to seniority), Benefit Increases (due to age). Interest rate assessments include benefit inflation, health care inflation, discount rate, and return on plan assets.
The things that can be adjusted generally fall into Actuarial Assessments, and that’s where the article focuses. Retirement age and years of service all fall into this category. What’s critical is the stuff that’s left out. We have no idea what the plan’s assumed rate of inflation, discount rate, rate of benefit inflation or health care inflation are, or what the assumed return on investment is. We don’t know what they’ve assumed them to be in the past. If those numbers are unrealistic, or even aggressive, we’ll likely find ourselves right back in the same place a few years from now.
Consider a simple scenario, where the plan assumes a constant 8% real return on plan assets. Historically, this might be reasonable. But if the bulk of the return is in the out years, the plan will have depleted its assets before those returns can catch up, and will run out of money. (Cool graphs on this topic here.) If you could forecast how returns would change over time, you’d have a more accurate model, but the fact is, as we’ve seen time and again, it’s impossible to make those sorts of predicts 5 years out, never mind 25 years out. Which means that the solvency of any defined-benefit plan is mostly guesswork. Promises of long-term solvency are simply mirages.
Maintaining a defined-benefit for incoming and even current employees is not realistic (promises made to those already retired must be honored). The only fair way to move forward is to transition to a defined-contribution plan, which has only assets, and by definitions, no liabilities. Unfortunately, the political will for this move doesn’t seem to exist.
UPDATE: According to the actuarial projections accompanying PERA’s legislative recommendations, they are indeed projecting a constant 8.0% return for the next 30 years. This strikes me as aggressive. But they key point to remember is that these returns are never constant, and that the shape of that returns curve strongly affects the ending balance. There is simply no way for even the best prognosticators to get that right, and worse, no acknowledgment in the docs that it even matters.
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