Imperiling Our Children & Grandchildren:
The Retiree Benefit Time Bomb

"It is incumbent on every generation to pay its own debts as it goes." - Thomas Jefferson
Many state and local governments provide significant benefits to its retired employees. The two typical benefits are a pension plan that pays the retirees a monthly income based on their previous salary and the ability to stay on the group health insurance at some subsidized rate. Unfortunately, most governmental entities are not setting enough aside to fully fund these commitments. As a result, many are racking up staggering liabilities for the future funding of these commitments, making them unsustainable in the long run.

I first became aware of this problem while studying the City of Houston's finances. The City finds itself, like many local and state governments, with a burgeoning liability for future retiree benefits that threatens its financial solvency.

Pensions

The City maintains three pension plans: one for fire fighters, one for police officers and one for all other municipal employees. The particular circumstances of each vary significantly, but for the purposes of this analysis, I am going to consider them as one.

Basically the way these plans work is that City workers are promised a certain retirement income equal a percentage of their salary for the rest of their life. Each year the City contributes cash to a trust fund from which these future benefits will be paid. These funds are then invested to make the future benefit payments. The funds are administered by quasi-public boards that are comprised of members elected by retiree and current employees and members selected by City Council and the Mayor.

About every two years, a study is done to see if the assets in the plan will be sufficient to pay the future pension benefits. This calculation involves a fair amount of guesswork as it requires predicting both how much the future benefits will be and the investment returns on the assets in the fund. This calculation becomes particularly problematic in volatile financial times as we are currently experiencing. In September, 2008, the most recent report was completed and delivered to the City by its consultant. The consultant concluded that as of the date of the study, June 30, 2007, the assets in the plan were $2 billion less than needed to fund the future benefit payments. This is referred to as the "unfunded liability" or the "UAAL" (unfunded accrued actuarial liability).

While that number is startling enough, the reality is that it likely much higher today. As anyone who has opened a 401k statement recently can attest, the value of the pension plan assets has likely declined dramatically since June, 2007, making the funding gap even higher.

Also, the $2 billion shortfall is based on the assumption that the plan assets will earn 8.5% from their June 30, 2007 values. The consultant's reports states that 8.5% is at the high end of their recommended range and cautions that a 1% change in this assumption can make a 10-15% difference in the liability calculation.

So, where might we be today? Unfortunately, that is not clear. An attempt to quantify the shortfall is complicated by the fact that pension plans do not immediately recognize profits or losses from their portfolios. The general idea is that these assets will be held for the very long term and that short term revaluations are not significant. Different methods are employed to "smooth" gains from bull markets and losses from bear markets.

At June 30, 2007, we had just finished about a 5-year bull market and as a result the plans had not fully recognized all of their investment profits. The calculation that the City was under funded by $2 billion did not take into account about $800 million in gains in the portfolio. Therefore, as of June 30, 2007, these plans, based on fair market value and an 8.5% investment assumption were about $1.2 billion underfunded.

The Standard & Poor's 500 Index has lost more than 50% since June 30, 2007. The pension plans holdings in common stocks were about $3.3 billion. If their portfolio performed in line with the S&P 500, it is worth about $1.65 billion less than last June 30, which would wipe out the unrecognized gains and add another $800 million to the tab.

Also, one must wonder, based on the last year and the current economic climate, whether an 8.5% investment return assumption continues to be reasonable. If we lower the assumption by 1%, the liability swells by about another $1.5 billion.

If we look at the downside of each of these factors, it comes out something like this:

	(in billions)
UAAL per consultant as of 6-30-2007	2.0
Unrealized gain as of 6-30-2007	(.8)
Potential loss on stock portfolio	1.65
Increased liability from changing return investment assumption from 8.5% to 7.5%	1.50
Possible unfunded liability today	4.35

There are many other factors which could move this number wildly in either direction. For example, the plans hold millions in assets listed as "alternative investments", real estate, limited partnership interests and direct mortgages. It is especially difficult in this market to know what these assets might be worth. The plans also have substantial bond portfolios. These could have substantial gains based on interest rates coming down. On the other hand, depending on the credit quality of the issuers, they could be selling at a substantial discount. The plans hold millions of dollars in bonds that are not considered investment grade. As result, it is impossible to know what the real liability is today, but I think it is safe to say that it is far greater than the $2 billion estimated in the June 30, 2007 report.

There are also significant assumptions implicit in the estimated liability with regard to future benefits. Traditionally, these assumptions have proved to be overly optimistic and are subject to unpredictable events. For example, if there was a sudden break through in cancer research that increased life expectancies, the future liability for benefits payments would rise significantly.

One might ask how we got ourselves into this predicament. Unfortunately, there is no clear answer. As late as 2000, the City's pension plans were actually overfunded, that is, there were more assets in the plan than necessary to pay the projected benefits. However, in 2002, the unfunded liability shot up to $1 billion and by the end of 2003 was $2.4 billion.

The increase appears to be attributable to several factors. First, we experienced a significant bear market from 2000-2002 which reduced the value of the plan assets. One investment advisor familiar with the pension plans' investments told me that in the late 1990s the plans adopted significantly more aggressive investment guidelines, shifting many of their fixed income investments to equities. Even more significant, in 2002 the City Council increased the pension benefits apparently without a clear understanding of the long term effect on the unfunded liability.

Some of you may remember Bill White's first State of the City address in which he disclosed that the pension plan review he has just received revealed the staggering run up in the unfunded liability. The White administration immediately moved to contain benefits and held an election in which Houston opted out of a State Constitutional provision that prohibited the City from lowering benefits under certain circumstances. The City trimmed benefits by eliminating certain abusive practices and stretching out the number of years required for new employees to qualify for a pension. Had it not been for these changes the situation would be even more dire today.

Also, the City began borrowing money to make its pension plan contributions. Since 2003, the City has borrowed about $600 million from long-term bonds to make cash contributions to the pension plans. The basic strategy behind the use of pension bonds is that in recent years the sponsoring entity has been able to borrow funds at a rate below the rate the pension plans are earning on their assets. The idea has been that this "profit" would then be used to reduce the UAAL. Of course, this basically is a bet, speculation if you will, that this positive arbitrage stays in place. The bet worked out well from 2003 through October, 2007 and the City's liability was steadily declining. Unfortunately the City has disastrously lost this bet since October, 2007.

The City is not alone in its use of pension bonds. Many jurisdictions across the nation made a similar bet with similar results. [ click here ] The most startling comment I have seen lately on pensions came from New Jersey Democratic Governor Jon Corzine who is also a former chairman of investment bank Goldman, Sachs & Co. In an interview, he said, "It's the dumbest idea I ever heard. It's speculating the way I would have speculated in my bond position at Goldman Sachs."

It is important to understand that borrowing money on pension bonds does not lower the City's total liability for future pension payments. Rather by issuing pension bonds we are merely trading one kind of debt for another. If the outstanding pension bonds are added to the unfunded liability, we are a minimum of $2.6 billion in debt on our pension commitments. The actual amount could easily be twice that high.



Pension plan administrators argue that we should not place too much significance on the UAAL. Craig Mason, the City's chief pension officer, in a recent interview, pointed out that the plans extend over a very long term and that ultimately the viability of the plan turns on the financial viability of its sponsor (i.e. the City) and its financial ability to make future contributions. Before the stock market crash, Mason projected that the required contributions to the plan will begin to come down in 2011-2013 as the reforms adopted in 2004 begin to have a larger effect on the liability calculation. But even under Mason's estimates, the City stabilizes at a contribution to the plans of 15-20% of payroll, which is, in my view, still unsustainable. But even if his more optimistic projections were accurate, they have clearly been waylaid by the market collapse. [Click here for Mason's comments to this blog.]

Heath Insurance Benefits

If you are not depressed enough yet, there is more. In addition to the pension income, the City also allows retirees to continue to participate in the City's group health insurance plan. The City pays approximately 75% of the cost. As recently as FY2002-2003 this cost was only $21 million. However, in FY2006-2007 the cost had ballooned to $54 million.

In the past, the City has not reported a liability for the future payment of these benefits. However, beginning this year, a new accounting rule will require governmental entities to estimate the total liability and phase in reporting this liability on the balance sheet.

In 2006, the City conducted a preliminary actuarial study in anticipation of this new accounting rule. The study found that the unfunded liability for future retiree health benefits was another $3.2 billion as of June 30, 2006. The City is currently conducting a new study to update this estimate. My guess is that it has not gone down.

Perspective

Based on the best information we have the City is in debt for retiree benefits in the range of $6-10 billion. The City is hardly alone in its predicament. A few years ago, Philadelphia issued $4 billion in bonds to make up part of its unfunded pension liability. Unfunded pension liabilities in Vallejo, California forced that city into bankruptcy last year. City officials in San Diego were recently charged with fraud for intentionally understating that city's unfunded liabilities. And a report last year found that the Texas State Teacher Retirement fund is underwater by $30 billion.

Nonetheless, the City's liability in relation to its size is alarming. Consider these comparisons.

• » The City's total bonded indebtedness for all of the infrastructure it has created in its 175-year history is only about $12 billion. To have run up a debt of 50-75% of this amount in less than a decade for retiree benefits is sobering.



• » A comparison to the City's net assets is no more comforting. According the June 30, 2007, the City had net assets of about $4 billion. If the City were required to put these liabilities on its balance sheet today, it would be grossly insolvent, even under the most optimistic estimates.



• » Most shocking, however, if the City devoted 100% of its property tax revenues (about $850 million annually) to pay down the retiree obligations, it would take nearly 10 years pay them off.

What is the Antonym for Legacy?

In January, my daughter gave birth to my first grandchild. While we were waiting on him to arrive, I was looking through the disclosure statement on the $400 million in pension bonds issued in December. As I did it occurred to me that he will be 30 years old when these bonds come due - a bill for employees' services that were rendered years before he was born.

I have no problem with borrowing money to fund infrastructure projects that will provide benefits over a long period. If our children and grandchildren are going to enjoy the benefits of such improvements it is not unreasonable to ask them contribute to the cost.

But borrowing to pay for services that have already been rendered is an entirely different matter. If we merely continue to roll this debt along to the next administration and the next generation, it will eventually have profound effects on the City. Depending on the outcome of the current financial crisis, those effects could come much sooner than anyone has previously expected. Increasingly our ability to finance future infrastructure projects will be compromised at a time when there are pressing needs. It is possible that we will see downgrades on our credit rating, which will increase borrowing costs. It is conceivable that one day the City could default on its promises to its retirees if fundamental changes are not made.

We must not allow this be to our legacy. We must reform this system so that it is on a "pay as you go" basis. It will not be an easy task. It will require sacrifice from all the stakeholder groups involved. The task must be undertaken not in form of an inquest of how we got here, but rather where we go from here. We must do so respecting the rights already earned but at the same time recognizing the burden under which taxpayers are already laboring.

Our forefathers left us a legacy of great public infrastructure . . . the interstate highway system, bridges, airports, libraries . . . just to name a few. And they bequeathed these to us with relatively little debt attached. We, on the other hand, are on the verge of leaving our children and grandchildren not with a legacy of great public works but rather of one of an oppressive and staggering public debt.

For policy discussions on other issues, visit www.BillKingBlog.com or www.BillKingHouston.

Banks May Not Be in as Bad of Shape as the Market Thinks

The narrative is well known. A bunch of greedy Wall Street bankers made trillions of dollars of bad loans to borrowers who had no chance of paying them back so that the bankers could earn obscene bonuses. Later when the loans went bad, the banks were left with billons in losses. The storyline has been so often repeated that it has become an article of faith in our national consciousness. But how likely is it that this is really what happened?

Dow Jones Bank Index

To believe this scenario you must be willing to accept a number of doubtful assumptions. In every major bank there are underwriters or risk managers that are the watchdogs on the quality of the banks assets. For this narrative to be true thousands of such underwriters were either compromised or became completely incompetent at virtually the same moment in history. These individuals' compensation are not typically tied to loan production so they have no incentive to take unreasonable risks. In fact, quite to the contrary they get fired when things go wrong.

Further at the executive level, we must believe that the top managers of these institutions were willing to bankrupt their companies in exchange for short term bonuses or, that they too were completely incompetent. In many cases, much of these individual's net worth are tied up in the stock of these companies. Therefore, their long-term financial interests were not consistent with the behavior suggested. Added to that, these guys were not dummies. Most were graduates of the finest business schools in this country. I find it pretty hard to believe the thousands of bankers suddenly went crooked, nuts or stupid all at the same time.

Next we must believe that millions of people decided to borrow more money than they had any chance of repaying. Now I agree that most of us tend to the optimistic side of the amount of the debt that we can handle. Does it really seem likely that millions of people bought a home when they knew they would default soon after the purchase and ultimately be forced out through foreclosure. Were they really willing to ruin their credit and have their families uprooted by forcible eviction? I suppose there might be a few people that would undertake such a proposition, but it seems incredible to think that millions of Americans families would subject themselves to the embarrassment and stress of financial ruin or that alternatively millions of Americans were too dumb to know that they were borrowing more than they could pay back.

I am probably skeptical of this narrative because I saw a similar one in the savings and loan crisis. Even today the commonly accepted cause of the savings and loan crisis was that a bunch of crooks looted the industry. However, after three decades, it is widely accepted among academicians and economists that fraud and insider abuse accounted for only 10% of the losses and that the real causes were a series of policy missteps by the government. (see www.aboutsavingface.com)

So is there a similar alternative explanation to the current mythology? It is extremely difficult in the midst of a crisis to sort out the events swirling around us. It was not until years after the savings and loan crisis that we were able to take full measure of the causes and effects. However, I have a principal suspect for the culprit in the current crisis and you will probably not be surprised that it comes from the government, in this case, aided by the Financial Accounting Standard Board ("FASB").

A fundamental issue in determining the health of any financial institution is to appropriately value its assets. Of course, in most cases this involves valuing the loans owed to the financial institution. In a traditional bank which makes loans directly to its customers, loans are valued at the amount owed by the customer unless there is some reason to believe that the customer may not be able to pay back the loan. Reserves for uncollectible loans are set by the bank and reviewed periodically by the bank examiners. It is a system that has worked reasonably well for almost a century.

However, in the late 1990s a fundamental change took place in the way mortgages (and some other loans) were originated. Instead of the financial institution making the loans directly to its customer, intermediaries began originating and securitizing huge pools of loans. On its face, this seems like a great boon to the banks. It reduced their cost of origination and provided them with a security that could be readily sold if they needed to increase liquidity.

Unfortunately, it turned out that there were a number of structural problems in separating the ultimate lender from the borrower. These problems will be the subject of another discussion. But there was another effect which ultimately proved much more insidious. Because the securities were more readily tradable, they were subject to the "mark-to-market rules."

In its simplest form, the mark-to-market rules are pretty straightforward. If a financial institution holds a security for which there is a ready market, that security must be shown at its market value. So if a bank owned Exxon stock for example, it would show the value of that stock at its market value.

However, any share of Exxon stock has exactly the same value as any other share. Also, there are metrics that allow investors to make reasonable judgments about the value of Exxon shares to, say, Chevron shares. This is not the case with the mortgage back securities (MSB). The value of these pools is tied ultimately to collectability of the underlying loans, which turns on the value of the underlying collateral, local market conditions, borrow credit worthiness and many other intangible factors that go into underwriting an individual loan.

The complexity of analyzing this array of factors on thousands of loans (especially when they were divided in tranches) creates an impossible task. The organizers of these transactions attempted to wire around this problem by having the credit rating agencies assign ratings to the pools. In their glee at the prospect of a whole new universe of fee income, the credit rating agencies rushed into to the market. (The role of rating agencies in this whole debacle is a story that has yet to be told.)

Unfortunately, the rating agencies made a fundamentally flawed assumption. They believed that home prices could not go down. As the real estate market and the economy began to cool, defaults in the loans began to occur. Suddenly the banks, the market generally and most importantly the banks' auditors and examiners began to doubt the collectability of the pooled loans and, therefore, their value.

Since these instruments were designed to be readily tradable, the mark-to-market rules applied. Auditors and bank examiners, determined to cover their own behinds, began to insist on marking down the MSBs. But because of the doubt that had crept into the market for MSBs there was no ready market. Banks, with the prodding of their auditors and examiners basically began guessing at what the MSBs might be worth and recording losses. Mind you, not actual losses of the sale of securities, but a theoretical loss on a theoretical sale. But the reduction of the bank's capital was not theoretical. It had to be reported to the SEC and the bank regulators.

Ironically, if the same loans in the MSB had been held directly by the banks, mark-to-market would not apply. The loans would be reviewed on an individual basis and an appropriate reserve established for the non-performing loans. But a bank may be forced to mark down the value of an MSB even if every loan in the pool is paying on time.

Once a bank's capital is impaired by these reductions in value, it is forced to de-lever. That means the bank has to sell assets to reduce the size of its balance sheet and to maintain the require capital ratio. Of course, when a large number of financial institutions all need to sell these assets at the same, they further depress asset prices, closing a vicious circle. The banks also began reducing new loans as a means to reduce the size of their balance sheet, thereby causing the banking crisis to spill over into the Main Street economy. As Main Street began to cut back, it eliminates jobs which mean more bank defaults, thus reinforcing the downward spiral.

But what if the MSBs have been marked down more than is really justified? Is that a possibility? I think so. We know that it happened in the savings and loan crisis. It has been well documented that RTC and its predecessors marked the S&L's assets to absurdly low levels. The liquidation of the S&L industry has been described as one of the greatest transfers of wealth in history as buyers at RTC sales made hundreds of millions of dollars.

Given the complexity of the MSB structures, it may be too early to predict that they have written down below their inherent value. But it is probably not a bad bet. If so, we may wake up one day to find out that much of the current misery was visited on us by accounting and regulatory rules intended to protect us. It would hardly be the fist time that unintended consequences have bitten us on the behind.

For policy discussions on other issues, visit www.BillKingBlog.com or www.BillKingHouston.