It’s a New World in Need of New Assumptions

PERSPECTIVE - I was on a panel yesterday discussing the pension problems facing the City of Los Angeles.
The event was the BudgetLA Forum.  The overall short-term budgetary challenges the city faces were also discussed.  That segment of the program was not a debate  – the panelists did not present contrasting views and focused instead on their respective areas of interest.  Opposing points of views did not surface until the audience Q&A immediately following the formal presentation.

Regardless, that portion of the program confirmed what many already know – the City’s focus is on this year, not the future.  Few of the mayor’s proposed budget remedies had any impact on the structural deficiencies threatening our future.  The aggregate impact of those that did is hardly worth mentioning.  If you want budget propaganda, send a request to Deputy Mayor Larry Frank.

The truth is, without a complete overhaul of the city’s employee benefit programs, we will always be existing from year-to-year until we cannot defer the costs any longer – please, no one say, “kick the can down the road.”

Joining me on the pension panel were the mayor’s Deputy Chief of Staff Matt Szabo and the SEIU’s Julie Butcher.

While this was not a debate, the differences of opinion between Butcher and me were clearly evident and only confirm how out of touch the leaders of the public unions are with reality.  Or maybe they know the reality but do not dare risk facing the anger of the people they claim to represent by admitting it.

Matt Szabo did not weigh in on how to deal with costly benefit programs beyond mentioning the proposal before the Coalition of City Unions – one that falls way short of correcting the city’s disastrous course.  Instead, he accepted the status quo as a fait accompli.  That’s understandable in the short-run but, without committing to overhaul inherent funding deficiencies of government employee defined benefit plans, his position is nothing more than acquiescence to the public unions.

Each presenter had fifteen minutes.  Unless you can talk as fast at the guy from the old FedEx commercial, you can’t possible scratch the surface of an issue as complex as funding defined benefit plans.  If you had more than fifteen minutes, you would risk losing your audience.  The subject can be as entertaining as a root canal for those not hopelessly engrossed in the minutia of the underlying calculations. If you ever have dinner guests who have overstayed to the point where you want to get rid of them, just start discussing pension accounting.  They will not only be out the door in short order, they will burn rubber pulling out of your driveway.

I chose to focus on the most important variable used in determining the size of the unfunded pension liability, that is, the  investment return assumption. For Los Angeles and most public pension plans it is an aggressive 8%.

I highly recommend you view this fifteen minute video produced by the California Legislative Analyst’s Office.  Although it addresses pension costs at the state level, the theory applies to local plans as well.

The unfunded pension liability is the cost of retirement promises the government cannot keep.  It is for all practical purposes unrecorded debt.  If you examine the financial statements of the city, you won’t find it.  In other words, the city’s equity is overstated and it could be by as much as billions of dollars.

Even if it were recorded, the size of the liability would be understated because of the aggressive investment return assumption used to measure the funding levels of the pension plans.  The more optimistic the rate, the smaller the liability appears.

But appearance and reality are two different things.  Bernie Madoff’s claims were all appearance and no substance.  It would have been doubtful he would have attracted as many investors had he promised conservative returns. The Ponzi aspect of his scheme notwithstanding, fewer people would have been hurt and for far less damage.

The mantra of public employee unions in general – not just the city unions – cling to the notion that past performance is indicative of future returns. That’s just the opposite of the financial advice offered by investment advisors whether they are employed by large Wall Street firms or independent professionals working from home.

Julie Butcher parroted the naive position of her union and pointed to an 8.8% annual return by LACERS over the last twenty-five years.  Of course,  Butcher failed to disclose that the Dotcom Bubble in the late nineties drove Nasdaq from a level of 1,000 to 5,000 between 1995 and 2000.  The Dow was also gripped by exuberance and  increased from 4,000 to 11,500 in the same span. The 8.8% average return was skewed in part by this unsustainable rise.  By contrast, the last ten years returned only 3.7% annually.

You see, you can paint any kind of picture you want from past performance.  Whatever range you choose will be impacted by unique events that are unlikely to reoccur in the average lifespan.
For certain, there will be other booms and busts; irrational or steady growth and decline.  To insist that investment earnings will continue based upon historic rates is pure folly.

We are not living in our parents’ economy.  For that matter, there have been significant changes since most of the Baby Boom generation’s children have been born.  The United States is no longer the sole eight-hundred pound gorilla it was for many years following World War 2.  Other gorillas have climbed in the cage and are growing bigger.

While there are benefits from increased world competition in the form of lower prices and productivity improvements,  investment risk has increased.  You can no longer count on blue chip stocks to support steady and predictable earnings as in the past.

State and local government pension boards would like you to believe they can achieve 8% growth without risk, a point made in a study prepared by esteemed financial scholars from Northwestern University and the University of Rochester.

A study conducted by graduate students at Stanford University made a compelling case for using a risk-free earnings assumption of 4%.  State and local pension board executives, along with many elected officials, dismissed the notion.  These dissenters are the same individuals who have a vested interest in protecting their taxpayer-funded jobs.  Do you think Mayor Villaraigosa is going to want to report a higher unfunded liability and make the already difficult task of balancing the city’s budget more challenging?
Hardly.

It would mean increasing the city’s pension contribution far more than the $500 million projected by Chief Administrative Officer Miguel Santana. The mayor prefers to hide under a blanket.  He does not want to raise the delicate issue of just who is going to pay for the shortfall.  Presently, the taxpayers bear the entire market risk of the defined benefit plans.  Ask the unions to cover it?  Fat chance.

You would think the mayor or City Controller Wendy Greuel would insist on sharing with the public different scenarios concerning the consequences of various earnings assumptions. Greuel is as timid as Villaraigosa, especially when she needs union votes to propel her mayoral bid.

They hide behind the reporting requirements of the Government Accounting Standards Boards (GASB) whose members include state and local officials.

I have another name for GASB.  I refer to it as the “Generous Accounting Standards Board.”  The members are enablers who wink at the unreasonable assumptions applied by the pension boards. 

They have failed and continue to fail at assuring full disclosure of possible outcomes.

State and local governments may not be able to hide behind non disclosure of the facts for too long.  Moody’s Investor Services is starting to consider pension funding as a factor in determining the creditworthiness of government units.

How can any entity begin to deal with a serious long-term problem when it does not consider a full range of projections?  How does the city know what to derive from collective bargaining while relying on a critical assumption such as investment returns made by biased, self-serving boards beholden to politically powerful unions?

I have heard calls for a citizens’ commission to examine the city’s pension accounting.
While I welcome the suggestion, it might amount to too little, too late.

What we need are professionally and independently derived pro forma financial statements and cash forecasts for the city showing  possible outcomes under a variety of conditions.  The approach would be similar in concept to the U S Treasury’s stress tests for banks.

Would you rather trust union officials or their surrogates in City Hall?

(Paul Hatfield is a CPA and serves as Treasurer for the Neighborhood Council Valley Village.  He blogs at Village to Village and can be reached at:   [email protected])    -cw



CityWatch
Vol 9 Issue 31
Pub: Apr 19, 2011

PERSPECTIVE

It’s a New World in Need of New Assumptions

Paul Hatfield

I was on a panel yesterday discussing the pension problems facing the City of Los Angeles.

The event was the BudgetLA Forum.  The overall short-term budgetary challenges the city faces were also discussed.  That segment of the program was not a debate  – the panelists did not present contrasting views and focused instead on their respective areas of interest.  Opposing points of views did not surface until the audience Q&A immediately following the formal presentation.

Regardless, that portion of the program confirmed what many already know – the City’s focus is on this year, not the future.  Few of the mayor’s proposed budget remedies had any impact on the structural deficiencies threatening our future.  The aggregate impact of those that did is hardly worth mentioning.  If you want budget propaganda, send a request to Deputy Mayor Larry Frank.

The truth is, without a complete overhaul of the city’s employee benefit programs, we will always be existing from year-to-year until we cannot defer the costs any longer – please, no one say, “kick the can down the road.” 

Joining me on the pension panel were the mayor’s Deputy Chief of Staff Matt Szabo [[http://mayor.lacity.org/PressRoom/PressReleases/LACITYP_006310 ]] and the SEIU’s Julie Butcher.

While this was not a debate, the differences of opinion between Butcher and me were clearly evident and only confirm how out of touch the leaders of the public unions are with reality.  Or maybe they know the reality but do not dare risk facing the anger of the people they claim to represent by admitting it.

Matt Szabo did not weigh in on how to deal with costly benefit programs beyond mentioning the proposal before the Coalition of City Unions – [[[http://phinvv.wordpress.com/2011/03/26/the-mayors-watershed-moment-fails-to-correct-future-course/ ]] one that falls way short of correcting the city’s disastrous course.  Instead, he accepted the status quo as a fait accompli.  [[http://www.youtube.com/watch?feature=player_embedded&v=MssCuETx2ig ]] That’s understandable in the short-run but, without committing to overhaul inherent funding deficiencies of government employee defined benefit plans, his position is nothing more than acquiescence to the public unions.

Each presenter had fifteen minutes.  Unless you can talk as fast at the guy from the old FedEx commercial, you can’t possible scratch the surface of an issue as complex as funding defined benefit plans.  If you had more than fifteen minutes, you would risk losing your audience.  The subject can be as entertaining as a root canal for those not hopelessly engrossed in the minutia of the underlying calculations. If you ever have dinner guests who have overstayed to the point where you want to get rid of them, just start discussing pension accounting.  They will not only be out the door in short order, they will burn rubber pulling out of your driveway.

I chose to focus on the most important variable used in determining the size of the unfunded pension liability, that is, the  investment return assumption. For Los Angeles and most public pension plans it is an aggressive 8%.

I highly recommend you view this fifteen minute video [[http://lao.ca.gov/webcasts/2011/pub_retirement_bens/pub_retirement_bens_021011.aspx ]] produced by the California Legislative Analyst’s Office.  Although it addresses pension costs at the state level, the theory applies to local plans as well.

The unfunded pension liability is the cost of retirement promises the government cannot keep.  It is for all practical purposes unrecorded debt.  If you examine the financial statements of the city, you won’t find it.  In other words, the city’s equity is overstated and it could be by as much as billions of dollars.

Even if it were recorded, the size of the liability would be understated because of the aggressive investment return assumption used to measure the funding levels of the pension plans.  The more optimistic the rate, the smaller the liability appears.

But appearance and reality are two different things.  Bernie Madoff’s claims were all appearance and no substance.  It would have been doubtful he would have attracted as many investors had he promised conservative returns. The Ponzi aspect of his scheme notwithstanding, fewer people would have been hurt and for far less damage.

The mantra of public employee unions in general – not just the city unions – cling to the notion that past performance is indicative of future returns. That’s just the opposite of the financial advice offered by investment advisors whether they are employed by large Wall Street firms or independent professionals working from home.

Julie Butcher parroted the naive position of her union and pointed to an 8.8% annual return by LACERS over the last twenty-five years.  Of course,  Butcher failed to disclose that the Dotcom Bubble in the late nineties drove Nasdaq from a level of 1,000 to 5,000 between 1995 and 2000.  The Dow was also gripped by exuberance and  increased from 4,000 to 11,500 in the same span. The 8.8% average return was skewed in part by this unsustainable rise.  By contrast, the last ten years returned only 3.7% annually.

You see, you can paint any kind of picture you want from past performance.  Whatever range you choose will be impacted by unique events that are unlikely to reoccur in the average lifespan.

For certain, there will be other booms and busts; irrational or steady growth and decline.  To insist that investment earnings will continue based upon historic rates is pure folly.

We are not living in our parents’ economy.  For that matter, there have been significant changes since most of the Baby Boom generation’s children have been born.  The United States is no longer the sole eight-hundred pound gorilla it was for many years following World War 2.  Other gorillas have climbed in the cage and are growing bigger. 

While there are benefits from increased world competition in the form of lower prices and productivity improvements,  investment risk has increased.  You can no longer count on blue chip stocks to support steady and predictable earnings as in the past.

State and local government pension boards would like you to believe they can achieve 8% growth without risk, a point made in a study prepared by esteemed financial scholars from Northwestern University and the University of Rochester.

A study conducted by graduate students at Stanford University made a compelling case for using a risk-free earnings assumption of 4%.  State and local pension board executives, along with many elected officials, dismissed the notion.  These dissenters are the same individuals who have a vested interest in protecting their taxpayer-funded jobs.  Do you think Mayor Villaraigosa is going to want to report a higher unfunded liability and make the already difficult task of balancing the city’s budget more challenging?

Hardly.

It would mean increasing the city’s pension contribution far more than the $500 million projected by Chief Administrative Officer Miguel Santana. The mayor prefers to hide under a blanket.  He does not want to raise the delicate issue of just who is going to pay for the shortfall.  Presently, the taxpayers bear the entire market risk of the defined benefit plans.  Ask the unions to cover it?  Fat chance.

You would think the mayor or City Controller Wendy Greuel would insist on sharing with the public different scenarios concerning the consequences of various earnings assumptions. Greuel is as timid as Villaraigosa, especially when she needs union votes to propel her mayoral bid.

They hide behind the reporting requirements of the Government Accounting Standards Boards (GASB) whose members include state and local officials.

I have another name for GASB.  I refer to it as the “Generous Accounting Standards Board.”  The members are enablers who wink at the unreasonable assumptions applied by the pension boards. 

They have failed and continue to fail at assuring full disclosure of possible outcomes.

State and local governments may not be able to hide behind non disclosure of the facts for too long.  Moody’s Investor Services is starting to consider pension funding as a factor in determining the creditworthiness of government units. [[ http://www.capitolbeatok.com/CustomContentRetrieve.aspx?ID=3847533 ]]

How can any entity begin to deal with a serious long-term problem when it does not consider a full range of projections?  How does the city know what to derive from collective bargaining while relying on a critical assumption such as investment returns made by biased, self-serving boards beholden to politically powerful unions?

I have heard calls for a citizens’ commission to examine the city’s pension accounting.

While I welcome the suggestion, it might amount to too little, too late.

What we need are professionally and independently derived pro forma financial statements and cash forecasts for the city showing  possible outcomes under a variety of conditions.  The approach would be similar in concept to the U S Treasury’s stress tests for banks.

Would you rather trust union officials or their surrogates in City Hall?

(Paul Hatfield is a CPA and serves as Treasurer for the Neighborhood Council Valley Village.  He blogs at Village to Village [[ http://phinvv.wordpress.com/ ]] and can be reached at:            [email protected]This email address is being protected from spam bots, you need Javascript enabled to view it )    -cw

CityWatch

Vol 9 Issue 31

Pub: Apr 19, 2011