Is Nashville's pension fund doubling down?

A Forbes blogger has singled out Nashville's city pension for betting on risky "alternative" investments with this lurid headline:

Nashville Pension Bails on Bonds, Piles on Risk

 If you participate in the Nashville pension, or are a taxpayer, I encourage you to pay attention to what’s going on in the investment portfolio. Rely upon your common sense and do not be swayed by financial alchemy. In my opinion, the Nashville public pension’s alternative fixed income and other gambles will, over time, prove to be ill-advised.      

I welcome this attention.  Anyone who has read this blog, or chapter 5 of our text book, knows that I have been worried about Nashville' unfunded pension liabilities for quite some time.  In fact, I was thrown out of a nice dinner party when I tried to "convince" the mayor that we should be discounting our future liabilities at a much lower rate than 7.5%.

Discounting at this rate is OK if we can earn 7.5% on our investments.  That way, when the future finally gets here, we will have enough to pay off the pensions.  However, if we earn less, then ...

Our city pension manager has put 15% of the pension fund into riskier investments to raise the return.  A former student, who manages pension money, agrees with the blogger and thinks this is a risky idea:

...our independent investment advisors have recommended we invest no more than 7.5% of our portfolio in these types of "opportunistic" real estate funds (or any real estate funds). 

Over a long enough horizon, the risk is supposed to average out.  But that kind of thinking led to the complacency that played a role in the financial crisis.

 Cross your fingers.  

Hyperbolic discounting and Nashville's growing pension problem

The city of Nashville uses discounting to decide how much to save for its future pension obligations. For a pension that pays out $100,000 in 20 years, Nashville must save $20,485=$100,000/(1.0825)^20 today, using an 8.25% discount rate.   If the city invests the $20,485, and earns 8.25%, the savings will compound and be worth $100,000 in twenty years.  If however, the investments return less than 8.25% (in fact they have done much worse),then the city will not have saved enough when the future finally gets here.  Of course, a more realistic discount rate, say 6.5%, would mean much higher current savings, 28,380=$100,000/(1.065)^20 to fund the same future pension.  But higher savings means less current spending, and spending is politically popular.

If voters were perfectly rational, they would recognize that their cities are not saving enough to fund their future pension obligations. 

That they don’t seem to care has long been recognized by psychologists, and even has a name, “hyperbolic discounting.”  It means that most people make decisions using discount rates that are too big.  In other words, they place too much weight on the present, and not enough weight on the future.  Businesses, like politicians, take advantage of this irrationality by, for example, offering a low “teaser” price which goes up in the future, or by offering a low price on a consumer durable, like a pod-coffee maker, and then charging a high price on the consumables,like the pod.  When deciding whether to purchase the pod-coffee “system,” consumers place too much weight on the “current” low price of the machine, and discount too heavily the “future” high price of the pods.  By shifting most of the system costs to the future, the coffee company makes the system appear cheaper, which increases demand.

What's the difference between Keurig Coffee and Nashville city government?

In order to persuade coffee drinkers to switch from normal drip coffee makers to Keurig's unique K-cup coffee system, Keurig has to keep the initial system price low by essentially giving away their coffee makers. Whatever Keurig loses on the machines, it more than gains on future sales of K-cups.

Similarly, Nashville discounts its future pension liabilities at the unreasonably high rate of 8.25%. This allows the city government to save less--and spend more--than they should.

Both Keurig and Nashville are taking advantage of people's irrational over-weighting of the present relative to the future, which is so common that economists have given it a name, hyperbolic discounting.

The difference is that Keurig will make up for the initial loss with profit from future sales whereas Nashville has no such plan. In the meantime, the size of our unfunded debt keeps growing. Someone else--presumably our kids--will wind up with the bill.

As strange as it may sound, we could learn something from California. Just yesterday, Calpers took the unusual step of lowering its discount rate to 7.5% (the actuary had recommended 7.25%). It is unusual because the the policy alleviates future problems, but causes pain today, exactly the opposite of what hyperbolic discounting tells them they should do.

By lowering the so-called discount rate, Calpers could ask the state to eventually contribute an additional $300 million annually. The pension board asked the staff to come up with a plan to phase in the increased contributions from state and other government agencies over the next two years to help soften the financial blow.

That such a small change in the discount rate (0.25%) can have such big effects illustrates the power of discounting. Imagine what would happen if they had to lower their discount rate to a much more realistic number, say 6.5%? (Derivation here).

See also Stossel on city pensions; and how the Swedes solved their pension mess.

And as if this weren't scary enough, the pension problems are dwarfed by the unfunded medical benefits:

while most public pension plans are 75 percent funded, the figure for health-care plans is only 4 percent nationwide. So unlike pensions, governments are setting aside little money in advance to pay for their future obligations.

HT: Instapundit

Why are defined benefit pension plans so under-funded?

States still have defined benefit pension and medical benefit plans that promise future payouts to state and local employees. To determine how much they have to save, they calculated the present discounted value of the future liabilities and compare it to current savings. Nashville's pension liabilties, for example are about 90% funded. Pittsburgh's are about 30% funded.  Neither saves for the medical benefits.

So what discount rate should they use? Most use discount rates near 8% because they expect to earn 8% on their investments. A recent paper blamed some of the under-funding on the use of discount rates based on the characteristics of the invested assets:

• the use of higher-than-appropriate discount rates reduces the value of the pension obligations that is reported to the public, and thus likely reduces the contributions that sponsors feel they must make to pre-fund their pension obligations.
  
  
• the link between the discount rate and the expected return on plan assets mayencourage sponsors to invest in riskier portfolios than they would otherwise choose in order to justify a higher discount rate, and thus a lower contribution into the pension trust.
  
  
• these rules may encourage fiscal gaming in the form of “Pension Obligation Bonds.” These devices allow governments to borrow, invest in risky assets through the pension trust, and treat the difference between the expected asset return and the bond interest rate as “found money.”
  

So what rate should they use? The paper recommends a rate equal to 30 year treasuries, adjusted upwards to account for their tax free status. Today's risk-free rate of 4.29% is equivalent to a taxable rate of 6.55%, given a marginal income tax rate of 35.5%.

Is this really an arbitrage opportunity?

Kansas has an under-funded, defined-benefit pension system that is becoming more and more costly to fund, diverting expenditures from roads, schools, and the like:

Many investors in the municipal-bond market are concerned that retirement costs will eventually cripple states, particularly in Illinois and New Jersey, which also have settled SEC charges related to pension disclosures. State retirement systems have far less funds than they need to meet all their projected payouts, with the Pew study putting the combined shortfall at $915 billion as of 2012.

Instead of trying to reduce its pension obligations, Kansas wants to earn some money by borrowing at 5%, and then investing the money in its pension fund, where it thinks it can earn 8%.  This would represent an arbitrage opportunity, except for the fact the the pension investments are in higher risk securities which naturally earn a risk premium.  This means that the extra return that they generate are compensation for the additional risk that Kansas will incur.

Even under the best circumstances, pension bonds come with the risk that expected spreads won’t materialize. Since Oakland, Calif., sold the first pension-obligation bonds in 1985, cities and states have issued about $105 billion of the debt, the Center for Retirement Research said last year. Those deals have had returns averaging 1.5% annually since 1992, thanks to market gains following the financial crisis, the center said.

We have blogged about under-funded pensions before.  They arise because the median voter, and the politicians they elect, typically do not understand or care about the problem. Refreshingly, Nashville's Mayoral candidate David Fox has raised the issue in his campaign:

...The danger of debt is probably the issue he's most passionate about: He gives the sense that the city's unfunded liabilities and debt really do keep him up at night.  

"What do you think is gonna happen when our national economy, as it will do cyclically — when our national economy goes sideways for several years?" Fox asks. "We're going to see a lot of municipal bankruptcies. Because unfunded liabilities are too big, the balance sheets are way out of whack, you have way too much debt at the municipal level, and a lot of cities are going to go bankrupt. That's not gonna be an accounting adventure, that's gonna have a real bad effect on people who live in these cities."

TRUTH IN BLOGGING DISCLAIMER:  I am leaning towards Fox (and his wife is a former student).  

Cross your fingers: Nashville's risky pension portfolio

In the past, when Nashville's pension fund earned more than required to fund the pensions, the politicians spent the surplus; but when it came up short, they did not fund the difference.  This lead to systematic underfunding.  Then the State passed a law to force Nashville and Memphis to fund their pensions.

Now, we learn that Nashville is investing in risky assets to reach its targeted 7.5% return:

Since the 2008 financial crisis, Nashville’s pension managers have been shifting taxpayer money into junk bonds, hedge funds, troubled mortgages, private equity funds and other alternatives to conservative stocks and bonds. If successful, these “alternative investments” can earn greater profits, but they also demand high fees and carry the risk of heavy losses.

So how is it doing?

Nashville's investments have shown mixed results. After taking out fees, the city’s fund grew by 4.7 percent a year since 2008, on average, while the Standard & Poors 500 gained 6.6 percent.

Keep your fingers crossed!

HT:  Preston

Tennessee forces Nashville and Memphis to fund their pensions

Two cities in Tennessee manage their own defined-benefit pensions, and it is no coincidence that both are majority Democratic, and both are underfunded.  We have discussed the reasons for this in past  blog posts.

Efforts at pension reform have been slow because voters in these cities do not seem to understand or care much about the future pension liabilities, which means that it is not a high priority for politicians.

For example when Nashville went to a more realistic discount rate, from 8.25% down to 7.5%, the city also changed the assumptions on pension growth so that the net effect was no additional savings.  So Nashville gave the appearance of change, without the substance.    

Also, for underfunded pensions, this kind of discounting creates an incentive for fund managers to go into riskier assets.  Indeed, Nashville's pension manager has adopted a riskier investment strategy.  Cross your fingers.   

And we still save nothing for medical pensions.  That is the elephant in the room.  

The obvious solution is a defined contribution schedule, like the Swedes, or  a more reasonable rate linked to the 30 year treasuries, adjusted for tax free status, e.g. 6.5%.

The latest development is a new state law, designed to force these cities to fully fund their pensions.  It does not force cities to make up for past underfunding.  

Choose Moody's to signal financial health

Moody's just downgraded the Chicago's debt to junk status while S&P has them rated at "investment grade."

The difference is due to the different methodologies:  Moody's uses its own growth projections while S&P defers to the city's growth assumptions.

We have blogged extensively about the systematic underfunding of municipal pensions and the political pressure to under-save:

The city of Nashville uses discounting to decide how much to save for its future pension obligations. For a pension that pays out $100,000 in 20 years, Nashville must save $20,485=$100,000/(1.0825)^20 today, using an 8.25% discount rate.   If the city invests the $20,485, and earns 8.25%, the savings will compound and be worth $100,000 in twenty years.  If however, the investments return less than 8.25% (in fact they have done much worse),then the city will not have saved enough when the future finally gets here.  Of course, a more realistic discount rate, say 6.5%, would mean much higher current savings, 28,380=$100,000/(1.065)^20 to fund the same future pension.  But higher savings means less current spending, and spending is politically popular.

So, for the purposes of illustration, S&P is using a higher discount rate (like the 8% in the example above) and Moody's is using a much lower discount rate, (like 6.5% in the example above).  

OK, now we are in a position of determining which of the agencies is doing a better job?

I trust Moody's for two reasons:

1. City assumptions are typically too high and are almost always backward looking, so after a long period of high returns, the assumptions will be for continued high returns. When in fact, high returns in the past are correlated with lower returns in the future.  

2.  I suspect that S&P gains clients for its consulting services from many of the same cities that it rates.  Its favorable ratings may be an advertisement to financially strapped cities that S&P will come up with a low savings rate which will provide cover to politicians who want to continue their irresponsible behavior.  

If this is correct, financially healthy cities may want to "signal" their financial health by hiring Moody's.

What can Nasvhille learn from Detroit's troubles?

In Detroit, where unions controlled the politicians, the politicians appointed union reps to administer the pensions:

Most of the trustees on Detroit’s two pension boards represent organized labor, and for years they could outvote anyone who challenged the payments.

They use this power to "redistribute" wealth from taxpayers to city workers, retired or not: 

Detroit’s municipal pension fund made payments for decades to retirees, active workers and others above and beyond normal benefits, costing the struggling city billions of dollars and helping push it into bankruptcy,

And they made it very difficult for outsiders to get the data necessary to "see" what they were doing. 

An investment banker now advising Detroit, Charles M. Moore, has said in a court declaration that the trustees of the general pension plan were “effectively robbing” the fund when they diverted its assets...

In Nashville, city pensions are underfunded by about half a billion, but our medical pensions are underfunded by about two billion.

New discounting rules from GASB should affect Nashville

Its not often that I get excited when a Government Accounting Standards Board acts, but this time they have done something really extraordinary--rewritten the rules on how much governments, like Nasvhille, should save:

Discount Rate. The rate used to discount projected benefit payments to their present value will be based on a single rate that reflects (a) the long-term expected rate of return on plan investments as long as the plan net position is projected under specific conditions to be sufficient to pay pensions of current employees and retirees and the pension plan assets are expected to be invested using a strategy to achieve that return; and (b) a yield or index rate on tax-exempt 20-year, AA-or-higher rated municipal bonds to the extent that the conditions for use of the long-term expected rate of return are not met.

I think this means that if Nashville is earning less than its discount rate (see previous post), they have use a much lower discount rate. In other words, a bunch of accountants may force political leadership in Nashville to do the right thing.

HT:  Steve & Beth

Under-funded muni pensions exposed by new accounting rules

We have blogged extensively about the way that mayors, including Nashville's, promise big pensions to city unions, and then hide the cost of the promises with accounting "gimmicks."  For example, a high discount rate, like Nashville's 7.5%, reduces the present value of future pension promises, and reduces the amount that a city has to save for the future.

Now, the GASB (govt. acct. stds. bd.) is proposing rules that will give taxpayers visibility into what mayors are doing by forcing mayors to add promises to the balance sheets of a city and use lower, more realistic, discount rates.  The net effect seems small

According to the Center for Retirement Research at Boston College, a group of 150 public-employee pensions that were 72%-funded in 2013, meaning their assets were 72% of their obligations, would have been only 65%-funded under the revamped rules.

But for cities and states with particularly egregious accounting, the effect is likely to be much bigger.

In a related development, young people seem to be noticing that they will be stuck with the bills run up by irresponsible politicians.  Here is an advertisement aimed at Louisiana's Federal Senator:

Signs of intelligent life in Nashville

... as voters forced Mayor Karl Dean to withdraw a plan to borrow $200M to help cover Nashville's unfunded pension liability.

Future Nashvillians are on the hook for about 2.5B (2B for medical pensions, 0.5B for regular pension) to city workers.  To help cover the short fall, the city proposed to borrow $200M at 4% interest, invest it and earn 7.5%. 

If the investments work out, then we can expect to net 3.5%, money that would ostensibly be used to pay down our unfunded liabilities.  In reality, it would likely fund more current government spending.

If the investments don't work out, our unfunded liabilities get even bigger. 

Moody's weighs in on Nashville Mayoral Race...

...albeit indirectly, when they downgraded Nashville's debt last year. (It is as if Moody's had been reading my blog posts on Nashville's unfunded pension problems).  In any case, David Fox seems like the only candidate interested in addressing the issue.

TRUTH IN BLOGGING DISCLOSURE:  I am leaning towards Fox, and his wife is a former student.