How to manage pension liability

Americans today exist amid the tension between hope for better times and the scars of the worst financial crisis since the Great Depression. Among the fiscal challenges we face are states and cities that are struggling to keep up with their promise to set aside enough money to fund public employees ‘defined benefit pension plans as those governments also struggle to recover from the longest economic downturn since the 1930s.

As difficult as it will be to live up to their pension promises, governments must avoid the temptation to increase their contributions to pension systems by raising taxes on average Americans. This would only deepen the wounds of those hit hardest by the 2008 financial crisis and subsequent Great Recession.

While corporate America has shifted to defined contribution retirement plans, most state and local government employees still participate in defined benefit plans. There is plenty of evidence that these plans lack the funds to make good on the promises made to public employees, but little evidence that structural reforms are being implemented.

Defined benefit plans promise a set monthly payment during retirement. Major challenges of managing these plans include estimating future retiree obligations and making accurate assumptions about variables such as length of service, future salary levels, retiree mortality and expected return on pension fund assets

Investment returns are critical, since investment earnings account for the majority of public pension financing. Any shortfall must be made up by increasing contributions or reducing benefits. One common flaw in pension plan management is undervaluing liabilities by assuming unrealistic rates of returns on pension assets.

Even small changes in rates of return can have a significant effect on assets. A Congressional Budget Office study found that with an 8 percent projected rate of return, unfunded liabilities amounted to $700 billion for state and local pension plans. If the projected rate of return dropped to 5 percent, the unfunded liability more than tripled to $2.2 trillion.

Public pension funds generally assume a high rate of return. For example, many base pension contributions on an assumed 7.75 percent annual return on fund investments, which is difficult to achieve in a near-zero interest rate environment.

Since actual returns have been less than the assumed rates, unfunded liabilities have increased.

There is no consensus on how best to deal with this crisis and preserve the sustainability of public pension plans. Since the 2008 financial crisis, nearly all states have enacted changes to make their defined benefit pension plans more solvent. Common options for overhauling the plans range from increasing employee contributions to benefit reductions, including cost of living adjustments and increases in eligibility requirements such as increasing the retirement age for new employees.

A handful of states have passed reforms that replace defined benefit plans with some version of defined contribution plans for new employees. Others have borrowed money through the issuance of pension obligation bonds, floating tax-exempt bonds at low interest rates in the hope of investing the money in securities with higher yields.

Still other states have changed their asset allocation mix to generate higher returns, investing in alternative investments such as private equity, real estate, hedge funds, commodities and derivatives. But along with higher expected returns, these investment vehicles also bring greater risk.

As part of the struggle to deliver promised benefits, some pension plans have begun to focus on investment management fees. For example, the California Public Employees’ Retirement System, the country’s biggest state pension fund with about $300 billion of assets, announced plans earlier this year to cut back on the $1.6 billion in management fees it paid to Wall Street firms last year.

Tough choices are needed to get public pension funds plans back on track. But in the current economic environment, increasing governments’ contributions to the plans by raising taxes on average taxpayers who have already taken a beating in recent years should be avoided at all costs.

originally published: June 27, 2015

America’s $4.7 trillion pension liability problem

The average American still feeling the effects of the Great Recession can be forgiven for not being riveted on the fact that state and local governments across the country are facing another fiscal crisis in the form of a public pension “tsunami” of epic proportions. Fixing the problem will require fundamental changes to public retirement plans.

According to Standard & Poor’s, 32 states are confronting budget shortfalls in fiscal 2015 and/or 2016. One contributor to those ills is growing unfunded public pension liabilities that now range as high as $4.7 trillion nationwide according to a report from State Budget Solutions, a non-profit organization that advocates for state budget reform. The unfunded liability works out to about $15,000 per person.

Public employees have been promised more than state and local governments can ever afford to pay and taxpayers are on the hook for the shortfalls. Many retirement plans are not setting aside enough money  to make good on their promises to current and retired state employees. Some, such as Detroit and Stockton, Calif., have already declared bankruptcy; countless public pension systems are in dire shape.

Moody’s dropped Chicago’s bond rating to junk status after the Illinois Supreme Court overturned state pension reforms. That means the Chicago taxpayers will be paying higher interest rates on the money the city borrows.

Last week the New Jersey Supreme Court ruled that the state did not have to increase its contribution to ensure the solvency of its ailing pension system. Politicians there found that shifting liabilities into the future by underfunding pensions was a convenient way to deliver on promises of low taxes and richer retirement benefits.

In Massachusetts, unfunded state and local pension and retiree health care liabilities total around $75 billion.

Most state and local governments in the United States offer defined-benefit pension plans to which both employees and employers contribute. The plans are supposed to provide public employees with guaranteed income, creating a financial liability for taxpayers when workers retire. Under this type of plan employees accrue the right to an annual benefit usually determined as a percentage of a worker’s average salary over the final years of employment multiplied by the worker’s years of service.

Under this arrangement, the employer is responsible for determining how much to set aside for employees’ retirement fund and how to invest it. Government (taxpayers) assumes the risk of coming up with the extra money if there is a shortfall. Government has several basic options in that case: they can raise taxes, make budget cuts, or default on their obligations. Given the magnitude of pension liabilities, some states may seek a federal bailout as was done for Wall Street and the automakers.

In contrast, the defined contribution plans that now prevail in the private and not-for-profit sectors empower employees to save for their own retirement and manage their own investments. A defined contribution plan transfers investment risk from the employer to the employee.

These are the simplest, most transparent, portable and straightforward pension plans. The employee and employer both contribute, the employee decides where to invest the funds and bears responsibility for investment risk. Upon retirement, there is often an opportunity to cash out with a lump sum payment or to select an annuity whereby payments are made to the retiree over a specified period.

However bad the problems are now, the pension situation is likely to get worse as politicians continue to “kick the can down the road,” the cliche that describes politicians’ response to virtually every fiscal crisis. One thing that would help would be to replace current defined benefit plans with a defined contribution plan for new public employees as Georgia, Michigan, Utah, and Oklahoma have done.

Such a move would minimize the risk of one major but often forgotten stakeholder: taxpayer.

originally published: June 20, 2015

Cost of being wrong about trade is paid by American workers

President Obama, powerful business and government elites, special interests and reflexive free trade advocates are working hard to garner congressional support to consummate the ambitious and furtive 12- nation trade agreement known as the Trans-Pacific Partnership (TPP). This is a big deal; linking 40 percent of the world’s economy- so big that it has been negotiated in secret.

We are told that free trade means the unimpeded flow of goods, services, capital and labor across international markets. In this best of all free trade worlds, consumers get the lowest prices.

This is all well and good for American consumers, but what about the increased unemployment and reduced wages free trade also brings? Unless consumer prices have fallen by more than the average worker’s income in recent decades, this may not be such a great deal.

In the real world, critics say the TPP is more like managed trade than free trade. America’s trading partners engage in currency manipulation to make their exports cheaper and U.S. exports more expensive than if exchange rates were determined by market forces. Consequently, some lawmakers worry that currency manipulation by trading partners is an important cause of the large and growing U.S. trade deficit, and will further injure domestic industries and workers. For them, many of the arguments for free trade are just globaloney.

Japan, a member of the proposed TPP deal, is by its own admission a currency manipulator. Its leaders want a relatively low exchange rate for its currency, the yen, because it makes their goods and services cheaper in the United States. Automakers and other manufacturers believe such currency manipulation constrains sales of American products.

Here is a simple example: The Japanese central bank prints more yen and then buys assets denominated in dollars. This increases demand for the dollar, which increases its value while at the same time driving down the value of the yen. By manipulating their currency Japan is subsidizing its exports by making them cheaper and placing a hidden tariff on imports. The U.S.-Japan goods trade deficit reached $78.3 billion in 2013, costing U.S. workers thousands of jobs. The U.S. is acquiescing in outsourcing the value of the dollar to a trading partner who wants to win jobs and gain higher incomes for their people.

On the other hand, there are those who see the trade deficit in a positive light as it provides foreigners with dollars that they recycle by bingeing on United States Treasury debt, thus financing federal budget deficits.

Opponents of the current deal complain that, among other things, it does not address currency manipulation, which subsidizes Japan’s exports and taxes American ones. A bipartisan amendment that would have cracked down on countries that manipulate their currencies was offered by Senator Rob Portman, R-Ohio, and Senator Debbie Stabenow, D-Michigan, during the Senate consideration of the TPP, but it failed by a narrow 51-48 vote.

The Obama administration has done a good job of sealing itself off from any discordant feedback, threatening to veto the bill if the amendment passed.

Wages for American workers have been stagnant for decades and the U.S. economy has kept going by substituting growth in consumer debt for growth in consumer income.

The essential unanswered question about TPP is whether the aggregate benefits of lower prices to American consumers that leave them allegedly with more discretionary income offset job losses for the American worker and displacement of American industries.

It’s easy to be wrong about the answer to this question when the costs of being wrong are paid by others – namely the American worker.

originally published: June 13,2015


Laboring over Obama’s trade deal

For those who came in late, President Obama has forged a rare alliance with Senate Majority Leader Mitch McConnell of Kentucky and congressional Republicans to push the Trans-Pacific Partnership (TPP), a proposed regional free trade agreement among the United States, Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam.

The deal has been developed in secret so the American public is on the outside looking in. Based on what has been leaked, there are apparently 29 chapters in the TPP, but only five deal with traditional trade issues such as tariffs. The rest are about intellectual property, financial regulations, labor laws, and rules for health, safety and the environment.

Sen. McConnell said that: “By passing this legislation we can show we’re serious about advancing new opportunities for bigger American paychecks, better jobs, and a strong economy.” But in fact it is the TPP’ s labor law provisions that may be particularly problematic for American workers and, by extension, our country’s economy.

While many people believe free trade is generally a fine idea, some have escaped its gravitational pull. Opposition to this deal comes primarily from the president’s own party, many of whom contend that “better American jobs” is a fatigued phrase with a truth quotient somewhere near zero.

Nothing will blind them to the fact that the United States has run consistently high trade deficits for more than three decades, ranging from of $35.1 billion in 1983 to $505.5 billion in 2014. The cumulative deficit over this period is in the trillions, even as American wages have been flat or declining. This is the trading profile of an 18th century British colony.

They argue that growing trade deficits have been a drag on economic growth; that putting the United States in direct competition with low-wage countries has slowed job creation and put downward pressure on wages.

According to the office of the United States Trade Representative, “The president has always made clear that he will only support trade agreements that include fully enforceable labor standards, which we are pursuing in TPP”.

But Massachusetts Sen. Elizabeth Warren is among those who believe this is utter nonsense. She has forcefully raised the question of whether what is proposed in the agreement is in fact achievable. Her IS­ page report, “Broken Promises,” reviews labor standards over two decades of free trade agreements and documents in detail the use of child and forced labor, intimidation of union activists, restrictions on free speech and assembly, discrimination against women and other deplorable working conditions. The report plainly states that: “The United States does not enforce the labor protections in its trade agreements.”

A 2014 Government Accounting Office report also detailed the failure to enforce labor provisions in free trade agreements. Based on these reports, assurances that it will be different this time are hardly persuasive.

This reality cannot be ignored. Labor abuses are not waiting to be found, like eggs at an Easter egg hunt. Who is going to police labor standards in other TPP countries, especially those with weak judicial systems? Are the “best and the brightest” in the federal government going to ensure workplace compliance in foreign countries when they can’t even control the number of undocumented immigrants who overstay their visas here in the United States?

The TPP’s Investor-State Dispute Settlement mechanism enables foreign corporations to sue governments for lost profits using special tribunals of private attorneys in secretive proceedings, yet workers don’t have a comparable tool to address labor standard violations.

Free trade only works when the exchange is an equal one, when all the players operate under the same rules, including labor policies. If they don’t, American workers face unfair competition, and domestic jobs and industries are sacrificed to trading partners with pools of exploitable labor.

originally published: June 6, 2015