The biggest scam going in American financial life may be the collusive effort by Wall Street, the political class, and public sector unions to use union retirement money to prop up Wall Street speculation.
Step One: state politicians promise big pension and health care benefits to their unionized work forces, but don’t set aside enough money to fund those benefits when the bill comes due. This makes union leaders and unions look good, because they can point to the shiny new benefits they have negotiated with the politicians. Meanwhile, it makes the politicians happy because the unions support them with contributions and volunteers at election time, but because the unions don’t insist on full funding for the benefits, the politicians don’t have to raise costs or otherwise disturb the big majority of voters who don’t work for the government.
Step Two: Make aggressive assumptions about the rate of return on pension investment funds. This has two consequences: it covers the gap between promise and reality (for a while), thereby postponing the day when the politicians have to face the voters and the union leaders have to tell their members that those beautiful benefits were bogus from the start. But the other purpose, equally important, is that it forces America’s public sector pension funds into the deep end of the financial markets, leading pension funds to be major investors in hedge funds, derivatives and various other not-for-the-widows-and-orphans investments. If these work out, great — the funds hit their investment targets and the benefits, or at least some of them, get paid. If they go awry — as many did in the last few years — then the pension problem turns into a crisis.
But whether or not the investments work for retirees, they work very, very well for Wall Street. Fees from giant public sector pension funds played a significant role in creating Wall Street’s buccaneer culture and speculative frenzy that the left claims to hate.
Looking for examples? Head to Pennsylvania:
The Pennsylvania State Employees’ Retirement System, for example, has more than 46 percent of its $26.3 billion in assets invested in riskier alternatives, including private equity funds and real estate. Over the last five years, the system paid roughly $1.35 billion in management fees – over 5 percent of the total value of the fund over a five-year period – while realizing an annualized return of just 3.6 percent, well below the 8 percent it needs to meet its financing requirements and also lagging behind the 4.9 percent median return for all public pension systems.
There’s bad news for Pennsylvania’s teachers, too:
The $51.4 billion Pennsylvania public schools pension system…which has 46 percent of its assets in alternatives, pays more than $500 million a year in fees. It has earned 3.9 percent annually since 2007.
California is also struggling:
Fees for the $242 billion in California’s giant state pension system, known as Calpers, nearly doubled, to more than $1 billion a year, after it increased its holdings in private assets and hedge funds to 26 percent of its total in 2010, from 16 percent in 2006…
Calpers…has earned 3.4 percent annually over the last five years.
Compare that with Georgia, which is at the other end of the investment risk spectrum:
In Georgia, the $14.4 billion municipal retirement system, which is prohibited by state law from investing in alternative investments, has earned 5.3 percent annually over the same time frame and paid about $54 million total in fees.
Pension reform is about more than cutting benefits to realistic levels, and ensuring that politicians and union leaders have to stop the collusive scams. It is also about enabling pension funds to invest in safer investments and stop paying huge fees to hedge fund managers and investment banks — and because public pension funds are such large pools of capital, this would be an effective way to help bring Wall Street back down to earth.
Pension funds should not be aggressively invested. Retirement funds should be conservatively managed — and that means enough has to be paid into those funds so that with moderate investment results, retirees can be sure that their promised benefits will in fact be paid.
The key to this change is stronger regulation of government pension funds, to force them to observe the same requirements that apply to private sector pension funds as well. Amazingly, the same union leaders and lefty experts who call for tough regulations elsewhere in the economy want to keep government workers chained to the roulette wheel in the Wall Street casino: they are bitterly opposed to seriously prudential regulation of government pension funds.
The current battleground in the union effort to subsidize go-go trading on Wall Street involves proposals by the Government Accounting Standards Board to introduce new rules for accounting on public pensions. The New York Times reports that the new rules, which will take effect in 2015, will require pension plans to factor the possibility that they will run out of money into their calculations:
The controversy centers on the way governments measure their future payments to retirees in today’s dollars, a common financial calculation known as discounting. The accounting board has devised a method that will require severely depleted pension funds to factor in the likelihood that they will run out of money at some point, and have to borrow to pay retirees their benefits.
Healthier plans will be allowed to discount future payments as they do now.
These are very mild reforms, and will spare most pension funds from changing the way they do business. Worse, the new rules still don’t require public pensions to apply the same accounting standards used in the private sector:
“This is still a flawed accounting system,” said Joshua D. Rauh, an associate professor of finance at Northwestern University. He says states should measure their pension promises much as an insurance company sets the price of an annuity — using the market rates for so-called risk-free bonds that are considered very safe. Using that standard, many states appear to have promised far more than they can reliably pay.
Private sector pension funds “are required by law to use low, risk-adjusted discount rates to calculate the market value of their liabilities, [but] public employee pensions are not.” This means that the private pension funds must take into account the chance that their projected rate of return on investment isn’t met. The higher the assumed rate of return, the greater the risk that must be taken into account.
This is exactly what public pension plans, backed by the unions, do not want to do. Ignoring the chance that assumed rates won’t be achieved disguises a harsh reality for state and municipal pension funds. As a new report from Boston College’s Center for Retirement notes: “there is a total of $2.6 trillion of assets on [the 126 public sector pension plans tracked by the study] but current liabilities under today’s assumption that they can grow by eight percent annually are $3.6 trillion. If the investment assumption is moved down to four percent (still high when compared to current returns), then the liabilities of those plans jumps to a staggering $6.4 trillion.”
Pension funds and union officials like the current lax rules. When Montana needed a new actuary it ignored all applicants who suggested using the same methods private pensions do to assess their future risks. “If the Primary Actuary or the Actuarial Firm supports [market valuation] for public pension plans, their proposal may be disqualified from further consideration,” read the job description. Scott Miller, legal counsel of the Montana Public Employees Board, was more blunt: “The point is we aren’t interested in bringing in an actuary to pressure the board to adopt market value of liabilities theory.”
The new GASB rules allow many pension funds to continue to use these lax risk accounting methods that would be illegal in a private company. And amazingly, once you sprinkle a little pixie dust and some optimistic, undiscounted assumptions onto them, a number of shaky pension systems look strong. For example, New York City: “The current accounting rules make New York City’s plans look almost perfectly funded. Using the risk-free [market-based] method, Robert C. North Jr., the chief actuary for New York City, has said, there would be shortfalls running into the billions of dollars.”
Even the new rules, weak and watered down as they are, reveal a devastating picture of political irresponsibility and opportunism from one end of the country to the other. When a pension fund can reasonably project having 80 percent of the money needed to meet its obligations, it is considered to be in reasonably good shape. Under the new rules, startling numbers of large state pension funds don’t come anywhere close. (Click here for a Wall Street Journal table that shows what the pension situation looks like around the country.) In Illinois, the pension system for teachers is about as well funded as a Bernie Madoff fund: 18.8 percent of what it needs.
And remember that the new rules are still much looser than anything that would be legal for private companies. These underfunded pension systems become the slaves of Wall Street: to have any hope of meeting their obligations without hefty tax increases, politicians have to channel retiree money into some of the riskiest bets on the Street.
The net result of all this is to shift huge risks onto both taxpayers and state employees while paying Wall Street bigger fees and creating a huge pool of funds for the craziest ideas the bankers can dream up. The unions and the politicians get to keep the lax regulations on pensions that allow them to keep lying to workers and taxpayers, and as a direct result Wall Street investment banks earn or at least receive hefty fees. Retired civil servants in this way have become a captive market for the riskiest, most exotic and expensive products. Meanwhile both the unions and the politicians do their best to conceal the weakness in public pension funds from retirees and the public as they expose millions of unknowing Americans to risks that retirement funds should never run.
This is not a pretty sight, and the whole mess is a strong argument for those who believe that “regulatory capture” means that a powerful government ends up serving the rich and well-connected rather than helping working and middle class Americans. Transforming what ought to be a safe and reliable pension system into a Wall Street boondoggle is exactly the kind of thing a serious labor movement would fight. That the public unions are in effect fighting to retain the “freedom” to put worker pension money in high risk, high fee assets is an indication of just how intellectually and politically bankrupt much of the American public sector labor movement has become.