December 29, 2013 6:53 pm

US public finance: Day of reckoning

Chicago is tackling the worst pension crisis in the US. But methods that got it into its bind are still used across America

Member of the Chicago Teachers Union, students, and other opponents of a plan to close 54 Chicago Public Schools during a demonstrate and march through Chicago's downtown©APDemonstrators in Chicago protesting this year against a plan to close 54 Chicago schools

Since the start of this school year, Annie Stoball has been walking her nine-year-old granddaughter Kayla across four blocks to Gresham Elementary on Chicago’s South Side. The route takes the pair through turf claimed by rival gangs – a far more dangerous journey than to her old school, Morgan Elementary, just across the street from their house. So far this safe passagetrip – the city has hired monitors to watch over the children – has been uneventful.

Kayla feels safe because I walk her to school every morning and I pick her up when it’s done. My concern is how long they’ll stay out here,” she says, referring to the safety workers.

US pension plans

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Worst funded cities and states

Morgan was one of about 50 elementary schools forced to close this year, collateral damage from the ballooning pension crises in Chicago and the state of Illinois. The budget gap in Chicago’s school district alone is $1bn, mainly because of pension liabilities, while the combined unfunded pension liabilities of the city and the school district runs to over $27bn.

Rahm Emanuel, Chicago’s Democratic mayor, has said the school closuresalong with 3,000 job cuts in the school system – were necessary to close the yawning hole in the district budget. The episode has further soured the mayor’s relations with the teachers union, which held a seven-day strike last year. Karen Lewis, head of the union, called the school closuresracist” and “classist”.

The woes of the city and the state of Illinoiswhich has its own, worst-in-the-nation, $100bn unfunded pension liability – have been driven primarily by the government’s failure to pay its share to keep its pension promises.

But this month, after years of inaction, Illinois passed a bill to tackle its unfunded pension liability. The state hopes the new law will save $160bn over the next 30 years savings that will come from cuts in retirement benefits for state workers and forcing the state to make its pension contributions. The law has won plaudits as a first step towards fiscal reform. But it comes only after repeated downgrades that have left Illinois with the lowest credit rating of any US state.

Now it is up to Mr Emanuel, the hard-nosed former Obama administration official, to do the same for Chicago. Any proposal to solve the city’s pension problem is bound to look much like the state dealcutting benefits for public workers and raising contributions.

“The pension crisis is not truly solved until relief is brought to Chicago and all of the other local governments across our state that are standing on the brink of a fiscal cliff because of our pension liabilities,” Mr Emanuel said after the state deal.

The Chicago teachers’ pension fund is roughly 54 per cent funded, far below the 80 per cent threshold considered healthy. But it is better off than the city’s municipal workers, police, labour and firefighters’ pension funds, which Fitch, the credit rating agency, estimates are collectively 33 per cent funded.

Mr Emanuel has warned that failing to reform Chicago’s pensions by next year could force cuts in servicesincluding the police department, at a time when the city has had the highest number of murders in the US. The alternative, he says, would be a 150 per cent rise in property taxes.

His administration points to the recent reform of the city’s parks department’s pension system as a model. Retirement ages were raised, with workers no longer able to retire at 50 with full benefits, employees will pay more towards their retirements and the city will increase its contributions.

Still, Mr Emanuel has been criticised for backing plans to delay some payments, and Moody’s has attacked Chicago’s latest budget for failing to set aside enough money for pensions. And the unions are preparing to fight back in Chicago, just as they have against the state deal, which they are challenging in court. A coalition of unions called the state reformattempted pension theft”.

. . .

Mayors across the US are facing predicaments similar to Mr Emanuel’s. From Detroit to Chicago to San Diego, American cities have found their budgets choked by unfunded pension obligations. Part of the national problem lies in the swelling number of pensioners and the ruinous effect the 2008 crisis had on public finances. But mainly it is because politicians failed to pay for pension promises, choosing instead to pass the burden on to future taxpayers.

Chicago and Illinois, with their worst-in-the-nation status, are outliers. Even Detroit, whose huge pension gap was one reason it was forced to file for bankruptcy this year, is in better shape.

Yet even those states and cities that paid their fair share of costs are probably understating the actual cost of the pension promises they have made. Current rules allow them to make assumptions each year based not on what their portfolios actually earn – or lose – but on what they expect to earn. These expectations are often too rosy; many state and municipal schemes assume investment returns will be much higher in future than those earned in the past decade. Even then, a pension scheme can tell members it is well funded” when it has only 80 per cent of the assets needed to meet its promises.

In fiscal 2010, the most recent year in which data are available for all states, the state pension gap in the US hit $757bn, according to a report from the Pew Center on the States.

But the high assumed rate of return most states use to calculate the cost of benefits understates the problem, according to research by Joshua Rauh, a finance professor at Stanford University. Based on a more realistic rate, the actual nationwide unfunded state pension liability would be closer to $4.5tn, his research has found.

The standards for calculating public pension returns have long been abandoned by private sector employers in the US and the UK, and rejected by pensions regulators and accounting standards setters. In the private sector, when more realistic methods of counting the cost of pension promises were introduced, employers tended to stop making them.

Last year, a report from the State Budget Crisis Task Force, co-chaired by former Federal Reserve chairman Paul Volcker and financier Richard Ravitch, concluded that actual shortfalls at state pension schemes may be as much as three times the $1tn their own actuaries say they are.

That is because the methods used by US states and cities such as Detroitwhere bankruptcy proceedings threaten to turn pensioners into unsecured creditors – are standard practice at pension schemes across the country.

“The structure and management of Detroit’s [pension scheme] is no different from those of other municipal schemes,” says Genevieve Nolan, an analyst at Moody’s.

Often overlooked in the pension debate is the role of actuaries, who assign a value today on benefits to be paid decades into the future. Critics say they sometimes use outdated methods when calculating public pensions. Blame, too, goes to the Governmental Accounting Standards Board, which has fallen far behind the private sector in requiring clarity in pension accounting.

When it comes to actuarial valuations, there are no hard rules over how to count the money a scheme has at hand today. Actuaries smoothvalues over three to five-year periods, meaning that market crashes can take a long time to show up. International accounting rules no longer allow companies to do that.

A rare look at how this practice can distort the true health of a pension fund can be seen in a report commissioned by the emergency financial manager of Detroit. Gabriel Roeder Smith, the actuary for Detroit’s General Retirement System, concluded at its latest valuation that it had enough on hand to pay 87 per cent of promised benefits.

But the city commissioned a second opinion, which found that the market value of assets was $648m lower than reported, thanks to smoothing. Worse, the assumed investment returns were far too high, and a more realistic assumption shows that the scheme is little better than 50 per cent funded. Even with freezes to benefits, it could be roughly two-thirds funded.

Altering an estimate, even by tiny amounts, makes a big difference to whether a scheme has enough cash. Actuaries, says John Ralfe, a UK-based independent pensions adviser, have “a magic pencil” that can turn a shortfall into a surplus just by changing a key assumption.

It is the more optimistic scenarios that show up on Detroit’s – and other municipalities’ balance sheets when bond investors are considering loaning them money. Worse, the rules do not help municipal workers understand the value of promises made to them. In bankruptcy proceedings, unless there is a special deal cut for them, workers find that they were not accruing an income in old age, but instead were lending that income to their employer.

The GASB, after more than a decade of debate and years after private sector accounting standards setters altered rules, is moving to inject more realism into the way pension obligations are accounted for.

Jeremy Gold, a professor at the University of Pennsylvania’s Wharton School, who has been critical of actuarial methodology for years, describes the system as follows: “The actuaries invented it and the accountants fell in love with it and married it.”

Carl Hess, global head of investment at Towers Watson, a consultancy, says the system has remained dysfunctional because “most stakeholders have an immense interest in maintaining the status quo”.

Scheme members have no interest in challenging overly rosy calculations, and they may not be informed enough to raise objections. State treasurers, Mr Hess says, serve terms of four to eight years and do not want to see taxes raised on their watch.

Indeed, the National Council on Teacher Retirement and the National Association of State Retirement Administrators – along with the actuarial and accounting firms that live on public sector pension business – have been critical of reform efforts.

. . .

Nick Sposato, an 18-year veteran of the Chicago fire department, serves as an alderman for a ward that is heavily populated by city workers. In between fielding calls on mundane district mattersgarbage collection, neighbour disputesMr Sposato hears from his former colleagues who are worried about their pensions.

“It’s scaryeverybody is scared about this whole thing,” he says, noting that many city workers are not eligible for Social Security, the US social insurance programme.

There is little an alderman can do. Still, people come to Mr Sposato for answers and the most he can offer, he says, is a frustratedwait and see”.

“The whole problem is that the city, the county, the state, the Feds – they didn’t do what they were supposed to doif they did, I don’t think we’d be in this mess,” he says. “The people who earned the pension – they did everything right.”


Law: Legal challenges loom for reform efforts

Lawmakers bear the bulk of the blame when it comes to the sorry state of pension funds, writes Neil Munshi. More often than not, they failed on a multitude of fronts: overpromising generous benefits in return for public employees agreeing to take lower pay packages, succumbing to union lobbying for ever-more generous benefits, and skimping on government contributions for years on end.

It is no small task, however, when they finally muster the courage to reform their systems. The political risks are high, since the challenge often involves raising taxes and cutting benefits. And, as many US states have found, cutting benefits opens the door for serious legal challenges that can delay reforms for years.

Most states protect pensions under the contract clause of the US constitution, or a similar state provision, which prohibits lawmakers from passing any law that impairs existing private or public contracts, according to Boston College’s Center for Retirement Research. Seven US states – including Illinois, Michigan and New York – have explicit constitutional protections of public employee benefits.

In Illinois, the state constitution says pension benefits are contracts that “shall not be diminished or impaired”. Union leaders have cited this in their legal efforts to challenge the new reform.

Michigan’s constitution has similar language. But Judge Steven Rhodes, in his ruling deeming Detroit eligible for bankruptcy earlier this month, said the constitution did not offer pensioners any special protections over other creditors. Nevertheless, the unions involved have vowed to fight on.

Labour groups take some solace from a 2012 decision in Arizona, where a judge ruled that a reform that would have increased employee contributions violated the state constitution’s protections against the impairment of contracts between the state and its employees.

“Their retirement benefits were a valuable part of the consideration offered by their employers upon which the teachers relied when accepting employment,” Judge Eileen Willett, of the Maricopa County superior court, wrote in her opinion.

The case ended up in the state supreme court, which heard oral arguments last summer but has yet to issue a ruling two-and-a-half years after the reform passed through the legislature.

Copyright The Financial Times Limited 2013.

Getting Technical


The 2014 Stock Market: What the Charts Say


The market's momentum should carry into early next year. But will the inevitable correction be shallow or deep?


The simple strategy of identifying the major trend and then holding on through the bumps paid off handsomely in 2013. With just one day of trading left, the broad market is sitting on a total return north of 30%. But all good things do eventually come to an end. By the look of the trend it is hard to think that end is immediately upon us. Later in 2014, however, may be a different story.

Indeed, even several technical issueslagging small stocks and deteriorating market breadth, for instance – have been resolved. The Russell 2000 index of small company stocks may not be leading the market, but it is at least keeping up with it again. And the NYSE advance-decline indicator, which keeps tabs on the number of stocks going up and down each day, has moved to fresh 52-week highs.

For me, the big problem is sentiment. I've written here about very high levels of bullishness among investors and traders and very low levels of bearishness.

What constitutes too much bullishness and too little bearishness is up for debate, but at some point the giddiness will reach the critical level where theoretically everyone interested in buying stocks has already done so. Without fresh demand, it will be difficult for prices to advance any farther. Extremely bullish sentiment also leaves the market vulnerable to a shock that could cause people to try to sell into this vacuum of demand, leading to a steep and swift decline.

Last week, bearish sentiment according to the Investors Intelligence survey of financial advisors dipped to 14.1%. This is the lowest level in more than two decades in terms of the dearth of bears and in the ratio of bears to bulls. This does not mean the market is about to tank but it should keep us alert for the first true sign of trouble. The long-awaited market correction can easily catch everyone napping under such extremes of sentiment.

Let's move to the big picture to see where the market is now and what that might mean going forward.

The Dow Jones Industrial Average broke out from seven-month trading range in mid-November and based on the size of the range the implied upside target is roughly 16,750 (see Chart 1), up from around 16,490 Monday. This is simply the height of the range projected up from the breakout point.

Chart 1

Dow Jones Industrial Average


In early December, prices backed down to once again touch the top of the former trading range in what technicians call a "test" of the breakout. If demand for stocks swells, which it did, the breakout holds and prices move back up. The odds that the upside target will be achieved increase.

The target is also in line with the top of the rising trend channel that has defined the market since the major low in October 2011. A rising trend channel is just a trendline drawn through significant lows and a parallel line drawn through significant highs.

For the Standard & Poor's 500, pundits have seen many bearish patterns on long-term charts from triple tops to expanding triangles (see Chart 2). None seem valid given the size of the current bull market from the 2009 low because it has stretched those patterns beyond what seems reasonable. In other words, the current rally invalidated them and that is good news for long-term bulls.

Chart 2

Standard & Poor's 500


But it would also be premature to call the action in 2013 a breakout from a 20-year trading range. One of the events I have noticed over my career is that breakouts that occur after strong moves are prone to failure. These momentum-based breakouts, where trends are already in effect before resistance is broken to the upside, are often just temporary overshoots of that resistance.

What can cause such a self-propagating trend? Extreme bullish sentiment. Nobody wants to be left behind, and so investors buy at any price, even if indicators flash warnings. Sooner or later, however, the market will correct.

As the Dow did with its shorter-term pattern, the S&P 500 can suffer a sharp decline, perhaps down to 1,550, in round numbers, to test its breakout above its 2000 and 2007 highs. If that happens, we'll have to see if demand swells again and prices hold that level.

If so, it could be the great buying opportunity for which many savvy investors are waiting. It would also be the confirmation of the start of a secular bull market that can last for several years. The problem is that this scenario calls for a good deal of pain beforehand.

To sum up, the Dow has some unfinished upside business in the short-term and that is good for stocks in general as 2014 begins. However, in an environment of extreme bullish sentiment, the S&P's long-term breakout seems to be in need of rest, if not outright correction. If it successfully holds 1550, give or take a few dozen points, then stocks will be in good shape for a very long time.