Classic STUMP: Public Pensions Primer--Why Do We Pre-fund Pensions?

What do you mean "we", buddy?

The following is an update of a post early in this blog, from June 2014. At the time, the Detroit bankruptcy was in process, having started in 2013, and ended in November 2014.

Detroit’s example should have served as a warning. My 2020 comments will be at the end of the post.

Why do we pre-fund pensions?

The main reason: Governments fail:

A blogger has compiled a bunch of Google Street View images to demonstrate how some of Detroit’s neighborhoods have continued to deteriorate since the housing crisis.

Alex Alsup from Loveland Technologies published the astonishing images on his Tumblr called “goobingdetroit.” They show how drastically the bankrupt city’s streets have changed from 2008 to 2009 to 2011 to 2013.

Let’s look at a few pictures, shall we?:

Swallowed up in green:

2009:

2011:

2013:

This tumblr is full of such progressions, including deliberate razing of abandoned homes by the city of Detroit. Many are just like the above – an untended yard taking over, a shoddily made house just decaying over a few years, abandoned homes ransacked for materials by those who are left.

More recent progressions

As noted, this was originally posted in 2014. The site has continued, though not as frequently in updates.

About a year ago, he updated because pictures from August 2018 were now available in the view.

Before and after:

This reminds me of the Life After People series from the History Channel.

People go away, so do the taxes

Think of what this represents.

Lost property taxes as owners simply walk away and let tax liens pile up.

Lost income tax and utilities tax.

Some of the ex-residents of Detroit simply moved to the suburbs, so perhaps Detroit can soak them in the bankruptcy (ongoing in June 2014), but some have left Michigan entirely as jobs have also gone away.

Back to the pension promise

Now, Detroit had a bunch of public workers it made pensions promises to. If these promises are not fully pre-funded by those making the promises, they have little chance of being made whole when the operation goes belly-up, as we see in Detroit. Supposedly, the Detroit pensions were in good funded status, but we shall see in this series (starting with this one), why this is misleading.

It is going to take some time to get through this primer. I wouldn’t be surprised if it takes me the rest of the year [2014] to go through it. I have some thoughts as to what to do with this stuff later, possibly spinning it off into its own website.

My plan is this: to explain very high level principles in public pension plan financing and design. Yes, there will be some numbers, but it will be mostly toy models one can play with to understand how different parts interact. These will be greatly simplified, and not to be confused with the specific situations of specific plans.

I am not a pension actuary (I am a life insurance/annuity actuary, with a huge dose of investment & risk management thrown in), so no, I do not know all the itty-bitty regs, etc. That is one reason I will be sticking to high-level principles. The other reason is my intended audience are non-actuaries, and non-finance people in general.

Those reading this who are pension actuaries or who are public finance experts, I would love to hear from you if you think I got something wrong, or if there are certain topics I should cover. The best way to contact me is via email: marypat.campbell@gmail.com

We will look at a history of public pensions, some of the principles of finance in general and public finance in specific, features of public pensions, and what the dispute over such things like the discount rate is about.

The primer series [2020 comment]

I had several posts in this series, over multiple years. I am still working on this material, obviously.

I have revisited two of the above, and now this is a third. I will not necessarily revisit them all, but some are especially relevant now in 2020.

Real consequences to pension underfunding in 2014

Remember that while I will be talking in some abstract and simplified terms, these things do mean real consequences here and now [2014], such as current retirees seeing huge cuts to their pensions, when they can least recover from such a blow.:

MACKINAC ISLAND, Mich. — City of Detroit retirees considering whether to approve a bankruptcy deal that eases pension cuts and spares the works at the Detroit Institute of Arts should have no illusions or false hopes about what a “no” vote could mean, the city’s emergency manager warned Friday.

“We want to make sure people understand that it doesn’t get better by voting no,” emergency manager Kevyn Orr told reporters after a speech at the Detroit Regional Chamber’s annual policy conference on Mackinac Island.

His comments came ahead of a state Senate vote expected next week on the state’s nearly $195 million contribution to the DIA-pension deal, in which the museum would be spun off from the city into a private authority for about $816 million, with the proceeds used to reduce pension reductions for city retirees.

That money disappears if retirees reject the plan, with both facing even harsher cuts. Orr said he has heard that some retirees are pledging to vote no as a protest, or to hold out in hopes of a legal challenge based on Michigan’s constitutional protection of pensions that U.S. Bankruptcy Judge Steven Rhodes has ruled is trumped by federal bankruptcy law.

It’s not all arguing over politics, over theory, over standard actuarial practice. There is reality, and it will always take its toll.

The reality is that governments do fail, tax bases can get hit catastrophically, and pensions, if not fully funded, will go along with the tide.

Everyone will get hit.

Real consequences in 2020?

In the above, I was thinking about loss of population, with people moving elsewhere. I knew that Detroit wasn’t the only place with such a problem; at the time Puerto Rico had shown a huge population loss (and it’s even worse now).

But let us consider what is happening right now all across the United States: states and local governments are hard hit as residents have trouble paying property taxes, and the commercial sector was hard hit: sales taxes down, gas taxes down, restaurant taxes down, hotel taxes nil, and so forth.

Public pensions are looking at the ability to make contributions fall just as they’re hit with a rocky market. Needing to make up for markets “underperforming” by going cap-in-hand to a Congress loathe to fill the pension hole is unlikely to work, and it seems the taxpayers of various kinds won’t be able to cough up the dough.

Public pensions had a decade of a bull market, and yet their funded ratios were stuck in the 70s.

Everybody knew the market wouldn’t grow forever. No, we didn’t expect this economic hit with pandemic (after all, that’s not what happened with prior pandemics), but it was expected that the bull market run would end. We were “due” a recession.

And yet, so many public pension systems merely nibbled at the edges of their problems, and seemed content to merely tread water. After all, the promises don’t all come due at the same time! We can make up for the losses over 30 years….

…..until all of a sudden, you realize the holes are too big. You don’t have 30 years to try to fill it as the fund goes into an asset death spiral, and then it’s a really unaffordable pay-as-you go situation.

It would have been best if they had fully-funded their pensions were times were good, and to build their systems so that they could better absorb financial catastrophe when it inevitably came. But most didn’t.

And here we are. Some learn lessons only in the hardest of ways, and sometimes, that may be too late.

(Have a happy weekend!)

Original STUMP post