State Bankruptcy and Bailout Reactions: Bail Them Out With Strings Attached Contingent

But will the strings stay attached?

This is the “Yes, but” group.

They also see that state bankruptcy is not really a workable idea, but they think we can’t trust the states to default on their promises “correctly”, so we’ll bribe them (via federal government) to make the changes we’d have them do with a bankruptcy.

Yes, this is an uncharitable take from me, and it’s only going to get harsher by the end of this piece. Because most of the “yes, but“s I’ve seen are even more unworkable than the state bankruptcy idea.

The main problem with all these proposals is that there is no way the strings would stay attached. It would require an ongoing will to enforce something that could be un-enforced after just one year.

At least with a bankruptcy process, there is a well-defined beginning, middle, and end, with the various parts supposed to take a relatively short period of time. [Much less than three decades, for example.]

And heck, it’s not even clear that the strings-attached approach would even be considered constitutional [depending on the strings] — we saw that get struck down with Obamacare and Medicaid expansion, though that was a near thing. The devil’s in the details.

Finally, I don’t see any of these getting through the House [this year], and this would be a piss-poor election issue for the Republicans to try to retake the House.

In short, none of these proposals are going to be on the table. Not this year… and probably not even next year. But hey, in a year of pandemic, murder hornetsofficial UFOs, and Krakatoa erupting, who knows what next year holds?

R. Eden Martin’s Proposal

Unfunded Public Pensions—the Next Quagmire

The troubles in Illinois and other states may soon force the federal government to choose among three options. The first is to do nothing — in which case some pension plans will go bankrupt, retirees will suffer, and many local governments will face emergency cost-cutting and taxing scenarios that will drive out businesses and jobs.

The second option is to yield to the pressures, especially from state officials and organized labor, for condition-free bailouts and loans. Finally, the feds could choose to pressure (“incentivize”) states and cities to straighten out their own affairs through loans to which they attach stringent conditions.

The consequences of doing nothing would be painful. But they would be far less harmful than the consequences of an unconditioned federal bailout, which would mean massive new fiscal commitments at the federal level.

Unfortunately, leaders in Illinois and elsewhere are now talking quietly about the possibility of a federal bailout. Such speculation undermines state and local efforts to reform pension systems or make other hard choices. Why agonize over unpopular budget cuts or tax increases if the feds will ride to the rescue?

Okay, you must know that something is up at this point. Mr. Martin hasn’t mentioned coronavirus once!

Yes, this is a piece from August 2010. No, Illinois got no bailout back then. They’ve managed to limp along. Let us look at Martin’s actual proposal from back then:

A better approach would be for Washington to offer states support coupled with sustained pressure over the next decade. Participation by each state would be voluntary.

One form of support could be low-interest federal loans. An alternative could be federal authorization to issue tax-subsidized bonds, as suggested in June by Messrs. Rauh and Novy-Marx in The Economists’ Voice electronic journal. Either way, federal support should be conditioned along the following lines:

— State and local pension funds — and not the federal government or state and local governments (except where state or municipal guarantees have already been made) — would be responsible for pension obligations already incurred for past service.

— Current defined benefit pension plans would be “frozen,” meaning no new benefits would be accrued under those plans.

— Participating states could set up new retirement programs for both current and new employees in the form of defined contribution plans such as 401(k)s. Under this approach, the money contributed by employers and employees would be used solely to generate savings for those employees; it would not be used, Ponzi-style, to pay pension benefits to current retirees under the old underfunded plans.

With defined contribution plans, states and cities would not bear the risks associated with underfunding or the underperformance of fund assets. Most state and municipal workers would be able to start taking their money out of the plans at the same age as private-sector employees (police and firemen could retire earlier, e.g., at age 60). As an alternative to a defined contribution plan, states could adopt new, lower-cost defined benefit programs, subject to the requirement that funding be adequate to cover the costs.

These reforms would still leave the state plans with their current underfunded, defined benefit pension liabilities. Though state laws vary, many states and cities may be able to take the legal position that they are not liable as guarantors if and when a pension fund goes under. In Illinois, a retiree’s contract claim would be against the pension fund, not the state. In any event, practically speaking, it is not likely that retirees would be able to recover tens of billions of dollars in past pension claims against their states.

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States might consider adopting one element of the federal PBGC plan. When a troubled private pension plan is administered by the PBGC, the agency pays less than 100% of what pensioners would receive if their plan were solvent. These reduced amounts vary with the retirement age: the earlier the retirement, the lower the maximum payment. In Illinois, where state employees can retire at 55 with enough years of service (and Chicago employees can retire at 50), such an approach would lead to significant haircuts.

You are going to hear variants of the above in the various published “Bailout, with Strings Attached” group.

If you think bailing out traditional defined benefit public pensions is a heavy political lift right now, I can tell you that shifting people onto a defined contribution plan, where they have to absorb all the investment risk, will also be a no-go. It was easier to do that to the private sector, not only because people were less likely to stay at one employer long enough to get good value of a DB plan, but also because these shifts occurred in bull markets.

My own preference, once all the crisis-panicking is over, is for public plans to transition to a risk-sharing plan like Wisconsin’s and New Brunswick’s. I think it’s important to provide a certain minimum level of retirement lifetime income, which a DC plan cannot do, but to have extra amounts responsive to fund performance. This works as a shock absorber and reduces the risk of plan failure.

But in the middle of a crisis, very few people make good decisions, and as we can see from Martin’s 2010 op-ed, it’s amazing how long deeply underfunded public pension plans can limp along. This can wait til next year.

Andrew Biggs’s Proposal

Okay, no more tricks. All of the following will be from after Mitch McConnell remarking that state bankruptcy would be the best way for over-promising states to get out from under their onerous pensions.

A Bailout for Illinois? Not Without Strict Conditions

Given Illinois’s record of poor pension stewardship, Congress should reject any bailout on the merits. And yet the alternative might be worse. I have spent the past three years as a member of the federal Financial Oversight and Management Board for Puerto Rico, wrestling with the island’s 2016 insolvency, which included the exhaustion of its main public pension funds. A governmental bankruptcy is an ugly process from which no quick or clean resolution can be expected. Illinois’s unfunded pension liabilities substantially exceed its bonded debt, meaning that even a complete debt default wouldn’t put its finances back on track. A statewide economic contraction could also become a regional threat.

So Congress may want to offer assistance, but it should come with strict conditions: Any state looking for a pension handout must either live by the stricter accounting rules federal law imposes on private pension plans or freeze its pension and shift all employees to defined-contribution retirement plans.

Private-sector plans must assume more-conservative investment returns than public-sector plans and address unfunded liabilities more rapidly. As a result, private pensions today have set aside more than twice as much funding per dollar of promised future benefits than have state and local pensions. If adopted decades ago, stricter funding rules could have saved pensions such as Illinois’s. But today those states are in a bind: Many can barely make their contributions using the lenient public-sector funding rules, much less the stricter rules for private plans.

The alternative is what the Puerto Rico Oversight Board insisted on: Freeze the old pension to prevent any new benefit accruals while shifting all employees to 401(k)-like retirement accounts. Freezing a pension doesn’t make its unfunded liabilities go away. But it caps existing liabilities while shifting employees to plans in which the government’s funding obligation is clearly defined and can’t be evaded using actuarial or accounting tricks.

Illinois politicians will claim their state constitution prevents pension changes. But it was a misguided 1970 amendment to that constitution that made public pensions in Illinois a contract for life. By contrast, federal laws governing private pensions prohibit cuts to benefits that have already been accrued but allow employers flexibility to alter the rate at which future benefits are earned. Any assistance should be premised on constitutional or legal changes to align state pension rules with federal law.

I have multiple problems with this proposal.

First, it will take at least two years for Illinois to amend its constitution [from my understanding of their process. Generally, it takes a lot longer than that]. The squawking over lost revenues, etc., is for right now so you can get Illinois politicians to say suuuuure, we’ll do these things, and here’s a token bill we passed, but we need the money right now pretty please.

And then they wait for the next congenial Congress and drop it all.

The Illinois state constitution from 1970 absolutely needs to have the pension clause amended away. But it’s up to the people of Illinois to get that done. They need to take responsibility for their own government. This is not the function of the federal government to force particular forms of government on Illinois. It’s not King George III pushing the Stamp Act or any such rot.

Illinois has to take responsibility for itself. [I have more beating up on Illinois to do later.]

That was just point 1.

Point 2, as with Martin’s proposal above, is that a DC plan is no-go. Also, I don’t trust Illinois to run even one of those without loads of corruption. Also, I think there is a better alternative to the traditional DB and DC plans.

Point 3: there are absolutely ways to play tricks with a frozen pension liability. But I don’t want to dive down that rabbit hole. I’ve seen tricks….

Okay, it’s really boring accounting stuff, but man, accountants can get tricksy sometimes.

Point 4: Puerto Rico is irrelevant. Sorry, PR is just not a sovereign state. The U.S. federal government can step in at any time and take stuff over, because PR has no real power except that which the federal government gives it.

Yes, the PR pseudo-bankruptcy is messy, but there’s a reason for that… it’s because the true power never bothered to provide any oversight for all the financial shenanigans, and PR always played the poor, pitiful dependent on the feds, sure that it would get bailed out. The accounting for PR is not yet straightened out, as far as I can tell. Tough to tell what you need to bail out when you don’t even have a clean balance sheet.

The states need to be told that they are responsible for their own decisions, and the federal government actually can’t clean up their messes. Puerto Rico is a bad precedent… but it’s also a territory. It would be better if it were a state or its own sovereign nation, but the people there have had their reasons for not trying very hard for either choice. Because the U.S. federal government is the actual responsible party, even if it doesn’t show much responsibility for it.

More Detail from Andrew Biggs

This is not to beat up on Biggs. I know he was limited about the detail he could publish via the Wall Street Journal. Here is a more detailed version of his views.

What role should the federal government play in addressing state and municipal pension debts?

Congress could allow state and local pensions to become ERISA-regulated in exchange for providing them with financial aid, such as to cover pension contributions over the next several years. Pension participants would also become employees eligible for Pension Benefit Guaranty Corporation benefit insurance should their plan become insolvent in the future. In return, the state or local government would need a credible plan to significantly increase future funding of their pension and address unfunded liabilities promptly, while also paying PBGC insurance premiums. Congress might also include a provision requiring that governments seeking federal pensions assistance enroll their employees in Social Security, if not already covered.

But ERISA regulation provides another option: if a state cannot or does not wish to fund a traditional pension to ERISA standards, it can instead freeze its pension and shift employees to a defined contribution, 401(k)-style plan. Because federal law pre-empts state law, ERISA coverage would free states like Illinois from legal prohibitions on changing future benefit accruals or altering the plan’s structure.

The issue is simple: Federal pension regulations exist for a good reason and those reasons apply to governments as much as to private companies. Those regulations offer employers a choice: either run a traditional pension prudently, using conservative assumptions and prompt addressing of unfunded liabilities, or don’t run one at all.

I’m not sorry to dive into this particular hole, but this proposal does make more sense. These are the details missing from the WSJ op-ed.

This is year-by-year support from a federal government entity, and obviously, if a state doesn’t want to be subjected to that entities’ standards, fine. Then there’s no support.

However, I don’t think state pension funds should have a federal backstop in the PBGC at all. To begin with, they’d swamp the private plans covered by the PBGC. That just isn’t workable.

But, in general, I don’t think the federal government should oversee any states’ finances, per se. They are sovereign in their own way and they need to be forced to see that. Too many problems occur in government because governing bodies pretend not to be responsible for what they’re responsible [in particular, legislative bodies] and then leave it to courts and executives to relieve them of their responsibility.

If we want to go to a monarchy, let us do so openly, rather than have a bunch of irresponsible politicians pretend they have no power over the very areas they’re supposed to be responsible for.

Actuarial interlude

I’m hoping the U.S. actuarial organizations can make some of this dispute moot. There is a key actuarial standard of practice draft exposure that has been in development for some time. Actuaries cannot dictate funding policy, but they can show various metrics that show shortcomings in pension fundedness. It would be something if the actuaries in the U.S. can expose this issue without needing to get the federal government involved. Perhaps I will spend a post only on the actuarial issues.

Ted Siedle’s Proposal

Before I start quoting his proposal, I will note I could throw Siedle into the “YOU WANT US TO DIEEEE!” contingent for his prior piece: Kiss Your State Pension Goodbye

When Kentucky senior Senator and Majority Leader Mitch McConnell said this week that he would be in favor of allowing states to use the bankruptcy route to deal with their underfunded public pensions amid the pandemic emergency, state workers and retirees—already struggling with the economic and health crisis—were rightfully alarmed. “Using the bankruptcy route” is code for slashing pension benefits promised to state workers. Under current law, only cities and other local governments can file for bankruptcy and only with permission of the state.

McConnell supposedly represents Kentuckians and Kentucky already had the worst-funded state pension system in the nation—only 16% funded—before the COVID-19 market meltdown. Chris Tobe, a former trustee of the Kentucky pension and SEC whistleblower, suspects when the pension reports fiscal-year-end performance July 1st, its funding level may fall into single-digits. (Full disclosure: I served as Independent Counsel to Mr. Tobe in connection with his SEC whistleblower complaint.)

Presumably Kentucky would be the first state to use McConnell’s bankruptcy plan to eliminate state worker retirement security. Kentucky has over half a million (514,000) current and future pensioners who are unlikely to support his reelection.

Given the Democratic governor of Kentucky won over the pension “reforming” Republican who ran last year, exactly when did Siedle think Kentucky would use state bankruptcy? In four years?

I don’t want to pick on Siedle for this specifically, because I have something different I want to beat him up on. It’s his assertion that the only thing going wrong with public pensions are the asset side. Also, he gets the cause/effect there [the increasing use of alternative, illiquid asset classes and the decreasing fundedness of public plans] mixed up.

But let us go to his own bailout-with-strings-attached idea.

A State Pension Bailout Even Mitch McConnell Can Support

I have personally investigated over $1 trillion in retirement plans, including many public pensions, such as the nearly $90 billion North Carolina and $8 billion Rhode Island state pensions.

Mismanagement of pensions—public, as well as private—has long been rampant, I have discovered. The phrase “gross malpractice generally practiced” aptly captures prevailing pension investment process. Trillions in workers’ retirement savings have been squandered.
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If McConnell is sincere about opposing throwing good federal money into badly mismanaged state and local pensions, a workable compromise would be to make any such bailouts contingent upon reviews of, and improvements to, the management of pension investments. Likewise, the Democratic State Senator from Illinois should welcome a review which would improve public pension performance and funding. Such fiduciary reviews are long overdue and desperately needed.

I actually have no issue with this, but the question is knowledgeable oversight. I don’t even have an issue with Siedle arguing his own interest: he is an expert in this area, and would be an obvious person to tap for such investigations. Other people could also do it, of course.

Every forensic investigation of a failing pension—or autopsy of a dead retirement plan I have undertaken over the past 35 years—has revealed had pension assets been properly managed, the plan would not have failed or died. That is, enough money went into the pension to support future obligations—the problem was mismanagement resulted in squandering of the ample assets.

Okay, I had a longer rant I never published in response to something Siedle wrote some months ago making this very claim.

Let me walk you through the logic:

- Every troubled pension plan I, Edward Siedle, have investigated had problems on the asset side, and if they were properly managed, they would not have failed
- Here are a bunch of troubled pension plans looking to be bailed out
- Ergo, they must have bad asset management making them fail

The thing is, why was Siedle hired for those earlier investigations? I think they had an inkling that something was amiss, asset-wise.

Because he obviously has no expertise on liability-side shenanigans. How would he know if something was up on that side of the balance sheet?

Perhaps there are asset shenanigans in Kentucky, Illinois, and New Jersey. But I’m pretty sure the biggest driver of these pension failures is that the states never made full contributions to their pension plans for decades.

The Worst-Funded Public Pensions Short-changed Their Plans for Decades

Maybe they have in recent years, but that’s not going to make up for 30+ years of under-contributions. It’s pretty well documented for the three states I’ve named [I know, because I documented it].

Here are some older posts you can look at, if you doubt me:

Illinois: from 2015 Illinois Pensions: How Did We Get Here? Development of Unfunded Liability and from 2016 Illinois Pension Watch: This is Why Your Pensions are in Trouble

I’ll give it away at the beginning: they’re in trouble because they’re not making the “required” contributions to the pensions.

Yes, there are all sorts of other reasons as well, such as spiking, early retirements, sluggish payroll growth, optimistic valuation assumptions, etc.

But ultimately the reason the pensions are so little funded is because the state didn’t put in enough funds.

And they knew it.

They knew it for years.

It’s not because of investment fees, though those should be more transparent. It’s not because of part-time board directors who get a lifetime pension for very little work, though that doesn’t help. (I’ll address why these aren’t significant problems in a later post.)

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They chose to underfund the state pensions and chose to force municipalities to fully fund their pensions. These choices have consequences.

These were choices made every legislative session, via actions made and actions not made.

Yes, I’m alarmed, too. But the time to have been alarmed started 20 years ago.

Plus a graph of the Illinois TRS contribution pattern:

Kentucky: from 2017 Kentucky Pension Liabilities: Trends in ERS, County, and Teachers Plans

So a few things can be contributing to this decreasing funded ratio for the county plan.

First, the underperformance of the assets. As noted in the prior post on Kentucky pension assets, the returns have been about 6% for 10 years, and the valuation assumption for County ERS was 8.25% in 2001 and has been brought down over time to 7.5% in 2015. That 7.5% may still be too high, considering. That’s one.

Here’s two: there is a payroll increase assumption. I’ve talked about this before. Reminder: assuming a growing payroll, and contributions are to be made assuming a level percentage of the payroll contribution will suffice, means that you’re backloading contributions some.

If the payroll doesn’t grow as fast as the assumed growth rate, you end up with actuarial losses. The Public Plan Database gave me the payroll growth assumption for only a few years: 4.5% in 2013, and 4% in 2014/2015.

Let’s see what the historical payroll growth rate has been: 2.7% from 2001 to 2015.

That’s a bit different.

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But let’s ignore the exact calculations and think things through: when the assumptions are all off in the same direction – that is, they all say you have to pay less now than what actual experience has turned out to be – then yes, you can be making full required contributions every year and your funding status deteriorates.

A picture of the Kentucky ERS contribution pattern:

New Jersey: from 2014,Public Pension Watch: New Jersey Report — They’re Screwed

In short, the alternative assets have built up to try to make the required contributions less. It didn’t work.

That doesn’t mean if they did a vanilla asset management set up, the pensions would be appreciably better-funded. These specific pension systems have a long history of bad behavior. In the case of the Kentucky county pensions, they had a set of valuation assumptions that artificially lowered their required contributions, in a way far exceeding what other public pensions have done [though it’s a widespread problem in public pensions.]

In any case, Siedle’s strings-attached is actually fairly minor, and I do think alternative asset set-ups in public pensions need to be scrutinized more closely. It may not be appropriate at all for public pensions to dabble in these asset classes at all, given the secrecy required in certain private equity and hedge fund arrangements. It provides too much opportunity for graft.

Political Argument Framing

Thing is, Siedle’s proposal has approximately zero chance of getting anywhere. And no, it’s not because of McConnell’s ties to Wall Street. [though he, and most major Congressional leaders, have Wall Street ties. I mean, if the senators from New York don’t have such ties, I’d be wondering. Finance is a huge part of the New York economy.]

It’s because that’s not going to be the political positioning of the argument. On the “no bailout” side, there are those who will point out over-promising and under-contributing of the profligate states. On the “GIMME!” side, there will be the argument of “the federal government gets a huge amount of revenue from our residents” and “YOU WANT US TO DIE!!!”

Asset performance due to too-high fees is too esoteric a topic to wedge in there. Sorry.

There is a letter from Sen. Ted Cruz and other senators, who seem to be into the “if there’s a bailout, there must be strings attached” contingent:

We believe additional money sent to the states for “lost revenue” or without appropriate safeguards will be used to bail out unfunded pensions, reward decades of state mismanagement, and incentivize states to become more reliant on federal taxpayers. Again, we are supportive of funding to respond to the Coronavirus and protect our frontline workers, but we cannot allow states and localities to get a blank check from American taxpayers to fund areas of their budget that have nothing to do with the Coronavirus.

So this focus is specifically on “Let’s just provide money directly for COVID-19 costs was already covered in an earlier bill. Most of the talk right now is complaints that the municipalities can’t use it for anything else, and a lot of places really don’t have much extra expenses directly dealing with COVID-19.

It’s mainly the stuff they’re not doing that’s hurting them: not collecting sales taxes [especially restaurant and other “entertainment” taxes], not collecting gas taxes, not collecting income taxes.

With Nancy Pelosi talking $1 trillion for state bailouts, the main argument is going to be about the amount and how it’s doled out. It’s not going to be about our particular hobbyhorse re: public pensions. It’s not going to be freezing the pension obligations and switching to defined contribution plans. It’s not going to be digging into hedge fund investments. I don’t see any of that being items of negotiation.

Meep’s Preferred Solution: Probably Not On the Table

As noted, the House is not in session right now, and they seem unable to do anything without physically being in DC. So the bidding and yelling will continue.

I will keep repeating my preferred “solution”: determine how much, and then distribute it per capita to the states. New York has already gotten money for its extra costs, as have other places. This would be a separate pile of money.

As for municipalities… you do have bankruptcy [and you can go begging to your states].

Trump has bloviated about sanctuary cities not getting bailout funds, so you think the niceties of investigating pension assets will be on the table?

I am not sure I will even have anything to blog about in the Congressional battle, because I doubt those of us who want to go into the niceties of resilient pension systems will be listened to right now.

It is all posturing, and now the stress has come to state governments as they become aware just how much tax revenue has dropped due to lockdown. Pensions aren’t really on their minds right now. Making payroll is.

So I’m not even sure if my simple solution, for the short term political problem, will even be considered.