Pensions and Local Government Fiscal Instability
KeywordsLocal Government Pension Fund Pension Benefit Trust Fund Bargaining Unit
Pensions and other post-employment benefits are compensation promised to an organization’s employees with deferred accessibility until after a given period of employment (the “vesting” term) and/or the employee’s attainment of a stated age. Such compensation is typically accessible only after an employee’s service to an organization has been willfully terminated.
The status of annual required contributions made to their pension and OPEB trust funds; the extent to which the local government is meeting an actuarially determined plan for its pension and OPEB obligations
The funded ratio; the actuarially accrued benefit liabilities of trust funds, compared to the actuarial value of each trust fund
The amount of the unfunded accrued liability for each trust fund; representing the extent to which trust fund obligations will meet or exceed a fund’s assets
The fiscal impact that results in unfunded liability is applicable anywhere pensions and OPEBs are a part of employee’s wage and salary package. These factors represent the product of a trust fund’s returns on investments, long-range fiscal planning, and the political will of its controlling elected officials. Cities of all populations and socioeconomic bases are seeing their retirement costs exceed 50% of their payrolls and are seeking legislative relief to roll back benefits (Ward 2010).
Pension Effect on Fiscal Stability
Pensions and OPEB are salary costs deferred until after an employee has met the criteria for claiming them and has willfully separated themselves from that employer. Despite being compensation, the payment for these elements of total compensation does not actually occur until later fiscal periods. However, they are an expense in the periods in which they are earned. Despite this, many local governments only fund them on a pay-as-you-go basis. This follows the Governmental Accounting Standards Board (GASB) contention that pension benefits should be recognized on an accrual accounting basis and OPEB costs on a modified accrual basis. GASB’s contention is that they are a part of total compensation and, when accrual or modified accrual accounting for their cost is not utilized, they may easily become an unfunded liability. Failure to appropriate them when earned means total unfunded liabilities grow and have substantial effect on future revenue streams despite being expenditures from previous periods.
Changes in accounting standards are effected by GASB through the issuance of “statements.” In June of 2012, GASB standardized how pension and OPEB costs are accounted for and reported through GASB Statement 67, Financial Reporting for Pension Plans; GASB Statement 68, Accounting and Financial Reporting for Pensions by governments that provide employee pensions; and, later, GASB Statement 71, Pension Transition for Contributions Made Subsequent to the Measurement Date – an amendment of GASB Statement No. 68 (GASB 2013). These GASB statements strengthen GASB Statement 43, Financial Reporting for Postemployment Benefit Plans Other than Pension Plans, as well as GASB Statement 45, Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pensions, issued in June of 2005 (GASB 2006). Standardization mandates uniform reporting as well as recognizing and presenting the liabilities that are created by these features of employee compensation.
Unrealistic Expectations for Pension Trust Earnings
Actual earnings by pension fund assets are critical to both the funded ratio and the calculation of the fund’s annual required contribution (ARC) (GAO 2008: 9–10). Overestimating returns on investment (ROI) for fund assets decreases the level of a local government’s ARC. Overestimating requires the ARC be increased in future years. Conversely, underestimation can decrease future ARC appropriations. The value of investments can also vary daily due to swings in the investment market that reflect the overall economy (GASB 2012). Thus, the date at which annual fund earnings (and therefore liabilities) are measured can be important. The failure to make an ARC on schedule also affects the funded ratio: Interest earned is reduced because it is earned on a smaller principal.
The sufficiency of a trust fund’s ability to meet its long-term obligations is a calculated ratio of the projected value of a fund’s assets compared to its projected obligations. One of the issues of financial reporting that GASB 67 and GASB 68 are intended to alleviate is the use of unwarranted estimates for return on trust fund investments for projection and the ratio calculated to express the level of coverage. An actuarially substantiated coverage ratio of 80%, or more, is commonly considered the benchmark for evaluating adequacy of fund coverage (Simms and Co. 2010; GAO 2008).
The use of unrealistic assumptions in estimating planned earnings has sometimes been intentionally used by fund managers. Such estimations enable a fund manager to calculate a lower ARC. CNBC, in a 2013 report, noted that the average projected return of defined benefit fund investments by the 100 largest public pension funds was 7.84%, while the actual ROI of those funds over the previous 10 years averaged only 5.6% (CNBC 2013). Another technique that incorporates overestimation is “smoothing.” An averaging of gains and losses over longer periods of time allows the effect of a growing stock market to be carried into future years, where the gains may be lower. These make funding problems appear smaller but limit the recapture of asset growth during recoveries. The negative effects of overestimating ROI only become evident in the long term, when the projected revenue is not available to pay pensions (CNBC 2013). The gains of the .com market in the 1990s encouraged local governments to offer greater pension and OPEB benefits, based on trust fund projections. When it came time for them to start the payouts, the gains had not materialized (CNBC 2013). Nonuniform assumptions, methodologies, and other indicators of financial performance made comparison of pension and OPEB funds impossible. This problem has been noted for some time (ACIR 1985: 50).
The overestimation of ROI is a tactic that GASB 67 and GASB 68 have made much harder to employ. Those statements allow local governments to utilize whatever discount rate (i.e., the ROI) they wish. However, this is only as “long as the projected plan net position …. exceeds the projected benefit payments” (GASB 2016; GASB N.D.). When the plan’s net position is no longer equal to or greater than the projected benefit payments (a crossover point), a local government is required to utilize “a high-quality municipal bond interest rate” as the discount rate (GASB N.D.).
Failure to Implement Plans that Accommodate Future Benefits
Failure to fully appropriate current obligations means that the required funds may not be available or leverage themselves to their planned level of growth. That is, the interest that is earned and compounded is on a lesser balance than planned. This increases the amounts that must be appropriated (the ARC) to meet pension and OPEB obligations.
Municipal bankruptcies since 2011
Interestingly, there is no requirement that the ARC actually be made. Similarly, the GASB statements established pension reporting requirements neither required local governments make any specific annual funding or meet some minimum coverage ratio on a periodic basis (Chieppo 2013). A government’s Comprehensive Annual Financial Report (CAFR) only must provide information on funding status (the actuarially determined fund net position) and the progress of both defined benefit and defined contribution pension funds in the CAFR’s accrual-based statements and as required supplementary information. Because they deal with funding liabilities, pensions can have an impact upon the local government’s cost of borrowing because they, at least partially, represent the risk level of the borrower (GASB 2016, 2013).
Political Dynamics and Costs
In the recent past, the effect of fiscal instability on local governments has been evidenced in the bankruptcies of cities of varying populations, economic bases, and geographic location. This is exemplified in the differences between Detroit, Michigan (bankruptcy, 2013; population, 713,777), and Central Falls, Rhode Island (bankruptcy, 2011; population, 19,416). The effect of economic conditions cannot be overlooked. However, local government political dynamics are a large part of the pension and OPEB benefits promised.
Political dynamics serve to “complicate any assessment of the direct effects of fiscal stress on the policy responses of localities” (Stein et al. 1986). Complicating elements in the evaluation are that the response to fiscal instability through policy change may not occur immediately and that the responses may pass through a series of “stages” before selective corrective action is accomplished (Levine et al. 1981; Levine 1980).
The earliest reflection of political dynamics on local government fiscal policy occurred in New York City. The “Tweed Ring” maintained political control through the establishment of a coalition of groups who were dependent upon public development projects and patronage appointments. Control of the city’s fiscal resources allowed the Tweed Ring to coerce upper classes by increasing and expanding capital development to benefit their economic interests while also providing jobs to the lower classes. This process provided the opportunity to both gain the acquiescence of the upper classes while receiving kickbacks on the project contracts that were being awarded (Shefter 1992: 17–19). The Tweed Ring’s patronage was extremely effective in controlling the outcome of elections. During that period, it is estimated that one of the eight voters in New York City was a public employee (Keller 1977: 239).
In a more current example, New York’s mayor David Dinkins obtained the support of the city’s three largest municipal unions. Following his being voted into office in 1990, Dinkins used the power of his office to declare a 5.5% increase in pay for all municipal employees (Shefter 1992: xiii). While the immediate effect of inflating the city’s budget is obvious, to appreciate its long-term effects, one must consider how the city’s already liberal pension benefits were affected by the wage increase.
While the salary components of every city department’s budget were immediately increased, the increase to postretirement benefits was reflected in pension benefits that rose by the amount of 5.5%, compounded to reflect annual merit and/or COLA (cost-of-living adjustment) wage increases. Pension benefits are most often based upon the highest years of an employee’s compensation. At the time of an employee’s retirement, their monthly benefit would have been increased by the compounded value, rather than the 5.5% alone. Conversion to estimate the impact and the effect of COLAs, exclusive of any general wage increases, after 30 years of service indicates that every dollar of benefit increase produced by Dinkins’ 5.5% general wage increase had the effect of more than doubling its value in the final pension benefit. Applying the Consumer Price Indexes for each year from 1990 through 2020 produces a conversion factor of approximately 2.07 (OSU 2016).
Where postretirement pension benefits are also subject to an annual COLA, the effect of compounding on the initial 5.5% continues to increase. In the case of police and other work classifications entitled to immediate full benefit collections after some specified term of service, regardless of age or disability status, the ultimate impact of the pay increase would be substantially more than initially planned and would likely stress the city’s pension trust coverage ratio even further. When perceived from this perspective, New York’s annually required pension contributions (ARC) were increased by a magnitude far in excess of the immediate cost of the pay increase.
The impact of political dynamics on pensions and OPEB costs is similar. As long as elected officials can resolve employment issues by agreeing to postretirement benefit improvements that will not affect budgets until after the officials have left their office, the costs for choosing that path are legislatively acceptable (ACIR 1973: 6). The process of “kicking the can down the road” (Stampfler 2013: 235) should not be allowed to continue as the norm.
Avoiding and Correcting Pension and OPEB Liabilities
Long-range financial planning is essential to establishing and maintaining fiscal stability. Knowing whether an organization is facing fiscal instability is possible only when a representative set of an organization’s financial indicators have been established. Written financial policy statements concerning the funding of pension and OPEB liabilities are also necessary to maintenance of the trust funds (Matzer 1986: 67–68).
Although the GASB statements address the recognition of the liabilities created, they have not resolved the necessity of establishing and funding trust funds established for those purposes (GASB 2006, 2013). Although the GASB statements require determination of the long-term obligations for pensions and OPEB, nothing obligates the long-term funding of liabilities incurred annually. For this reason, written financial policy statements requiring this practice are advised.
Matzer (1986: 66) specifically identifies unfunded pension liability and annual leave (as well as sick leave liabilities) as being central indicators to the task of measuring an organization’s level of exposure to fiscal instability. Matzer supports his position using a National League of Cities survey which indicates that 83% of the respondent cities consider increasing pension costs an important cause of their fiscal difficulties (Matzer 1986: 62). This financial trend monitoring system should also include OPEB liabilities.
A final requirement for this indicator system would be uniformity in the measurement system. To assure year-to-year comparability as well as comparability with other local government’s data, an actuarial cost method, such as the entry age normal or projected unit credit costing method, needs to be selected to allow representative comparison with other similar local governments. These methods amortize gains and losses by the fund rather than spreading them (Jarret and Zimmerman 1997: 2).
“Emergency Financial Managers”
Financial stresses that have built for years must be overcome by municipalities. Some of these sources of financial strain have come from increasing pension and medical and retiree health-care costs. Approximately one-third of the 61 largest cities in the United States are struggling to avoid bankruptcy (Sayegh 2014). Creative accounting maneuvers, one-time spending cuts, and short-term revenue increases will no longer bail municipalities out of their fiscal dilemma (Hakim 2012). More than half the states have enacted legislation that allows them some financial control over local governments that are experiencing financial instability.
There are conflicting opinions as to whether the appointment of an emergency financial manager improves or reduces the ability of local governments to avoid bankruptcy. Some hold that such appointments reduce the control of a local government and increase the probability that the economic situation will worsen (Stampfler 2013: 236). They reduce or excise entirely the decision-making authority of local elected officials (Holeywell 2012). However, the adoption of statute defining the conditions of financial emergency under which a state may appoint an emergency financial manager has long been recommended by the ACIR (1973: 7). Michigan enacted such a law in 2011, in awareness of the growing condition of fiscal instability that was dragging the City of Detroit to the brink of insolvency (Holeywell 2012). This strategy was successful in 1996 when the governor of the State of Florida appointed an interim city manager to take over control of the City of Miami, FL (Dluhy and Frank 2002). In the case of Miami, bankruptcy was avoided by the manager’s control of overspending by the city’s elected commission.
When pension and/or OPEB benefits grow large enough to cause fiscal instability, their costs can be mitigated through the use of a number of tools. These all involve a suspension of employer-provided benefits or portions of benefits. These strategies are sometimes referred to as a “clawback” (Goforth 2014: 4).
One method, if legally accommodated, is suspension or reduction of the cost-of-living adjustments promised. This strategy was employed by the City of Detroit to restructure its obligations in chapter “Organizational Structure” bankruptcy proceedings. This reduces immediate costs and reduces future pension costs by reducing or eliminating the base of the compounding amount for benefit increases.
A second strategy requires employees to be responsible for a greater proportion of their pension costs. This requires that an employee’s required contributions be increased. This lowers an employer’s funding liability while increasing the employee’s contribution to the pension fund’s interest-earning assets.
A third method is a shift from defined benefit to defined contribution plans. Defined benefit plans promise retirees a stated level of benefits paid. Defined benefit makes employers responsible for achieving a stated ROI or higher. Failure increases the employer’s liability to the fund; either increasing their unfunded liability or requiring an increased employer ARC. Conversely, defined contribution plans stipulate the annual level of the employer’s contribution to the fund on behalf of a covered employee. In this manner there is no specific postretirement benefit guaranteed, and the employee bears the risk of the fund’s ROI performance. This can be accomplished by covering all new employees through a defined contribution plan, by offering employees an option to shift from a defined benefit plan to a defined contribution plan, or by saddling new plan entrants with the added cost of the liabilities of the defined benefit plan.
Pension Obligation Bonds
When a local government finds that it’s carrying a substantial unfunded pension and/or OPEB liability, most often the local government will not have the reserves or fund balance to address the obligation. Accomplishing this short-term liability reduction may be possible through the issuance of pension obligation bonds (POBs). The issuance of POBs exchanges long-term debt for alleviation of their unfunded liability. In its essence, this is deficit funding to reduce fiscal stress.
The revenues pledged to retire POBs can come from a combination of three sources: employer contributions, employee contributions, and earnings on the trust fund investments (Kilgour 2014: 123). Employee contributions are typically a set percentage of an individual’s salary. They are not expected to change, regardless of changes in unfunded liability. The employer’s contribution varies yearly and is comprised of the stipulated ARC plus some calculated portion of the unfunded liability and plan administrative expense (Kilgour 2014: 124). The decision to issue POBs to relieve an unfunded pension or OPEB liability may be motivated by the belief that investments by plan trustees of the bond proceeds will produce an ROI greater than the interest component of the total debt service to be paid. If the financial performance of the borrowed funds does not exceed the interest charges of the issue, the decision to issue POBs is unwise.
Returns to the holders of POBs are taxable, and the issue is most often secured as a general obligation debt of the issuing government. There are numerous risks involved in the issuance of POBs. They include the financial risk of issuing bonds, the risk that investment of the proceeds may not produce gains that exceed interest charges and other costs of issuance. Thus, issuance of POBs is subject to a need to time the investment of the proceeds to when equity costs are low and the potential for growth in their value is great.
A point made above that bears repeating is that POBs turn what was considered to be “soft debt” into “hard debt.” That is, the POBs become a liability that is reflected on the local government’s balance sheet. Prior to the GASB statements, there was no real presentation of pension and OPEB unfunded liabilities in a local government’s Comprehensive Annual Financial Report (CAFR). The GASB statements do change this, somewhat. However, as noted previously, they impose no obligation to maintain a funded ratio of 100%. Formal debt, however, imposes an obligation to either pay the required debt service or be held in default. This limits a local government’s ability to adapt its revenues to its priorities. The subsequent loss of funding flexibility can cause problems (Kilgour 2014: 126).
Other forms of risk include political risk and the need to acquire voter approval for the issuance. The bond proceeds will be used to alleviate an unfunded liability. The lowered liability may be perceived by organized labor as an opportunity to demand increased benefits (Kilgour 2014: 126).
Mobile AL, in 1839, reported the first default of a US city (Hempel 1971: 23). Throughout history, municipal bankruptcies and defaults have occurred in groups (ACIR 1985: 2). The post-US Civil War era saw a rash of defaults, as did 1933–1935, the years of the Great Depression (ACIR 1985: 2–3).
Presently, a local government in default can file for debt restructuring under chapter “Organizational Structure” (U.S.C. 901). Chapter “Organizational Structure” provides a number of advantages over the chapter “Organizational Environment” filing that is required of private corporations. Among them is the ability to unilaterally reject the terms of collective bargaining agreements where it is necessary to achieve a successful plan for restructuring. To override obligations under a collective bargaining agreement, chapter “Organizational Environment” requires the debtor to propose to the bargaining unit, prior to a court hearing held to approve or reject the debtor’s plan for adjustment of debt, a modification of the agreement. The agent of the bargaining unit must then refuse the proposal. Additionally, the terms that have been rejected must be shown to be necessary for the successful enablement of the debt adjustment plan (Spiotto et al. 2012: 65). Under the provisions of chapter “Organizational Structure,” no rejection of terms by the bargaining unit is necessary.
Thus, chapter “Organizational Structure” allows for the reduction of pension and OPEB benefits. The emergency financial manager for the City of Detroit utilized the terms of chapter “Organizational Structure” to achieve reduction of post-employment benefits, an element critical to the plan of reorganization. Although the language and case history of chapter “Organizational Structure” allows for a complete rejection of all benefits, the emotional and economic stress of such an action makes that course of action unlikely. In the case of Detroit, what is referred to as “The Grand Bargain” created a coalition that included concessions by labor groups and pledged donations by corporations. This made complete rejection of the bargaining agreement retirement benefits unnecessary.
Theoretical Causes of Fiscal Instability
Socioeconomic Decline: Economic and demographic factors deplete the tax base; increasing the demand for public services. Outmigration occurs, leaving a population that requires more services, further increasing the cost of government. The decreased demand for real estate, due to outmigration, reduces taxable values and shrinks tax revenue (Kimhi 2008; Pammer 1990; Rubin 1982).
Local Political Dynamics: Fiscal instability results from changes in voter coalitions that cause elected officials to curry their favor their through spending. Political pressures by local influence groups motivate fiscal policy and decision-making. Fiscal instability may also result from politicians seeking the favor of employee unions, overextending government’s commitment to salaries and benefits (Kimhi 2008; Pammer 1990; Rubin 1982).
Bureaucratic Expansion: Bureaucrats, acting in their own self-interest, increase both the size of government and the salaries and benefits paid to employees. This increases their influence and power while also increasing presiding bureaucrats’ salaries and benefits (Kimhi 2008; Pammer 1990; Stein et al. 1986: 111–144). The increased salaries and benefits increase the cost of future pension and OPEB trust fund requirements.
Internal-Management Perspective: Inept management either indirectly causes fiscal instability through managerial and/or fiscal misfeasance or directly causes it by acceding to risky fiscal plans and decisions made to alleviate political vulnerability (Timiraos 2012; Kimhi 2008; Pammer 1990; Rubin 1982). Failure to create a long-term financial plan that fully funds promised benefits often results from internal-management issues.
Little imagination is needed to perceive how pension and OPEB obligations can produce the fiscal instability that can result from each of these four causes.
The preceding presents only a broad overview of the relationship of pensions with the causes of fiscal instability, the tools used to alleviate that condition, and the effects of their usage. Despite the potency of its effectiveness in reducing crushing debt and costs of labor that are difficult to deal with using other methods, the results of bankruptcy are hard for a local government to deal with from either the social or organizational perspectives. A government’s citizens will suffer from a reduction of services that may be critical to their life’s requirements. Socially, retirees and current employees will not likely extend their appreciation for having their benefits reduced. Further, with the reduction of gross wages and retiree annuities that are spent in it, the local economy is likely to feel the effects of decreased demand for the goods and services it provides.
Thus, it is quite easily seen that the best way to survive bankruptcy is to avoid it entirely. This can be best accomplished by engaging long-range fiscal planning that accommodates future costs of pension and OPEB trust funds while monitoring and acting upon the status of the net position of their funding. This should include estimation of plan earnings using realistic expectations and staying current in the appropriation of the funds’ annual required contributions. Lastly, written policies applying to the maintenance and management of the pension and OPEB trust funds should be adopted and implemented.
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