A tale of two woes (with apologies to Dickens)

It was the best of times, it was the worst of times. For public employees and retirees, the promise of improved retirement benefits and health-care security had never been rosier. (Ah, such great expectations!) For public agency employers, however, the prospect of paying for those perks had never been dimmer. (“Sorry, Oliver, there ain't no ‘more’.”)

Welcome to 2009 and a tale of two woes: threatened municipal bankruptcies and the feared demise of defined benefit public pension funds, which could be triggered by diminished cash flows and inaccessible credit markets. (See, for example, Gov. Arnold Schwarzenegger’s report to the California Legislature on June 2: “(B)ecause of California’s outdated and volatile tax system, our revenues have dropped 27% from last year … Our wallet is empty. Our bank is closed. Our credit is dried up … If we don’t act, the state will simply run out of money and go insolvent.”)

If you are a public pension fund trustee, here’s an exercise in transparency. Hold two sheets of paper up to the summer sky, one on top of the other. One sheet should show a graph of your actuary’s current projection of employer contribution rates for the next dozen years. (Pick any projection you like — even the one with the longest smoothed gains and losses, widest corridors and longest unfunded actuarial accrued liability amortizations.) On top of that, lay another sheet, showing your plan sponsor’s current projections of its expected revenue from taxes, user fees, state subsidies and all other sources for the same period of time. See anything scary? If your charts look anything like those of the most public funds, the trajectories on those two graphs race off in opposite directions — from now into all foreseeable future years.

Over a century ago, Charles Dickens might have dubbed this outlook “Bleak House.” Today, he might just call it, more simply, “Unsustainable.” Either way, it is not a rosy picture for plan fiduciaries.

The federal government and the states have designs to divert billions of dollars of local governmental revenue to help narrow their own deficits. The federal government is cutting back on local grant subsidy programs that fund public safety, transportation and other services usually provided by local governments, while states are taking bigger chunks of property tax and license fee revenues for themselves, leaving less for the local municipalities. In California, parks, schools and hospital districts all face loss of state and federal revenues, plus lost fees from the falloff in new housing developments. In addition, California voters recently rejected multiple ballot initiatives premised on mortgaging the state’s future to feed the present. The recent ballot rout has left the state a wounded and hungry carnivore of cash that threatens to leave only the scraps behind for the state’s cities, counties and special districts.

Faced with alarming operating deficits and unanticipated drains on available resources, our municipalities will have to make difficult choices between emergency public services and non-emergency pension obligations. Every public pension plan has recently reassured its nervous membership that despite the 2008 market meltdown, it has enough assets to satisfy the benefit promise to every current retiree on its books. Well, don’t be surprised if municipal plan sponsors call in that chit — and make the difficult but expedient triage decision to keep the doors open at the county hospital but close the pipeline on their current pension contributions.

Let’s go back to those diverging graphs for a moment. If you were a credit officer of a major national bank, continuing to extend hundreds of millions of dollars of credit (are you surprised to think of your plan’s unfunded actuarial accrued liability amortization as just that?) to a shaky borrower with an increasingly dire financial future might force you to classify your loan as “subprime” and reserve against the likelihood of your borrower’s default. This pension loan, however, is even shakier than a residential loan — because this loan has only a written promise behind it. No collateral, no guarantor, no credit enhancement and no mortgage insurance. Just the paper your statute or charter is written on. It’s an unsecured loan made to a municipal borrower who has told you it cannot continue to pay its debts when they come due. That paper promise is only an admission ticket to costly legal proceedings — in or out of bankruptcy court.

So, now what are you going to do?

Public funds need to start thinking of themselves as unsecured creditors and take steps to properly underwrite and secure their sponsors’ payment obligations. Those of us who have been through a couple of economic down cycles over the last 30 years know the kind of tools that work best — increasing our understanding of our borrower’s finances and prospects, identifying productive and disposing of non-productive assets, enhancing collateral positions and working cooperatively with our borrowers through the crises.

By acting more like responsible lenders, public pension funds also can be a catalyst for getting municipalities and public employees back to the bargaining table, to hammer out solutions to preserve current defined benefit plans at sustainable levels, without saddling future generations of employees and taxpayers with crushing debt burdens. As we have seen in the private sector, retirement age deferrals, benefit trade-offs, increased employee contributions and blended defined benefit/defined contribution plans for younger employees will all be on the table.

On the investment side, in the age of black swans, public fund trustees cannot act like ostriches. They need to re-examine their investment strategies to account for the risks posed by their plan sponsor’s fiscal distress. “Stress testing” the fund’s ability to meet its cash flow needs in the event of a yearlong suspension of employer contributions is fundamental fiduciary prudence and just plain good common sense. That kind of suspension could be imposed by legislative fiat (New Jersey already has enacted a state “contribution holiday”) or exigent circumstances. Either way, a fund that suddenly has to fire-sale portions of its portfolio to meet its monthly retiree payroll will jeopardize its long-term ability to earn the income it assumes it will have to pay future benefits. If we have learned anything over the past year, it is to expect the unexpected.

Now is the time for plan fiduciaries to avoid being merely “artful dodgers” and instead get to work, strengthening the future of the benefit promise entrusted to them.

Harvey L. Leiderman is a San Francisco-based partner and head of the fiduciary practices group of the law firm of Reed Smith LLP. Mr. Leiderman counsels public pension funds nationwide.