As Puerto Rico's investors and residents brace for the start of its financial control board, those previously imposed on the District of Columbia and Detroit might offer some clues to the future. But the commonwealth's experience is likely to be more painful, especially when it comes to rapidly shrinking public employee pension funds expected to run out of money before solutions can be found.
The fiscal oversight board created by the Puerto Rico Oversight, Management and Economic Stability Act signed by President Barack Obama on June 30 will have exclusive authority to enact and enforce fiscal reforms to reverse a decade of budget deficits and unmanageable debt, with the ultimate goal being better access to capital markets. The board was needed, Mr. Obama said, to avoid “an escalating series of lawsuits between creditors and against Puerto Rico,” and an even deeper economic and humanitarian crisis.
That crisis is already there for the 163,000 current retirees and 167,000 workers — nearly 20% of the commonwealth's total workforce — who without access to Social Security are depending on their government pensions. “Puerto Rico's pension systems are at serious risk,” the U.S. Treasury Department warned in October.
The new law calls for the control board to address “adequate funding” for pensions, but the first order of business is conducting an independent analysis of a pension system criticized for unrealistically generous benefits and plagued by conflicting or missing financial information.
The latest financial statement, released in 2016 by KPMG for the Puerto Rico Employees' Retirement System, Hato Rey, showed assets of $3.4 billion and a funded ratio of 0.27%, as of June 30, 2014. Under Governmental Accounting Standards Board rules for underfunded plans that require more conservative discount rates, that meant a net pension liability of $30 billion. Adding in the pension funds for teachers and the judiciary bumps the net pension liability up to $33.7 billion.
After nearly a decade of missed contributions, the stressed pension system is now using investment income for operating cash, while employer contributions are being used to pay debt service on some bonds that were supposed to help address years of missed contributions. According to the U.S. Treasury, pension administrators “are being forced to sell pension assets to pay current benefits,” and once those assets are depleted, payments will have to come from the commonwealth's already overtaxed general fund, which faces a $28 billion fiscal shortfall over the next five years. “It is unclear how the commonwealth will find the resources to deliver promised pension benefits, make full payment on its debt, and operate essential public services,” the Treasury Department said.
Various reports prepared for U.S. and commonwealth officials have all three pension funds completely out of money by 2019 or sooner. According to a November 2015 commonwealth financial report, the system's assets were exhausted by fiscal 2015.
“You have to have the money to invest to generate the investment returns,” said Keith Brainard, research director for the National Association of State Retirement Administrators.
During the 2013-2014 fiscal year, the main Puerto Rico employees fund returned 11.9% from a portfolio that was 64% fixed income, including loans, 22% equities, 13% in cash and short-term transactions, and 1% other investments, according to KMPG's report.
In Puerto Rico's deepening crisis, “the bondholders seem to be the first line of casualties, but given the pension plans' perilous funding condition, it appears that there will be others — potentially anyone who relies on payments from the Puerto Rican government,” Mr. Brainard said.
The District of Columbia's own economic crisis led Congress to appoint a control board in 1995. At first advisory in nature, it was later given more powers to address budget deficits. In a unique solution to its underfunded pension problem, the federal government assumed responsibility for $4.8 billion in unfunded liabilities for the pension system that it had originally set up when all municipal workers were considered federal employees. The control board era ended in 2001, with the city celebrating the four years of balanced budgets required by law. It went from a $518 million deficit in fiscal year 1996 to a $465 million balanced budget the next year, and the District of Columbia Retirement Board, which now has $6.4 billion in assets, got a clean slate with no liabilities.
In Detroit's case, a recovery plan overseen by an emergency manager had the city emerging from bankruptcy 15 months after filing for Chapter 9 protection. Besides settlements with the city's creditors, the plan eliminated $18 billion of outstanding debt, including $3.5 billion in combined liabilities for the $3.4 billion Detroit Police & Fire Retirement System and $2.77 billion Detroit General Retirement System. It took some painful choices, including closing the pension plans to new employees and trimming benefits for participants, but it avoided other more drastic ones.
Puerto Rico's seven-member control board will be appointed by Mr. Obama by Sept. 15, with six members recommended by House and Senate majority and minority leaders. Once installed, the board will have the authority to promote voluntary restructuring agreements with investors holding an estimated $70 billion in as many as two dozen types of bonds, and can adjust debts “in the best interests of creditors.”
Lawsuits filed by those creditors are now on hold for six months.
Control board members will have their hands full sorting out creditor claims against all the different bond issuers. And with Puerto Rico's July 1 default on $1 billion in general obligation bonds, “it makes it much harder to untangle,” said Greg Clark, head of municipal research for Debtwire Analytics in New York. “The revenue picture in Puerto Rico is harder to predict … and you have so many different parties. D.C. was a much easier situation for a control board to get its arms around,” said Mr. Clark, who adds that the control board's success will depend on cooperation from the Puerto Rican government, which will change after November elections. “I would expect the control board to prevail, but (creditors) are still going to get a haircut,” he said.
Officials at OppenheimerFunds, New York, which has an estimated $3 billion exposure to Puerto Rico debt, “look forward to working with all stakeholders to help get Puerto Rico on a long term, sustainable path while protecting the interests of our shareholders.” said spokeswoman Kimberly Weinrick.
That long-term path will be the Puerto Rican control board's biggest challenge. “The hard evidence of financial progress, by which control boards most often are judged, is clear: The credit rating agencies must be convinced that the financial improvements are rooted and will survive the sunset of the control board,” said Frank Shafroth, director of the Center for State and Local Government Leadership at George Mason University in Fairfax, Va.
He and others worry about a “brain drain” caused by Puerto Ricans with enough resources to leave while retirees are left behind.
“We can fix the books. A whole separate category is, what do you do to the economy so you can attract younger people? It's not just about stopping the leaking, but also focusing on the future,” said Mr. Shafroth, whose great-grandfather was the Senate sponsor of the 1917 act that created Puerto Rico's commonwealth status and made Puerto Rican bonds so attractive by exempting them from federal, state, and local taxes. ?
Control boards might not get warm receptions at first, but their impartiality allows them to make tough decisions and get things back on track. It also gives elected officials political cover, while creditors can say it is out of their hands.
“What people who have lived through them will tell you is that both politicians and creditors hate and love the control board,” said restructuring expert Jim Millstein, founder and CEO of Millstein & Co., New York, who is advising Puerto Rico's government.