STUMP » Articles » Tales of the Obvious: No Such Thing as Risk-Free; Don't Do Stupid Stuff » 16 January 2017, 17:09

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Tales of the Obvious: No Such Thing as Risk-Free; Don't Do Stupid Stuff  


16 January 2017, 17:09

Two items keep getting picked up in my alerts due to my interest in public pensions and public finance.

My responses won’t be long (for me). It’s a holiday; I’m not feeling well; yadda yadda.


Here we go: Opinion: Muni bonds aren’t risk-free anymore

Municipal bond investors this year will see increasing conflict with state and local government-employee pension funds. This conflict means investors cannot consider municipal bonds risk-free investments — especially bonds from states with strong public employee unions.

Most recently, news reports indicate that the Dallas Police and Fire Pension Fund is in crisis. Since the summer, participants with a special status — retirees who can continue to work, while contributing pension checks to a separate plan account guaranteeing an 8% annualized return with liquidity — have been draining the fund by taking lump sum distributions out of fear over the plan’s solvency.

The withdrawals prompted Dallas Mayor Mike Rawlings to file a restraining order as a private citizen against the fund, forcing it to refuse lump sum distributions in an effort to stop a “run” on assets. The Dallas District Court granted Rawlings his request, and the pension fund did not oppose the suit.

Previously the $2.1 billion fund had asked the city for $1.1 billion to keep it solvent.

After the events in California and Detroit, it has become clear that general obligation bonds, once considered sacrosanct, won’t always get 100 cents on the dollar. A subsequent municipal credit report from investment manager Columbia Threadneedle argued that tension between pensioners and bondholders would not always be resolved in favor of bondholders. The report argued that investors couldn’t own municipal bonds indiscriminately, assuming all obligations would be paid eventually.

Since the report was published, it’s become apparent that Puerto Rico creditors may also face receiving less than 100 cents on the dollar as a result of rescue legislation allowing the U.S. island territory to enter into negotiations with its creditors over it $70 billion in debt. Puerto Rico already failed to pay a close to $800 million payment due to general obligation bond holders last summer.

I elided over a lot. read the whole thing here.

First: obviously, not all munis have the same risk profile. The argument is made that California is not Detroit, and duh… but it’s partly duh because there’s no bankruptcy process for states, like there are for municipalities.

That does not mean that states will never default.

Default and bankruptcy aren’t the same things.

Second: There is always risk in bonds, of any sort. Even Treasuries.

The nature of the risk differs — to be sure, theoretically, the U.S. could default on its bonds, but much more likely (and has happened in the past), they can just print more money to pay the debt. It erodes the value of the bonds – and the currency – and that’s a type of risk.

Even if the default rate of munis has been low historically, there is a reason for that: growing tax base [Detroit showed the lie in that], careful underwriting of such bonds [there has been reasons that loosened], bond insurance and covenants to give these bonds precedence.

But anybody who has mindlessly parrotted “But government doesn’t go out of business!” knows precious little history, even covering the very short period of U.S. history.

Government goes out of business all the time, and overspending and over-borrowing is a common theme throughout Western history, at least. I just went through a really good lecture series on the Black Death in Europe, and one part was the effect the huge population drop had on public finance. As a result of the Black Death, all sorts of things went into abeyance, like the construction of cathedrals (very expensive) and wars (also very expensive). It wasn’t just a matter of lack of bodies and expertise to get these things done (though that was related), but there just wasn’t enough people to tax to support these projects.

It’s happened before. There’s no reason what happened before can’t happen again. Assuming that is far more foolish than assuming something that has never happened will not happen.

Okay, that’s what I consider a short answer on that item.

Related posts:

In short: forget about death and taxes — risk is the true unavoidable constant.


This is unhelpful info, number two: It might be too late for the Dallas Police and Fire Pension System, but here are 4 things other pensions should do

It may be too late to put the Dallas pension system on a sound financial footing without inflicting considerable economic pain on either workers or taxpayers. Similarly, those of states such as Illinois, Connecticut and New Jersey are also beyond salvation. For others, however, this moment provides a much-needed stimulus for change, albeit one carefully aimed. Otherwise, administrators risk wounding many more public servants as well as taxpayers.

It is tempting to use Dallas’ pension debacle as a case in point as to why governments should eliminate their current plans that promise a defined benefit upon retirement and switch to 401(k) or comparable defined contribution plans favored by most businesses. This would be a mistake, as an overwhelming percentage of private sector employees with 401(k) plans are fiscally ill-prepared for retirement. Public employees typically work for lower wages than their private sector counterparts in exchange for a promise of a more financially secure future. With a few common-sense changes, governments can avoid having to renege on that pledge.

1. Don’t make promises that are unrealistic.

Dallas’ immediate problems stem from the deferred retirement option plan (DROP) that is part of its overall pension program. The city promised participants that they could earn interest at an annual rate of 8 percent on funds in certain specially designated accounts. For the DROP to be financially viable the overall pension program also had to have investment returns at that rate, an obviously difficult target to hit in today’s low-interest environment. Until recently, it was common among government pension plans to assume they could generate annual investment returns of between 7.5 and 8 percent. Until 2015, Dallas assumed a rate of 8.5 percent. Only now are governments starting to reduce that assumption to something more conservative. CalPERS, the giant public pension system of California, recently reduced its estimated investment return rate to 7 percent.

2. Don’t try to juice up yields by getting into the most speculative of investments.

Dallas, as of the end of 2015, had 70 percent of its investments in real estate, private equity and various other nontraditional assets and accordingly lose $236 million in 2015.

3. Make the payments to the pension plan that your actuary tells you to make.

One of the easiest ways for a government to balance its annual budget is to cut back on its pension contributions. This approach is especially inviting in years of rising stock prices that allow pension plan investment earnings to exceeded expectations. Unfortunately, what goes up must come down. As a consequence of persistently contributing less than what would be actuarially recommended, Dallas’ plan is now inadequately funded; assets are only 38 percent of what is actuarially required, whereas 80 percent is widely recognized as the standard for fiscal health.

4. Don’t offer benefits out of line with conventional employment standards or that can readily be gamed.

Many cities not only grant workers full pension benefits after only 20 years of service but also allow them to begin receiving those benefits immediately upon retirement. Thus, “retirees” in their early 40s may be eligible for full benefits and are free to continue to work full time for other employers. Similarly, some governments base benefits on total compensation earned in the final year of employment. Employees are able to “spike” their benefits with sudden bursts of ambition and time-and-a-half overtime pay, and in some cases manage to collect more in pension payments than they did in normal year salary and wages.


As I wrote at the Actuarial Outpost:

Something about this list reminds me of the old elementary school joke:

patient: doctor, it hurts when I do this
doctor: stop doing that

Seriously, that is some really unhelpful advice.

Stop doing stupid stuff? We never thought of that!

In many cases, this is really unhelpful, because the idiotic decisions of the past persist for decades beyond the decision point. Maybe you see why the standard defined benefit pension structure may be unwise? No?

There are ways to design DB plans so they’re not quite so destructive or playable, such as: much more modest promises, more skin-in-the-game for employees, career averages used as opposed to back-loading the benefits, etc.

But that’s not what was done.

This advice would have been really helpful, say, 50+ years ago. Hell, even 20 years ago.

But it doesn’t really help matters now. And that Dallas Police & Fire issue? Yeah, that’s really nasty. It was a nastiness that could have been foreseen 20 years ago, but for some reason, it wasn’t.

I can think of some reasons.

Related posts:

That’s a stub of a list, to be sure.

Compilation of Dallas posts

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