STUMP » Articles » Public Pensions: On Accounting For Assets and Liabilities and REALLY BAD IDEAS » 24 August 2017, 08:20

Jack Dean pointed me to this piece at ftalphaville, and I think there are good and bad things both in here.

Let me start with the part I totally agree with (and the part they end the piece with): pension liabilities are undervalued for public plans.

Bad accounting rules also hamper state and local governments on the liability side of the balance sheet.

The municipal bond market is worth about $3.8 trillion. That figure is dwarfed by many American governments’ preferred form of borrowing: underpaying public employees today in exchange for generous pensions when they retire. According to Joshua Rauh of Stanford, the market value of these obligations is currently more than $7.4 trillion.

To be clear, there is nothing wrong with promising workers guaranteed benefits. People who go into public service might prefer lower incomes today for greater security in the future and if so, governments should accommodate them. The Bank of England does this by putting almost half of total employee compensation into its pension plan.

But it is foul to lie about the cost of these promises — precisely what GASB encourages state and local governments to do.

Yes, it is foul to low-ball pensions like that, because it makes the pensions more fragile, as I’ve mentioned here..

Experiences in Detroit aside, workers and retirees have every right to expect that they will get exactly what they were promised. The only way to capture this absence of default risk is to use the yields on the one set of dollar-denominated debt without any default risk: Treasury bonds.

Oh, dearie, dearie, dearie. You are obviously ignorant of what’s going on in the public pensions space. Other public pensioners have already had their benefits cut! (or at least not getting the COLAs they assumed they’d get.)

Let me go down my litany:

• Prichard, Alabama: pensioners didn’t get paid anything for over a year
• Central Falls, Rhode Island
• Rhode Island in general
• Pension plans separated from Calpers – one of my posts re: Loyalton cuts
• Detroit, of course

Many more will be added to this list. They’re just the canaries that everybody keeps dismissing: government never goes out of business!

ON VALUING PENSIONS

But that’s just a quibble. Pretty much everything they have to say about pension valuation I agree with.

Risky assets have higher discount rates than safe assets because they are risky. People like getting pensions because they aren’t risky. If the beneficiary receiving the pension thinks she is getting something safe, the pension sponsor shouldn’t be discounting its obligations using the risky rate.

Ta da!

This is exactly the sort of reasoning behind how insurance liabilities are valued. And how assets backing those liabilities are chosen.

PRIVATE INSURERS VS PUBLIC PENSIONS

Q for actuaries: Should a pension offering guaranteed benefits to a mostly-older population hold 3/4 of its portfolio in risky assets? https://t.co/VSyuOOca39

— Andrew G. Biggs (@biggsag) August 21, 2017

Well, I do an annual study of investments of insurers, including, specifically annuity insurers. They're ~90% bonds.

— Mary Pat Campbell (@meepbobeep) August 21, 2017

And the private insurers invest that way because state governments forbid them from taking risk and handing the bag to state taxpayers.

— Joshua Rauh (@joshrauh) August 22, 2017

And yes, this relates to why paying 100% ARC doesn’t mean you’ll improve funding levels (or even maintain a good funding level).

ON VALUING ASSETS

So governments have all sorts of real assets — you know, stuff like specific plots of land and buildings.

Under current standards, these are valued at depreciated cost.

According to GASB Statement 6, governments shouldn’t measure their assets using market prices. Instead, GASB says states and localities should value assets according to whatever was originally spent to acquire them, no matter how long ago. This deflates asset values and provides no incentive to invest in improvements. As Prakash and Tanzi noted years ago, “use of historical cost will not provide significant information on the underlying real economic value of the asset, and hence will not necessarily lead to better use”.

The example they use is a waterfront dump, which might be worth a lot more if the dump were moved out somewhere less desirable and the waterfront property turned into private condos.

I agree that real public assets are often misvalued (and they can be worth less than original cost, too). But where I heard the brakes screeching was this following bit:

If the public sector regularly measured the market value of its assets — and were able to reap the benefits from boosting the value of its portfolio using financial engineering — governments would make better decisions on behalf of their residents.

Holy fucking shit, no.

Pension obligation bonds are “financial engineering”. The Orange County derivatives fiasco was financial engineering. Those frickin Detroit & Chicago swap situations were financial engineering.

Public entities should stay the hell away from financial engineering — it’s dangerous enough when private entities do it… getting governments involved is a horrible idea.

BECAUSE EXPERIENCE

Oh, and I see they’re talking about cost accounting. Yes, cost accounting tends to be horrible, but you can’t mess around with the figures so much.

That’s really important when it comes to government and finance.

BECAUSE EXPERIENCE

Look, how trustworthy are politicians with respect to public finance? We know if they don’t have oversight they get up to all sorts of shenanigans.

Maybe you think that credit rating agencies provide that oversight.

You can’t depend on the credit rating agencies, because they’re lagging indicators with respect to their ratings. They generally don’t rate at junk until well after the bad deals have occurred. They’re just agreeing “Yes, they’re in a bad balance sheet/income statement situation.”

But even assuming politicians aren’t corrupt, there is the question of how well they can actually have the knowledge/wisdom to oversee such situations.

The example I love to point out is where Harvard lost a shitload of money because they forgot to unwind a “financial engineering” deal.

I used to use that example to beat up on Larry Summers, who set up the deal, and then realized later it was somebody else who made the bad decision not to unwind the situation and they just “forgot”… and then I decided to blame Summers again. If it requires a lot more knowledge/expertise than the Board of Trustees can handle, it’s his fault for setting something up they wouldn’t be able to oversee.

This reminds me of critiques of Dave Ramsey. Yes, his advice isn’t mathematically optimal, but he is very realistic as to how people who need his help actually behave.

So guys, let’s look at how politicians actually behave when they try to get into “financial engineering”.

ON PUBLIC FINANCE BAD BEHAVIOR

I mentioned the swap problems of Orange County, Detroit, and Chicago above. Those were playing around with financial instruments.

What these authors are talking about is more like the Chicago parking meter deal.

Toward the end of the Daley years, a lease deal was made on the city’s parking meters. Supposedly this was a win-win, but when the city had to pay when parking meter take was too low, just how “good” this deal was became known.

Private players are more apt to think of how technological developments may disrupt their asset value.

Self-Driving Cars: Won’t Anybody Think of the Poor Revenue-Hungry Governments?

I’ve been following the self-driving car developments for a while, partly because it impinges on my day job, which has to do with the insurance industry.

….
The prospect of self-driving cars impinges in my day job in another way, because I live in New York (Westchester County), and I work 70 miles away in Hartford. Every weekday, I get in my car, listen to my audiobooks and swear at slow drivers in the left lane (60 mph in 65 mph zone is WAY TOO SLOW DAMMIT MOVE ASIDE), I have to deal with the crap that is passing through Waterbury and then negotiating the awful Hartford streets (but they’re getting better), and then I park in a parking deck that I pay a fairly hefty monthly charge for, and I go into my building. Sometimes at lunch I need to drive somewhere to do an errand or eat somewhere other than what downtown Hartford offers, and where I go has parking lots.

But what if that all went away?

…..
THINK ABOUT THE CASH-STRAPPED GOVERNMENTS

One of the things I didn’t mention in my intro of my car use was my costs. Obviously, I have to maintain the car, etc., and that wouldn’t change much (the insurance costs would be different.)

But I’ve gotten parking tickets and a couple moving violations in my driving career (one was a straightforward speeding ticket, and the other was driving a commercial vehicle on a parkway (which is a long story)). And I think of the various small town speed traps I used to deal with down in the South (I NEVER sped in those small towns, even if the speed limit was 15 mph.)

In this age where governments have signaled their desperation to find new revenue sources, losing a reliable revenue source — parking meters, parking deck fees, parking tickets, speeding (and other traffic violation) tickets — would be pretty devastating.

…..
CHICAGO: THE PARKING METER DEAL

We’ve seen a negative effect before from traffic-related revenue with Chicago before.
…..
‘It turned out that the metered spaces were probably worth billions more than the city received. In addition, the city has to return some of the money to the private company, Chicago Parking Meters, every time officials take a metered spot out of commission for street repairs, festivals, traffic control, or any other reason.

‘Emanuel entered office in 2011 promising to look into retooling or even revoking the agreement. “The parking meter deal is particularly wrong,” he said.’
……
So.

What happens when those meters are worthless? And that will come far sooner than seven decades.

Let’s see. Politicians just wanting cash up front to “monetize their asset”.

Private players who know how to write a deal to minimize their downside risk.

Who is likely to be the winner in this arrangement? That also happened with the swaps.

The governments are very unlikely to be able to find a good price on their assets. They’re not the ones with the expertise. Sure, you can hire outside consultants… but how much can you trust them?

and besides, most politicians know very well they can be decades out of office once the crappiness of the deal becomes evident.

More recently, we have the New Jersey lottery gambit, where the future cash flows of lottery profits will supposedly fund the pension (and the stuff it used to fund… uh…. MAGIC!)

That is an accounting trick to try to make the pension look better-funded.

Do you really want to encourage these shenanigans? ABSOLUTELY NOT.

What happens when lottery revenues don’t develop the way you projected?

I agree cost accounting for government assets is distortionary, but I think encouraging “cleverness” to monetize or otherwise “optimize” government assets through financial engineering is a horrible idea.