Gary North's REALITY CHECK
Issue 380 September 21, 2004
THE LOOMING MUNICIPAL PENSION CRISIS
On September 17, the "New York Times" ran an article,
"Budget Use of Pensions Sows Trouble in San Diego." It was a
nice piece of journalism. We are going to see similar stories
like this one over the next 20 years.
San Diego is caught in a financial bind, facing the
possibility of a bankruptcy filing, largely because of
a $1.2 billion shortfall in its pension fund for
municipal workers. For years the city has spent money
from illusory pension fund earnings, according to the
authors of a new report released yesterday.
The purposes of pensions differ, according to the viewpoint
of particular interest groups. The main groups are these:
employees, employers, and trade union officials. When we
consider public pension programs, we add a fourth group:
taxpayers.
EMPLOYEES
Employees decide to take tax-free income during the period
in which they are in higher income tax brackets than they are
likely to be after they retire. They are allowed to do this by
the tax authorities when their income comes in the form of
pension fund contributions, which includes matching funds from
the employer.
These employees could be paid this money in wages. They
choose to invest it, meaning that they choose to have a third
party invest it: the company's pension fund managers. If an
independent third party organization manages this fund, its
managers have no strong incentive to use the money for purposes
other than capital growth. If, however, the company runs the
fund, it is tempted to use this money for other purposes. One
such purpose: buy the company's publicly traded stock, so as to
raise the share price, so as to increase the value of the stock
options of senior management, who sell their shares when they see
trouble coming. Call it the Enron strategy.
The employees assume that the pension fund managers are
acting as their economic and legal representatives -- as
trustees, in other words. But when there are millions or even
billions of dollars involved, this assumption becomes
increasingly naive, unless the fund's management can be held
personally accountable in a civil court if the decision-makers
use the funds in ways unsuitable for third-party trustees.
This gets us back to the "New York Times" story. When
government-run pension funds are involved, the courts are not
empowered to enforce trusteeship laws that apply to private
pension funds. To review: "For years the city has spent money
from illusory pension fund earnings, according to the authors of
a new report released yesterday." Here is the legal problem:
Cities are not held to the same standards of disclosure
that corporations are when they issue stocks and bonds.
The only relevant provisions of the federal securities
laws are broad prohibitions of significant omissions
and misstatements. Until now, the S.E.C. has never
brought an enforcement action over a city's pension
disclosures, Mr. Maco said.
The legal system gives special exemptions to politicians and
bureaucrats. This is because the legal system is run by
politicians and bureaucrats. It is not in their personal self-
interest to enforce the judicial principle of equality before
the law.
EMPLOYERS
Employers use pension funds to compensate employees in ways
that encourage the employees to forego wage raises. The
employer's investment in the pension fund is a form of an implied
promise: "I'll see to it that you are taken care of in your old
age if you will hold down your demands for immediate
compensation." Whenever you hear this offer, think of a carnival
barker with a top hat and a pointing stick: "Tell ya what I'm
gonna do." (For those readers who are too young to remember a
carnival barker, think of Bill Clinton, a tear visible, assuring
us, "I feel your pain.")
The pension fund came of age in the post-World War II era.
Employers were ready to pay workers minimal pension fund
contributions, which were going to compound over time. This cut
the companies' immediate expenses. It freed up money for other
purposes, such as bonuses for senior managers.
What corporations have done, cities have done. They have
used the money that would have gone into wages to pay for
immediate benefits.
This is borrowing from each worker in the name of his future
retirement. He was given hope. The trouble is, you can't eat
hope.
The problem, it turns out, is that corporations and cities
have used paper increases in their pension fund portfolio returns
to justify a reduction in quarterly pension fund contributions.
This has freed up even more money for other uses.
At the core of San Diego's troubles, according to the
report, is its use, year after year, of pension fund
earnings that exceeded projections to pay for a variety
of local projects, including expenses associated with
playing host to the 1996 Republican National Convention
and paying health insurance premiums for retired
teachers and firefighters.
This is sometimes called borrowing from Peter to pay Paul.
The two apostles would probably not appreciate this use of their
names. It sounds crooked.
Yet the practice, which the authors called dangerous,
is sanctioned by law in California and other places and
is commonplace among cities that offer pensions to
their workers. The findings raise the possibility that
other communities will face similar financial
disasters.
Possibility, indeed! I call it probability -- high
probability. The temptation to use the money to buy votes is
just too great.
But actuarial projections are long-term averages, and
when the above-average earnings are used in a good
year, that does not leave any money to offset the
inevitable bad year.
This was not a problem from 1982 to 2000. High returns
seemed to justify reduced funding. The stock market boom, which
was stimulated by the fall in long-term interest rates, gave
pension fund managers the best of both worlds: rising stock
equity and rising bond equity. The market price of long-term
bonds is inverse to the rate of interest of the particular bond.
When rates fall, market price rises.
Instead of steadily putting aside so much money per employee
per quarter, San Diego skipped payments when its pension fund
portfolio rose in value. San Diego is not alone. The same
approach was taken by all American savers. This is a major
reason why the savings rate fell in the 1990s. People decided to
let the market make them rich in their old age. They reduced
their savings rate and bought consumer goods. It was "free
money."
The idea that a pension fund provides "free money" that
a city can spend is "dangerous and widely misused,"
said the report, which was commissioned in February by
the mayor of San Diego in an effort to identify flaws
in the city's financial reporting procedures and to
recommend corrections. Many local governments harness
illusory pension money as San Diego did, the authors
said.
"This was not something done by stealth. This was not
unique to San Diego," said Richard Carl Sauer, a former
official of the Securities and Exchange Commission and
now a partner in the Washington office of the law firm
of Vinson & Elkins. "Any number of municipalities have
used surplus earnings to cover budget items."
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UNION OFFICIALS
Union officials want victories. Victories are what justify
their continued election. Like every other good, the lower the
cost of victories, the more will be demanded.
Low-cost victories were obtainable for decades by going the
pension-fund route. Union officials could point to the
establishment of a corporate pension fund for workers, and then
tell the members, "See? We have forced management to
capitulate." Management played along. "Please, don't throw us
in the pension-fund briar patch!"
Management went along with labor union officials because it
was cheaper than either risking a strike or paying higher wages.
It was a mutually beneficial deal. Management kept more money
inside the corporation, and union leaders were able to look like
hard bargainers. Each group stayed employed.
This joint strategy has continued in municipal government
under post-1960 conditions, in which American trade union
membership has fallen everywhere except in government jobs.
Trade unions have become less and less powerful in the United
States. Employment has moved to states that have outlawed
compulsory union membership. Also, white collar workers are more
independent and therefore more difficult to organize. The
computer revolution has put pressure on all workers not to join a
union by increasing their efficiency but also by making them
replaceable.
The unions do not want to go on strike. Ever since Reagan
broke the strike of the Professional Air Transport Controllers
Organization (PATCO) in 1981, government unions have preferred to
avoid strikes. This makes them more willing to accept low-cost
victories.
TAXPAYERS
Everyone wants a good deal. This includes taxpayers. They
want to get more subsidized goodies out of local governments.
This is why they consent to official pension fund promises. It's
so easy to make a promise. Payment is always way in the future.
The future can somehow take care of itself.
Voters look at pension fund obligations in the same way that
they look at Social Security/Medicare obligations. They expect
the tax fairy to show up monthly and put a pension check under
the pillow of retired ex-employees.
They are unconcerned with the future property tax
implications of these present promises. After all, if things get
tight, they can just pass the equivalent of Proposition 13, which
capped California property taxes. That will force the tax fairy
to show up.
The fact that the pension funds' legal obligations are large
and growing doesn't bother voters. Social Security and Medicare
obligations are also growing. Who cares? Not the typical voter.
There is always a way out. Something will turn up.
IT'S SO EASY WHEN YOU KNOW HOW
There is really nothing to this procedure. It's the Enron
solution. Juggle the figures. Make economically improbable
assumptions regarding future rates of return. Cook the books.
Nobody will notice.
Mr. Sauer and the new report's other author, Paul S.
Maco, said they were not aware of any single source of
detailed information on the handling of state and local
pension funds. Therefore, they said, it was impossible
to predict how many other localities might end up in
San Diego's situation.
"One thing that is fair to say is that part of the
story in San Diego is that people were not taking a
very close look," said Mr. Maco, a former S.E.C. lawyer
who oversaw the agency's work on Orange County, which
declared bankruptcy in 1994. He, too, is now a partner
with Vinson & Elkins in Washington, specializing in
securities law and public finance.
"If there's one message that comes from this," he said,
"it's that cities should take a very close look at the
status of their obligation to fund their pension
system."
You might imagine that the accountants would be blowing
continual whistles. But if there is one sure thing in this life,
it is this: accountants do not blow whistles. Instead, they
insert verbiage at the end of their reports. The old rule of
investing is not widely understood: "The longer the accounting
firm's qualification at the end of the report, the less risky a
short sale."
Though San Diego's troubles are thought to have been
brewing for more than two decades, their severity was
not widely understood until recently. For many of the
years when the city was setting the stage for its
current problems, it was winning awards for the quality
of its financial reports and being given high ratings
by credit agencies.
HURRICANES
The hurricanes that have hit Florida this summer have
created havoc for municipalities and huge losses for property
insurance companies. They are nothing compared to the financial
hurricanes that the pension fund system will create. This
applies to all third-party managed pension funds, but especially
municipal and state funds.
Most people wait until the last 24 hours to go to the store
and stock up on water, food, Sterno, and similar post-hurricane
items. This pattern is unbreakable until two hurricanes hit and
the third is on the way.
The same phenomenon applies to economic hurricanes. These
little ones come by, and everyone else thinks, "It can't happen
here." But it can. The same motivation and the same accounting
assumptions apply in other cities. But no one monitors this, so
the public doesn't know. That's how city managers prefer it.
CONCLUSION
You are going to pay, one way or the other. Either you will
pay as a retired city worker or else you will pay as a taxpayer.
The promises have been made for decades. They have accumulated.
That is, they have compounded.
Voters have faith. This faith is going to be paid off in
funny money. "In God we trust," it says on Federal Reserve
Notes. That's a warning. Treat it as such.
**************
APPENDIX 102
Abraham Case Study #434 does not deal with money. It deals
with time. But, as you know by now, time is money.
One of the most effective tips has been the observation
that so much time is wasted by "got a minute"
management. It got me thinking about how I'd react to
things when people asked me something -- by phone,
email, or in person -- without thinking about how
important that interruption actually was. So I'd get
sidetracked from more important things into just
reacting to a phone call, looking up things then and
there instead of putting it onto my things to do list
and allocating it a priority. I try now to put all "got
a minute" requests into perspective, and deal with them
when I choose, not "on demand" as I used to. This has
saved me a lot of time which would otherwise have been
wasted on less important tangents.
You have to adopt this policy carefully. "Got a minute?"
really means, "Got any valuable time to donate to me?" If "got a
minute Joe" is unlikely to apply the information in a way that
benefits you and him, with more of the benefit for you, allocate
a minute. One minute. Time it. Cut Joe off after one minute.
"Time's up." He'll get the picture.
Set up a call-back schedule. Call it the "Chinese Fire
Drill Hour." (No, don't. You might get sued by some Federal
agency.) Call it the "Five-Minute Solutions Hour." Devote an
hour a day (or whatever) to answering emails. Have the
questioners submit their questions by email -- one question per
email. Then allocate 5 minutes -- maximum -- to writing a
solution. Save your solution in an email folder.
Also add a report-back date. Make the questioner report
back to tell you of his solution. This will add extra work to
his schedule. "Raise the price; cut the demand." Make him know
that to get a free minute from you, he will have to give back
more than a minute. He will have to implement a solution. This
will reduce the demand for your minutes.
Another fantastic tip was the "Dream 100 sell" -- Who
specifically do I want as clients, who are my "clients
of choice", and how will I approach and keep pursuing
them, and what will I do for them, to try and secure
them as ongoing clients who value what I can do. It's
the thing about sending ten letters, notices, etc., to
one selected and targeted prospect instead of one
letter to ten prospects.
This is why I use the $200 AutoResponse Plus program. I
send out lots of automated follow-up emails. This service costs
me a flat rate of $10/month (www.siteshack.net), and I send out
tens of thousands of emails. See my free web site on how to do
this.
http://www.garynorth.com
Part of this approach has been to develop a free
newsletter with useful information for my general
audience, to keep my name popping up on a regular basis
(it's a bi-monthly). This has resulted in people
emailing back to ask what I can do, and has definitely
increased my credibility among the ones I have worked
for.
The free newsletter is easiest by email. I use AutoResponse
Plus for my letters, too. I have multiple lists with over 90,000
names/addresses. I also have this newsletter. The strategy
works.
One thing you keep harping on -- continuous incremental
improvement -- has echoes of Deming, but the way you
developed it in the idea of workshopping an hour a week
on different key aspects is absolutely brilliant. Even
though I'm a sole trader, it has made me rethink the ad
hoc way I'd do a lot of things, without giving myself a
set of simple procedures to follow. The idea of
developing written procedures has been a great
timesaver. . . .
This is the hard part. Implementing a systematic program of
improvements is really difficult. It takes self-discipline. It
takes great attention to detail.
I handle this as a writer by having output deadlines and
input deadlines for anything that doesn't have an output
deadline. A requirement to write three newsletters a week
focuses my attention. My main project -- writing my economic
commentary on the Bible -- takes 10 hours a week, 50 weeks a
year: input. This is my Sistine Chapel strategy. Remember the
movie about Michelangelo, "The Agony and the Ecstasy"? Whenever
Pope Julius II asks Michelangelo when the project will end,
Michelangelo always answers, "When it's finished." That's the
correct answer for books for which you have not accepted an
advance.
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