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This is a story about promise and decline in America, and it begins in San Bernardino. What 40 years ago was alien to Los Angeles is now an extension of it; the city of San Bernardino, population 200,000, is a continuation of 70 miles of Burger Kings and poor-credit car lots that stretch east from the southern Californian coast. It has been said that San Bernardino is a city that works on the nerves, a last stop for those who come from somewhere else. Ironic then—or perhaps appropriate—that the exit into town off the Christopher Columbus Transcontinental Highway yields to businesses hawking bail bonds and tires, both mechanisms, in a way, for escape.
Imagine Hospitality Lane first, because Hospitality Lane typifies the optics of this situation. Lying beyond these dilapidated businesses, through a highway underpass, lining this innocuously labeled road, sits the administrative buildings of the San Bernardino bureaucracy. Glare off their glass exteriors bathes the landscaped greens that surround them, the region’s natural grit halted at the gardens’ edges—relative luxury against a backdrop of need. One of these buildings houses the San Bernardino County Employees’ Retirement Association (SBCERA), an organization that has agreed to pay $8 billion in benefits to retirees and currently possesses $6 billion.
The promise is what is owed; the decline is what’s missing.
Fair or not, this comparison—sterile public wealth standing stark against private need—has percolated through the American political discourse. In Washington, Wisconsin, and beyond, public pensions have been vilified as exorbitant and out of touch as the nation continually nears debt ceiling standoffs and credit downgrades. The unions, conventional wisdom goes, have forced politicians to promise benefits in return for campaign contributions (or, just as valuable, to not campaign against them) and electoral support; the bill, both sides know, will not come due until later.
But this story of promise and decline, as with most stories, is much more complicated than the stereotypes personified on Hospitality Lane. If this simple road and the surrounding buildings typify the stereotype of public pensions as a whole, then the people within these buildings—and, especially, the two men charged with leading the fund’s investments, CIO Donald Pierce and Deputy-CIO James Perry—typify the stereotype of public plan investors. Both military men by training, they exhibit an economy of movement and speech. Their suits, ties included, are sharp without being flashy, more Chicago than Wall Street. Their hair, although no longer of military closeness, is cut conservatively. Their manner of speech is friendly without being chummy. Superficially, they could just as easily be small-town bank managers or accountants. But beyond the superficial, their personas are strikingly at odds with the situation in which they find themselves. One gets the sense that neither is in the habit of promising more than he can deliver. It would not shock anyone if neither were comfortable with even a modicum of debt.
They also deal with what is instead of what should be—for what else can they do? Chief investment officers may dream of better governance and funding structures, and they can often create change on the margin, but wholesale alteration is not within their purview. “I think it is best to operate in the markets as they are, and not hope for a situation I would like,” says Pierce. This conservative vein—conservative not in politics, but in temperament—is exemplified by his larger goal: Not losing money for the fund and its participants. “I find it very helpful to understand the price the market will pay to offset the risk of not losing money in the options market,” he adds, “because at times it may be better to sell that option than buy it. While we would always like to not lose money and get phenomenal returns, we try to focus more on not losing money.” San Bernardino wins by not losing, in essence—a lesson long-ignored by the elected officials charged with giving investment teams like Pierce and Perry the tools with which to work.
This story of promise and decline does not start in San Bernardino because it is a particularly egregious example of the public pension problem. It does not start there because it is a particularly exemplary example. The problem of how America, as a country, got to where it is—where for decades its politicians promised benefits to workers and then left it to another generation to pay for those promises, and where a few good men and women tirelessly work to meet the targets mandated of them—starts in San Bernardino because it is so utterly typical.
“It all comes down to the accounting.” That is the opinion of many insiders regarding public pensions in America, but few state it more clearly and compassionately than a man 1700 miles from San Bernardino: Joshua Rauh, associate professor of finance at the Kellogg School of Management, Northwestern University. A quick conversation with Rauh makes clear that he is deeply interested in not just political arguments about unions and elected officials, but in the nuances that make this story of promise and decline so much more than a sound bite.
Rauh is fond of couching his arguments in images. “Start at 35,000 feet for a second,” he begins. “When a state or local government promises a pension to a public employee, in essence what they are doing is providing deferred compensation to the employee. They are essentially borrowing money from that employee. If the pension hadn’t been offered, the logic goes, the government would have had to pay that employee more now.” The question then, Rauh’s argument goes, is “how much money should the government set aside today in order to pay off the promises tomorrow? If we don’t set aside enough today, taxpayers of tomorrow will have to repay that debt. So the question of what is a sufficient amount—it is very, very critical to answer correctly.” It’s even more critical, he continues, because state and local governments, unlike their federal counterparts, almost always are required to run balanced budgets. Those budgets pay these benefits, and with other demands competing for the limited pool of available capital there are “incentives to claim they are balanced when they really aren’t.”
Here is where he really gets moving, his voice quicker and more forceful as he continues what is, essentially, a pension monologue. “Governments claim they’re balanced, even though they’re not, through accounting. The system they are using violates all principles of financial logic and common sense.” He is referring, of course, to the Governmental Accounting Standards Board—the much-maligned GASB—which allows public pensions to set a target return (often between 7.5% and 8.25%) based on little more than their institutional gut. “What GASB says is that they should measure liabilities using expected returns on the assets in the plan—a classic financial fallacy about which we try to educate students as undergraduates and in business schools. If you have a liability, the present value is not calculated by using what you expect to earn—it’s how certain you are to be able to pay that.”
Rauh then lays out a thought experiment to stress just how remarkably illogical this system of accounting is in his eyes. “Suppose that you had a mortgage,” he suggests, and “you were $100,000 underwater on it. You also had $20,000 in a bank account, and those were your assets and liabilities. Now, say you went to bank and asked for new loan. The bank would assess your position in a way that saw a negative net worth of $80,000.” But, Rauh asks, what would happen if you went away, came back, and told the bank you had moved the $20,000 from the bank account into a diversified portfolio of stocks that historically returned 11% (11% being the approximate nominal return on stocks since 1900, according to Rauh). You then told the bank that you no longer had a negative net worth of $80,000 but, instead, had no unfunded liabilities because the stock portfolio would pay off the mortgage debt in 12 years. “The bank would laugh in your face,” Rauh says. “In the corporate space, you’d be investigated by the authorities. But this is exactly what GASB does.”
If state and local governments were forced to use more commonly-accepted accounting standards—the corporate-bond tied discount rates used by private defined benefit plans under the Pension Protection Act (PPA) of 2006, perhaps—the “situation would be much, much worse,” according to Rauh. “And they should. The point of accounting is to reflect the truth of a situation. GASB is not the truth.”
So, what is the reality of public pension deficits under a PPA system, according to Rauh? Bad. “With GASB accounting, we now have about $3 trillion in assets and $4 trillion in liabilities,” he says. “If you correct the return assumptions and use something like corporate plans do today, you have more like $7 trillion in liabilities—and still $3 trillion in assets.” What is a 75% funding ratio under GASB turns into something more akin to 40% under a more logical system. One can understand, then, why there is so often such consternation over lowering a public pension discount rate even a quarter or half percentage point.
“We are borrowing from future generations of taxpayers,” Rauh explains, his disquieting monologue coming to a close. “And we’re not borrowing with bonds, but with a coin toss. If the toss comes up heads—and these plans somehow make the 7.5% to 8.5% that we are saying we’ll make—future generations don’t have to pay more. But if the toss comes up tails, they have to pay a lot more.”
Elected officials, it is now clear, have all but failed to establish a responsible structure to pay public employee retirement benefits. The assets they have contributed, however, must still be invested—and this act of investing represents the single bright light in this big, debt-ridden issue. But what are these often undercompensated (relative to their private-sector peers) and underappreciated chief investment officers and their staff to do? One option is to depart for greener pastures. Indeed, Tim Barrett—the well-respected predecessor to San Bernardino’s Pierce who was the primary driving force between the changes instituted at the fund (see page 30)—did just that, leaving the county fund in 2010 for Rochester, New York, and the Eastman-Kodak pension fund. (That corporate fund may well benefit from Barrett’s experience in stressful investment environments: Eastman-Kodak entered bankruptcy in January.) For those who stay, however, the choice is stark: invest in an extremely conservative manner and miss any chance of making up the funding shortfall left by irresponsible governments, or take on risk in hopes of making up that shortfall.
The trend since the mid-1990s has been clear: dial up the risk. “Under this system, pensions have taken aggressive investment policies to meet fixed liabilities,” Rauh suggests. “They have to meet these liabilities regardless, but they are acting as if the return is secure—and the return is not secure. They often ignore the downside that taxpayers have to pick up the bill if the returns aren’t sufficient. And frankly, these returns haven’t been sufficient over the past 10 years.” And while some might argue with the 10-year horizon—many public pension officials would suggest a 30-year horizon more accurately reflects their long-term liability stream—none would suggest that the time since the turn of the millennium has been kind to public pension portfolios.
But are investment teams wrong to pursue risk? Not really, according to Rauh. “Given their mandate—a target of 7.5% – 8.0% return mean—they’re doing all that can be done, which is putting together a portfolio of asset classes meant to diversify risk and produce returns. They are in a difficult position. They are asked to complete this charge, and they’re not really allowed to say ‘that’s too aggressive’ because state and local governments can’t afford to assume a rate of return lower than 7.5%.”
People go to New York to become rich. They go to Los Angeles to become famous. People go to San Bernardino, it seems, to conduct automobile smog tests. Pulling away from Hospitality Lane, back toward the Christopher Columbus Transcontinental Highway, one comes across a string of run-down shop-fronts offering this service—a service that some economists argue is one of California’s few government successes. At the very least, it acknowledges an externality—that of automobile pollution. If only state and local governments acknowledged similar externalities that stem from failing to match their pension funding promises with action—externalities such as lower credit ratings that lead to higher borrowing costs, higher taxes on future generations, and a wholesale distrust of government. But they haven’t. And all available evidence suggests they won’t. Promises will continually be made, and declining funding ratios will be the result.
But the decline is due to much more than that. It’s a shirking of duties, of kicking the can down the road. It’s the Greatest Generation leaving a debt to the Baby Boomers who are, in turn, leaving it to their kids. These kids will, in time and if they still can, pass it on to their children as well. Until the cycle stops—and nothing suggests it will unless external events such a true national bankruptcy occurs—the only bright lights in this debt-ridden problem are the investment teams tasked with making up what others won’t.
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