Debt Crisis, Part 2 -- Invading the Pension World

Effective July 1 of this year, a new law became effective in the State of Rhode Island which gives municipal bondholders priority in municipal bankruptcy cases. Yes, towns and cities go bankrupt. For those of you who like your citations, you may marvel in the intricacies of Chapter 9 of the Federal Bankruptcy Code. For the rest of us, suffice it to say that it can be done.

There is a smallish town in Rhode Island called Central Falls. It has about 19,000 residents and has been paying out nearly $300,000 per month in pension checks. Starting next month, it will pay out about $100,000 less.

Nobody died. Nobody told the town that he didn't need his pension anymore. Central Falls filed under Chapter 9. Pensioners need to line up with every one else. They are going to get a haircut of about one-third.

Is this legal? I suppose it is, but if you really want to know, you need to ask an attorney who is familiar with Rhode Island law. This is not an ERISA issue. This is a governmental plan. So, while your favorite ERISA attorney in some other state may have a strong opinion, chances are that he or she doesn't know the ins and outs of Rhode Island law and the Constitution of the State of Rhode Island.

I am going to assume that this is all legal. If I assume it's not, then I would have to blog about something else today.

Let's consider the implications. If you are a potential bondholder, municipal bonds in Rhode Island are pretty safe. If you are a rating agency, these same bonds are far safer than the general credit of the town. If you are an investor, you will likely consider municipal bonds in Rhode Island as part of a safe fixed income portfolio. The bonds of these municipalities will probably yield a lower interest rate in the future.

What about the pensions? There has long been a debate in the pension community about the proper funding and funded status of public pensions. On the one side (let's call them the public pension traditionalists or PPTs for short), the argument has been that public pensions don't need to be fully funded. They have an essentially infinite lifetime. Their sponsors have peaks and valleys in tax revenues and the pension plan is just one of the items that must line up for funding along with public safety officials, roads, parks, and the like. In fact, most residents would tell you that those other items deserve priority. They affect every citizen on a regular basis. They make the town livable.

On the other side are the Financial Economists (FEs). They argue that when you offer a pension to an employee, you are, oversimplifying somewhat, taking a loan from that employee. By funding that pension, you are placing into escrow a pool of assets. The FEs would argue that the market value of assets in that pool should equal the market value of liabilities. The PPTs would disagree, perhaps saying that increases and decreases in the market value of liabilities are largely due to external forces (rises and falls in interest rates) that are not overly relevant to this ongoing pension plan.

You know what? For most public pension plans, I can argue that the arguments of both sides have their merits. (By the way, there is a bill (PEPTA) pending in Congress that would purportedly improve disclosure and therefore funding of municipal pensions. It's not the answer, but if you want to read about it, you can read my take on it here.)

In any event, Central Falls is not the only public entity in the US in financial trouble. And, of those, Central Falls is not the only one with a severely underfunded pension plan. In fact, there are many. But, Central Falls is in Rhode Island. And, Rhode Island has this new law. In my opinion, many other states will copy this new law.

Consider what will happen when employees find out. Those often ultra-generous public pensions may not be safe, or at least not as safe as we thought they were. Will public employees insist on higher pay? More generous benefits (other than pensions)? Will they just leave municipal employment for the private sector?

And, what of private pensions? They have more well-defined funding rules. For the most part, benefits in those plans are guaranteed by the Pension Benefit Guaranty Corporation (PBGC). But, there is a lesson to be learned. Let's separate those plans into a few categories:

1. Well-funded ongoing plans of thriving companies where the plan's obligations represent only a small part of the company's balance sheet.
2. Poorly-funded frozen plans of struggling companies that, because of their size, represent a significant drain on the company's balance sheet.
3. Everywhere in between.

With regard to group 1, even the most ardent FEs might tell you that such a company can withstand blips in its pension plans, even large blips. The company runs the pension, but the pension doesn't run the company.

With regard to group 3, it depends on where that company and its pension plan fall on the continuum between groups 1 and 2. Certainly, the PPTs are more likely to be on the side of letting the economy take its course while the FEs will likely want to see assets in high quality fixed income instruments matching the plan's obligations.

As for group 2, they are in trouble. To a large extent, the pension plan runs the company. Due to the relative size of the plan, the company's P&L is driven significantly by pension expense. And, the balance sheet and the company's ability to borrow to run its business will be largely driven by the state of its pension plan. Even the most fervent PPTs would probably admit that something drastic needs to be done to manage this risk.

Private pension funding rules, as most readers know, have lots of smoothing techniques available to them in funding calculations. Smoothing techniques are wonderful tools to help a company manage its cash flow. At the end of the day, however, a plan does have a market value of liabilities. Different individuals may have different opinions on how to calculate that market value, but it is there somewhere. And if that market value of liabilities is getting ready to swallow up the company, then there is truly "Danger, Will Robinson!", significant danger. 

Readers should be reminded that what I write here is usually my own opinion (sometimes I use literary freedom to offer up ideas with which I do not agree), and sometimes not even that, but should in no event be attributed to anyone else. But, the issues in this particular piece are real. I rarely use this blog as an advertisement, but in this case, I am going to, for just a moment. I know of a company that happens to be a leader in helping clients manage their retirement plan risks. In fact, they are good enough to send me a paycheck once a month. Please contact us if any of these issues hit home for you.