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Out of Control Policy Blog Archives: 2.16.14–2.22.14

Sasha Volokh on the Counterproductive "California Rule" on Pension Benefits

Sasha Volokh has a new article on Reason.org well worth a read that discusses the so-called "California rule" on pensions, which basically says that California government employees acquire a right to their promised pension benefits on day one of employment, and those benefits (or more generous ones, if granted) are assumed to be protected for their entire career in government. In other words, they are seen as permanent contractual rights that cannot be changed—unless the terms are modified to bestow enhanced benefits. Policymakers are thus precluded from later deciding to enact reforms to rein in those benefits in the interest of the financial sustainability of the pension system—such as reducing cost of living adjustments or increasing contribution rates—even if on a purely prospective basis, where previously accrued benefits would be left untouched.

California's constitution protects pension benefits is curious, as Volokh explains in the article:

Does it make sense to protect the rate of future pension accrual as a contract? If there were an explicit contractual term regarding pensions, the question would be easy; but usually there’s nothing but a statute defining pension rules.

The basic idea that a pension statute creates a contract with employees is sound: pensions are deferred compensation, and government employees take their jobs in reliance on the full compensation package, from current salary to fringe benefits to pensions. But what’s covered by this contract? Certainly whatever has been earned so far should be protected; this includes past salary and benefits, including whatever part of the pension has already been accrued. As to the more extensive rights protected by the California rule—the “collateral right to earn future pension benefits through continued service, on terms substantially equivalent to those offered” when one was hired—it seems that this, too, should be protected in California now. Given that it’s been the law since 1955, public employees have sensibly relied on the rule in accepting employment. So it’s reasonable to consider that the future rate of pension accrual has implicitly become part of public employees’ contracts.

Nonetheless, the California rule isn’t sensible. Consider what isn’t protected. Salaries aren’t constitutionally protected, even if a salary reduction will have an indirect effect on the amount of one’s pension. Cost-of-living increases to salaries can be revoked for the future, but cost-of-living increases to pensions can’t. Tenure in office isn’t constitutionally protected either, though states can adopt civil service laws if they like. Only pension rules have a special status. But it seems strange to privilege pensions over everything else in this way.

Read the rest of the article here, where Volokh goes on to explore several potential workarounds to the "California rule," including shifting to defined contribution plans, providing benefits via short-term contracts, amending the state constitution, and privatization.

For more, see Volokh's December 2013 white paper on the "California rule," published by the Federalist Society. And be sure to peruse Volokh's other legal analyses written for Reason Foundation, which are archived here.

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Proposed L.A. E-Cigarette Ban Would Perpetuate Smoking, Not Discourage It

From my new commentary on L.A.'s proposed e-cigarette ban:

On Monday, a Los Angeles City Council committee is set to consider an ordinance that would ban the use of electronic cigarettes anywhere that traditional cigarettes are prohibited under the city’s smoke-free air laws. The City Council already unanimously passed a law subjecting e-cigarette sales to the same regulations and restrictions as tobacco products — even though e-cigarettes don’t contain any tobacco.

Not only does latest move to ban e-cigarettes run counter to public opinion, it would also set back public health by implicitly discouraging smokers from seeking safer alternatives.

A national Reason-Rupe poll recently found that 62 percent of Americans e-cigarettes should be allowed in public places, while just 34 percent thought they should be banned in public places. The public sees through the types of unjustified fears espoused in the proposed L.A. ordinance, namely that e-cigarette vapor could harm users and bystanders in a manner similar to secondhand cigarette smoke and that the use of e-cigarettes might “re-normalize” tobacco use.

Read the full article here.

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Do Detroit's Pension Funds Need Reform

Few would deny that Detroit's city government has been a model of corruption over the past few decades. Most agree that the sky high property and income taxes have to be slashed (its just a question of how to do it when short-term revenue flow is already so challenged). And no one is going to suggest the status quo of Detroit city services are at peak performance.

But when it comes to Detroit's public pensions--the General Retirement System (GRS) and Police and Fire Retirement System (PFRS)--there is far less agreement over whether a problem exists... and if so how to fix it.

Thorny view: Most of the arguments that the city's public pensions are in trouble have focused (justifiably) on generosity of pay, the so-called "13th Checks" that were commonplace up until a few years ago (which if never allowed would have meant $1.9 billion more in pension assets today), the $1.4 billion pension obligation bond taken out in the mid-2000s that made the pension funds look as if they were fully funded when it was just on borrowed money, and the unfunded liability of $3.5 billion estimated by Emergency Manager Orr. Andrew Biggs hit most of these in a post for the American this weekend, and they are fair.

Rosy view: Those points have been countered by advocates pointing out (justifiably) that the funded ratio of the pensions are relatively okay--GRS is funded at 77% and PFRS is funded at 96%. It is also pointed out that the 13th Checks were technically legal under the accounting standards for the pension funds, and the city has actually filed for bankruptcy because of bonds issued to creditors and not the $1.4 billion pension obligation. These points are technically true too.

So are the pension funds in trouble or not?

The problem with the rosy view is that it rests on the assumption that the actuarial standards adopted by the Detroit pension funds are responsible. In fact, they are setting the systems up to fail over the long-run, and Detroit pensioners should be aware of the coming challenges.

Consider the funding ratio. For GRS this has been falling rapidly over the last five years (since the financial crisis) and is unlikely to stop. Back in 2008, GRS was fully funded, but its added some $200 million a year to its unfunded liability and now has at least $840 million in debt-and most certainly more than that if using more realistic assumptions about future investment returns (see p.26 of this PDF report). The PRFS looks stronger over the last few years, but it (along with GRS) has to contend with an investment assumption challenge too.

Currently GRS assumes an investment rate of return of 7.9%, and PFRS 8.0%. There is also an annuity plan available that promises a guaranteed 7.9% return minimum to those who choose to participate. These return assumptions are unrealistic. Emergency manager Orr has assumed a discount rate of 6.9% to 7%. A safer assumption would be something just above long-term yield on Treasuries, so roughly around 4%.

Just look at what the last few years have wrought for Detroit pension investments. In market value terms PRFS had negative investment returns of 4.4%, but because it spreads losses and gains out over a seven-year accounting period, PRFS reported a funded value return of positive 3.8% (see p.12 of this PDF report). The later number still missed the target 7.9% though, which is not one-time occurrence. As we mention in the op-ed, Detroit will need to revise down its assumed discount rate (what it expects it'll get from investing pension assets on an annual basis, averaged out over seven-years).

Detroit should also reduce its actuarial method of seven-year "smoothing" to something more like two or three years. Every year the city actuary estimates how much will be needed to pay benefits, and then tells the city to pay a lump sum into the assets that will then be invested (supposedly with a 7.9% return). But if losses aren't recognized on an actuarial basis sooner than later, then those estimates can be off, which means the city winds up not contributing enough, which means whatever investment return it does get wouldn't be enough even if it hit the 7.9% assumption, and taxpayers wind up having to contribute more from the city budget.

This has a ripple effect of forcing the city into more debt and/or reduction in city services since the cash is all going to fix previous pension accounting mistakes.

According to the most recent financial reports on GRS and PRFS, there is a $1.35 billion difference between the "funding value" of the combined assets and the "market value" of the combined assets. That difference is the real loss suffered from investments not hitting assumed targets that are being distributed over a seven-year smoothing period. Those losses were suffered primarily during the financial crisis (FY2008 & FY2009). The funds saw strong market returns in FY2010 and FY2011, as the Federal Reserve juiced the equities market, but FY2012 was a flatline year for investments and may become common place in the coming years (depending on what Fed QE policy is and the portfolio mix of GRS and PRFS assets). Here is the audit language directly:

"As of June 30, 2012, the funding value of assets was nearly $650 million dollars greater than the market value (see page A-12). As that difference is recognized, computed employer contribution rates will continue to increase by approximately an additional 13%-15% of payroll over the next several years, unless the losses are offset by future experience gains. On a funding value basis the system is 77% funded. On a market value of asset basis, the system is 59% funded." - GRS FY2012 annual report, p.A-5

"Because of the past unfavorable market returns and the 7-year smoothing, the funding value of assets exceeds the market value by $701 million. Unless the market recovers remarkably within a relatively short period of time, upward pressure on the employer rate can be expected in each of the next several years. If there are no experience gains during the next 7 years, the employer contribution rate could double during that time." - PFRS FY2012 annual report, p.12

So those arguing that pensions are well funded in Detroit may be technically correct under the particular accounting standards the city has adopted, but in the long-run the pension system needs to be robustly reformed. It is shortsighted to think that they are not in trouble. The funding ratios would be much worse if the accounting wasn’t delaying realization of losses. Unless Detroit's pensions are adjusted to address these challenges, even the best bankruptcy deal wouldn't keep the city from burning down again and being right back in this place a few years from now.

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Bankrupt, but Not Broken: How Detroit Can Build from Bankruptcy

Any day now we should have the next proposed roadmap for Detroit's bankruptcy proceeding. The plan will suggest how much Detroit thinks should be repaid to certain creditors and what cuts the city's pension funds should take. Whatever the details that emerge (and subsequently get negotiated and challenged in court), the discussion will be focused on Detroit in the short-term. But what about the future of the Motor City?

In a Detroit News op-ed today, my colleague Len Gilroy and I outline how Detroit should start thinking about its future beyond bankruptcy, and what long-term challenges lie ahead that it should make moves now to address.

The first challenge will be improving the delivery of city services:

"One step in the right direction Detroit has taken is outsourcing residential solid waste collection to save $6 million annually... Transit presents another opportunity. In recent decades, Denver’s regional transit agency has used competitive contracting to lower costs of bus transit operations by approximately 30 percent, and Nassau County, New York, hired a private provider in 2012 to lower its costs by 24 percent. Further, Detroit should consider using “managed competition”: having public employees compete head-to-head against private firms to provide city services."

The second challenge will be tax rates (and regulatory restrictions):

"Detroit also has the highest property and income tax rates in the state. Savings from leveraging the private sector to provide city services would help it weather the short-term revenue shocks that prevent these rates from being slashed. Without tax relief, the city will have a hard time attracting businesses and individuals and reversing decades-long population decline."

The third challenge will be pension reform:

"Finally, Detroit has to ensure that it doesn’t let unfunded pension benefits risk its fiscal health again. It cannot unrealistically count on receiving a 7.9 percent annual return on pension investments.Moody’s Analytics suggests that a more honest assumption wouldbe annual returns of 4 percent. Unfortunately, lower investment returns will require more retirees to be paid out of general revenues that would otherwise fund city services."

Read our whole op-ed here.

If you are in the Detroit area on Thursday, Reason is hosting a panel discussion on the the topic of this oped. Click here for more details.

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