rj pensions 745p

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Robert Johnson

Senior Fellow

The Roosevelt Institute

February 25, 2014


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CROWDING OUT PENSIONS: STATE AND LOCAL FINANCE IN THE ERA OF DOLLAROCRACY-Draft 2

Abstract

State and local pensions are the focus of a highly charged debate surrounding public

finances and fairness in America. This paper argues that the root of the problem is the

difficulty of taking collective action to finance pensions for the future.

Fundamentally, this is a problem of governance. Defined benefit pension plans are

structured so that the risk is borne by taxpayers who also desire current services and

expect their representatives to be prudent with regard to taxation. Statistical evidence

suggests that most states and localities handle this responsibility well. But a few have not

acted responsibly, even before the Great Recession and the crisis of 2008. The ensuing

federal fiscal austerity led to a triple disaster of declining revenues, declining transfers

from the federal government, and declining asset values. The crisis unmasked the

conditions of the states and localities that had been remiss in their funding and pushed

nearly every state in the direction of underfunding. Severely underfunded pension

systems then naturally produced conditions analogous to those of savings and loans asthey slid into crisis in the 1980s: Fiduciaries reached for yield in order to recover from

the deterioration of funding ratios as a result of the crisis.

The movement into alternative asset classes in a substantial way to meet these challenges

has potential benefits, but it also raises significant questions about the transparency and

information quality of this aspect of the investment process. The dangers in this realm

appear to be significant, as both forensic and empirical studies find significant evidence

of underperformance by public pension funds in private equity and real estate. The

regulatory process in this realm is inadequate and difficult to manage when highly

sophisticated investors can take advantage of flaws in the democratic process to distort

outcomes in their favor.

As reforms and restructuring debates flair up and pension obligations threaten to crowd

out current services such as education, infrastructure and ordinance, media accounts

tend to suggest that public sector workers are overcompensated and should bear the

burden of losses. Yet the evidence does not indicate that overcompensation of public

sector employees is at the core of this crisis. In fact, it appears that higher skilled public

employees are somewhat undercompensated when wages and benefits are combined.

Based on earlier studies of the mobility of labor between the public and private sectors,

the evidence also suggests that compressing the wages of high skilled public sector labor

will likely cause significant difficulties for state and local governments to attract andretain high quality workers. This is likely to be particularly true in education, where

quality teachers may be difficult to attract if relative compensation differentials widen as

a result of pension reforms.

As concentrated and moneyed interests protect corporate subsidies, ward off tax

increases, and push to make pensioners and public employees (including firefighters,

police, and teachers) bear the brunt of adjustment and to shift risk onto their backs,


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inequality is likely to deepen and reduce the quality of social investment in our future

human capital stock. In the case of Detroit, the lack of correspondence between the

causes of the citys fiscal challenges and the proposed remedy in the emergency

managers plan is breathtaking. And it is a glaring example of the harm that

dysfunctional political systems can do at the state, local and especially federal level.


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Introduction

The crisis of 2008 set off a debate on the role of government in society. After the

Depression that followed the Great Crash of 1929, proponents of a greater role for

government prevailed in what became the New Deal. After the Lehman crisis in the fallof 2008, government came to the rescue of the large complex financial institutions in

order to avoid a massive coordination failure that would have sent society into another

depression. Public approval of government subsequently plummeted. The ensuing Tea

Party and Occupy movements were visual symptoms of a deeply held sense that

American governance system had lost legitimacy.

Many on both the right and the left were dismayed that financial markets could fail so

profoundly. Many progressives thought it obvious that a greater role for government in

the regulation of markets was the remedy. Others, particularly on the right, asserted that

government was ineffectual and could not play a constructive role in the strengthening of

the nation. Arguments against government intervention included capture, bothcognitive and financial, and technological and knowledge limitations. Both sides found

evidence for their views in the sad history of the TARP bailouts, in which bonuses at

financial institutions were unimpaired even as banks were rescued at the publics

expense. As anger about the bailouts mounted and federal deficits soared, the politics of

austerity blossomed. Proponents of austerity who distrusted government and feared

extreme fiscal excess generated great pressure for cutting government spending.

Two factors caused pressure at the federal level to transmit to state and local

governments. First, state and local governments depend directly on sizeable transfers

from the federal government. In 2012, these transfers were nearly three percent of U.S.

Gross Domestic Product. Second, many state and local governments are required to run

a balanced budget, which means that downturns in the economy lead immediately to

revenue deterioration. Together, these factors redoubled the calls for spending cuts at

lower levels of government..

It is in this context that the current crisis in state and local pensions must be viewed.

Systemic factors raised the tension on state and local budget priorities. All of the

elements of this larger crisis combined to exert pressure on the proper funding for

pensions for state and local workers., including 1) dissatisfaction with the performance of

government after the financial crisis, 2) calls to cut current services to balance state and

local budgets in a downturn, and 3) fears of the loss of vital current services.

Not surprisingly, given the urgent need to maintain current services for ordinance,

education, and other aspects of public administration, the enthusiasm to properly

provision for pension obligations was diminished. As the ratio of assets to obligations

owed deteriorated, underfunding became a serious concern in some areas. In

addition, accounting artistry was sometimes used to disguise the extent of the problem.


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Changes in investment behavior which emphasized higher yielding, and therefore riskier,

asset classes were also offered as a way out for underfunded pensions.

As these pressures deepened, debate on what could be legitimately cut to alleviate them

increased. A large number of websites emerged with news updates on the pension crisis

in various localities around the country, particularly in California.1

Campaigns to showthat public sector workers were overcompensated, and thereby doing harm to the

finances of the state or locality, became increasingly visible.2

As the historically tepid recovery from the U.S. slump unfolded, various cities began to

explore filing for bankruptcy, the best known and most significant of which is Detroit,

Michigan. The case has attracted enormous attention because pension obligations

guaranteed in the state constitution as immune from bankruptcy are now being ruled by

federal judges as subject to restructuring in the courts following Detroits Chapter 9

bankruptcy filing. The emergency manager filed a plan on February 21, 2014 that

included pension cuts between 10 and 34 percent. Other states and localities are

following these proceedings closely. It appears that the U.S. is entering a new era ofpolicy regarding public pension obligations.

The fervor surrounding these issues, stoked by the efforts of well-organized groups

through skillful media strategies, is intense. But it is an open question whether proposed

remedies will put our society on a sound footing given issues related not only to

pensions, but also to the quality of federal government services, including education. A

close look at the evidence concerning the social and political mechanisms that created

this crisis, along with the proposed remedies, is critical.

This paper explores the issues surrounding pension reform in the context of the post-

2008 crisis. The decisions made in this realm will be important to the quality and

functioning of American society in the years to come. In order to understand the logic of

collective decisions and the variety of vested interests surrounding these issues, it is

necessary to explore several questions:

1. Are state and local pensioners receiving compensation through pensions that,

when viewed in light of their wages and skill and experience levels, can be

deemed excessive?

2. What lessons have we learned for policy so that the crisis in pension funding can

be averted in the future?

3. How do unsound promises regarding the security of their pensions impact thequality of people who will work in state and local government careers?

1For an excellent example, see Pension Tsunami, accessed Feb. 24, 2014, http://swww.pensiontsunami.com.2 See David Johnson, Meet the Billionaires Using Their Immense Wealth to Make Life Miserable for OrdinaryAmericans,AlterNet, accessed Feb. 24, 2014, http://www.alternet.org/economy/meet-billionaires-using-their-immense-wealth-make-life-miserable-ordinary-americans?akid=11530.1075639.c3fXWi&rd=1&src=newsletter961303&t=4.

Also see the The Plot Against Pensions by David Sirota at http://ourfuture.org/wp-content/uploads/2013/09/Plot-Against-Pensions-final.pdf


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4. Is pension underfunding pervasive or confined to just a few special cases?

5. How does underfunding happen? What is the political logic underpinning

funding decisions and who is complicit?

6. How are discount rates chosen for defined benefit pension plans and what are the

consequences for taxpayers and budget politics?

7. What role does the alternative investment industry (hedge funds and privateequity) play in pension plan performance? What role do they play in altering the

incentives for investment choice through pay to play schemes using placement

agents?

8. Do investment advisors recommend investments to pensions that outperform,

underperform or conform to the performance of major market indices?

9. What do further cutbacks in compensation and pensions for public employees

imply for developments in the U.S. labor market and what do they mean for

inequality of incomes in both the private and public sectors in the United States?


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State and Local Public Employee

Compensation

A very widely circulated theme in the media suggests a simple problem at the core of thepension crisis: government employees are just paid too much. Claims that pensions are

excessive are common, particularly on the Internet, and if vehemence and repetition

created truth, the verdict would be rendered. It is important to understand whether or

not overcompensation and excessive pensions claims are correct, and if so, how they

contribute to resolving the current pension crisis in American states and localities.

There are several highly controversial aspects of evaluating pensions, notably the

questions associated with imputing a value for alleged leisure and security of jobs.

Underlying assumptions behind any given study require serious scrutiny. For example,

studies may derive a result based on ad hoc assumptions about the value of some non-

pecuniary aspect of the work. A thorough tour of the literature on the relative value ofprivate and public compensation brings forth several observations.

1. Most careful studies that suggest little basis for a broad conclusion that state and

local employees are significantly overcompensated relative to those in the private

sector given similar levels of education and experience, and when the numbers

are adjusted to reflect the influence of gender and race.

2. There is convincing evidence that state and local government workers have lower

wages and higher levels of retirement benefits than their comparable private

sector counterparts. The combined total, however, does not justify reducing the

compensation of state and local employees.

3. At lower skill levels, public sector employees may be comparably paid, but at

higher skill levels the case reverses: private sector employees are significantly

better compensated than their public sector counterparts.

4. Some analysts suggest that excessive compensation is not monetary but rather

comes in the form of more leisure time and greater job security. They couple this

assertion with claims that cuts in public pension funds are warranted and should

play a meaningful role in putting many pension funds back into financial balance.

5. Empirical studies of inter-sector mobility in response to relative compensation

changes suggest that employees are quite responsive to the differences and tend

to migrate to better compensation with vigor, particularly at the higher skill

levels.3

After carefully reviewing the evidence on the compensation of private sector and public

sector employees, Alicia Munnell, the Director of the Center for Retirement Research at

Boston College summarizes the findings as follows:

3See George J. Borjas, The Wage Structure and the Sorting of Workers Into the Public Sector, (NBER Working Paper,October 2002). Accessed Feb. 24, 2014, http://www.nber.org/papers/w9313


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1. Researchers agree that: pension and retiree health benefits for state and local

workers roughly offset the wage penalty, so that total compensation in the two

sectors is roughly comparable.

2. The difference between state/local and private sector compensation is modest

and policymakers need to be cautious about massive changes without carefully

studying the specifics of their particular situation.3. This caution is particularly relevant in the case of teachers, who constitute more

than half of state/local employees and who often fall within the top third of

state/local workers and already earn significantly less than private sector workers

with similar socioeconomic characteristics."

There may be individual compensation programs that have paid a significant premium

over average compensation, and there are surely examples of extreme individual pension

obligations that are objectionable and that warrant careful scrutiny as to their origin for

the purposes of curtailing excesses now and in the future. 5But these cases are atypical

and do not add up to a systemically significant proportion of the total level of

underfunding reported by analysts that have led to this crisis.

4 Alicia H. Munnell,State and Local Pensions: What Now? (Brookings Institution, 2011). See chap. 6, Are PublicEmployees Overpaid or Underpaid?5See Transparent California for an example of efforts to illuminate excessive wage and pension payouts in California.Accessed Feb. 24, 2014, http://transparentcalifornia.com.


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The Breadth of Underfunding

If the baseline cause of the pension difficulties were excessive compensation of public

workers, with the excess concentrated in pension benefits, one would expect to find the

problems of pension underfunding to be pervasive nationwide. However, that does notappear to be the case. Neither does it appear that underfunding is concentrated in

particular sectors, such as firefighters, police or teachers.

The data show a wide variation in performance across the states and localities within the

U.S. The funding ratio (Pension Fund Actuarial Assets/Pension Fund Actuarial

Liabilities) varies from 40 percent in the case of the Kentucky ERS to 101.4 percent for

the North Carolina Government Plan. One can examine the varieties of experience at the

Center for Retirement Security at Boston College, which provides data on 126 plans at

the state and local level for the years 2000 to 2010. There are 36 teachers plans and nine

other school employees plans included in the series, as well as seven plans for police

and/or firefighters.

As of 2010, the most recent year for available data at the Center for Retirement Security

public plan database, there were 11 plans in acute distress, with funding ratios of below

50 percent. Of those, five are teachers pension funds and one pertains to police and fire

pensions. Using a broader threshold for concern of funding ratios below 70 percent, one

finds that 48 plans exhibit funding tensions, of which 20 are teachers plans and four are

plans for police and fire departments. These are in line with their proportions in the

sample.

Further evidence that the employment sectors are not at the core of the problem lies at

the other end of the funding spectrum. The 11 best-funded plans include five that are

teacher or school plans and two that are police and fire-related plans. It should be noted

that teachers tend to have higher incomes with a longer working lives, while police and

firefighter plans are associated with shorter working lives and longer benefit payout

periods. Notably, both of these structures are present among the best ranking and worst

ranking performers in the data set. The differing structures of payment and benefit

profiles do not appear to be at the core of so-called pension problem.

The most telling result is a regional concentration of problems. At the state level,

Kentucky, Illinois, and New Jersey each have three plans of concern, while Connecticut

has two. As the table below illustrates, distressed conditions in many of the fundspreceded the onset of the macroeconomic downturn that was caused by the financial

crisis of 2008. It thus appears that problems originate inside the workings of state and

local government.6 What Alicia Munnell calls bad actors that do not meet their

funding responsibilities appear to be significant contributors to the pension crises we see

6For the vivid story of Kentucky see Chris Tobes gripping account, Kentucky Fried Pensions: Worse than DetroitEdition, accessed Feb. 24, 2014 http://www.amazon.com/Kentucky-Fried-Pensions-Worse-Detroit-ebook/dp/B00GCTHPFG/ref=sr_1_1?ie=UTF8&qid=1392780851&sr=8-1&keywords=kentucky+fried+pensions


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in the headlines. Chris Tobes work in Kentucky and Edward Seidels forensic

investigations of public pension systems in Rhode Island, North Carolina, Kentucky, and

Connecticut help us to understand the processes at work among such bad actors.7

7See Edward Siedle, Rhode Island Public Pension Reform: Wall Streets License to Steal, (October 2013, BenchmarkFinancial Services). Siedles column at Forbes.com regularly addresses these issues. See also his Independent CounselReport on Kentucky in Chris TobesKentucky Fried Pensions(CreateSpace: 2013). Appendix I.


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The Measurement of Underfunding

(The Devil is in the use of the Discount Rate)

There is one cautionary note regarding the numerical notions of safety or dangeraccording to funding ratios. Pension liabilities are a long flow series of payouts over

many years. Reducing them to a number called the present value to compare with the

stock assets on hand is not a firm science and subject to potential abuse. In some

circumstances this method is a Cassandra and in others a dangerous mask. Put

differently, pension fund assessments are like judgments of bank solvency: they can be

subject to accounting tricks.

Two immediate concerns are somewhat interrelated: 1) the question of the breadth of the

problems of underfunding across the nation, and 2) the depth, or degree of underfunding

of particular pension plans.

Methods of measurement that suggest a deeper degree of underfunding in any given plan

are also the methods that enlarge the scope of plans deemed to be in danger. Selecting

the appropriate discount rate that much of this analysis hinges upon is not an exact

science8 and provokes sharp disagreement. A lower rate, the so-called riskless rate, leads

to lower estimates of future earnings on the stock of assets in the pension fund and

therefore a larger Actuarially Required Contribution (ARC) to the fund to meet future

pension liabilities. Using a higher discount rate, which may better reflect the expected

yield on assets in the pension fund, provides a lower present value of future unmet

pension obligations because earnings on the portfolio of assets do more to provide for

future pension obligations and reduce the need for provisioning out of current budgets.

Controversy arises from the fact that there is a second aspect of this higher yield, the

investment risk that is part of what the higher yield on assets is rewarding the fund for

bearing. In other words, if the pension fund loses money on a risky investment, the

pension liability remains.

As we focus again on the political pressures around the choices of pension funding, it is

important to bear in mind that lawmakers may be tempted to have their funds bear more

risk (a hidden or contingent cost) in order to mask the true cost of providing public

pensions. In the public sector, this is the equivalent of off balance sheet financing in the

private sector. It may also be a contributor to a process where, following a period of

extraordinary investment returns, political pressures rise to ratchet up benefits or reduceprovisioning instead of laying in reserves for potential rainy days of poor performance at

the other end of the risk pendulum. A conservative measure of the discount rate, called

the riskless rate and reflecting the yield on government securities, may therefore be a

8See Robert Novy Marx and Joshua D. Rauh, Public Pension Promises: How Big Are They and What Are They Worth?.Journal of Finance66(4), 2011: 1211-49. Also, see Andrew Biggs and Kent A. Smetters, Understanding the Argument forMarket Valuation of Public Pension Liabilities. (American Enterprise Institute, 2013). Accessed Feb. 24, 2013,http://www.aei.org/files/2013/05/29/-understanding-the-argument-for-market-valuation-of-public-pension-liabilities_10491782445.pdf.


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more prudent measure, even if less accurate in gauging the level of resources that the

assets in the pension portfolio will generate on average.

As a result, the contingent liabilities that may be imbedded in pension obligations are a

valid source of public policy concern. The contingent depth of underfunding, which

pertains to all elements of pension plan analysis, is particularly important to understandafter the experience of large negative drawdowns, such as those experienced in the crisis

of 2008. Pension plans are implicitly short bonds (they owe money in the future, which

is like having issued a bond) and long risky assets like equities. When risky assets

tumble and the present value of the future obligations expands as interest rates fall, the

pension plans financial vulnerability becomes glaringly evident. The acute level of

underfunding that results from these financial exposures ignites the public alarm -

particularly among those fearing that they will bear the burden of emergency funding

through taxes or default upon pension obligations.

In fact we are now in such a period, one that is akin to what was observed in the years

before the savings and loan bailout in the U.S. in the 1980s. When investment managersface severe insolvency or underfunding, the temptation to resort to increasing risk taking

to avoid bearing the burden of proper funding may be difficult to resist. In public

finance, this is like the Hail Mary pass in football: touchdown or lose. If successful,

taking more risk may alleviate the crisis. On the other hand, if riskier behavior results in

big losses, then the crisis deepens. In that event, some may say the loss was inevitable. In

any case, the pension fund stewards are not much worse off. It is this kind of despairing

strategy that must be monitored for the public good to prevent reckless investments.

With this in mind, some commentators have raised concern about the long-term rise in

the public pension portfolio share of equities and also of alternative investments. This is

a subject we will return to below when we discuss the attraction to alternative assets.


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Pension Finance in a Volatile Financial

World: Not So Easy Come, Easy Go

Economists often make the distinction between stocks

9

of assets and liabilities on theone hand, and the flows of income and payments associated with each on the other. The

decline in the crisis and subsequent rebound of equity prices in the U.S. have led some to

suggest that we have ridden out the storm of acute risk of asset stock value declines and

that we are back on track. With interest rates still very low, the riskless discount rate one

might apply to future liabilities would generate a large present value snapshot of future

pension obligations. In the coming years, interest rates may return to somewhat higher

levels reflecting more normal economic conditions

If one were only looking at the stock valuation effects on the portfolio, this analysis of

transient mark to market changes would be the right one. The message would be that

the changes would be alarming if they were not transient, and that in the end thingswould be back to solvency after riding out the anxious storm.

But understanding asset liability and stock valuation is not sufficient for a complete

understanding of what happens in a crisis. The flow dynamics between the onset of the

crisis and its conclusion can also have a significant impact on the resulting asset and

liability balances. During a prolonged slump in the economy, revenues decline and the

resulting pressure on current services creates a resistance to fully funding the

contributions required for the present provisioning of pension outlays and for the stream

of future obligations. This is particularly acute when states have a balanced budget

requirement, and it is compounded when the fiscal consolidation emanating from

declining tax revenues and/or declining federal government transfers to the state or

locality tighten the fiscal condition further. The temptation to skip or skimp on

provisioning leads to cumulative accrual of liabilities and possibly also a rundown in

assets by selling holdings to meet current pension outlays.

In this respect, macroeconomic factors may play a significant role in the determinants of

pension plan solvency. For example, the deep and prolonged downturn experienced in

the aftermath of 2008 led to sharp declines in property values and thereby the value of

real estate taxes collected. It also resulted in losses of employment and income tax

revenue as well as declines in sales tax revenue. In states and localities that have a

balance budget requirement, the deep and prolonged cyclical effects lead to a dilemma inwhich the legislature must decide among such strategies as cutting current services such

as education, infrastructure, ordinance or fire protection; cutting corporate incentives

designed to inspire growth in the tax base and local economy over time; or raising taxes

to make up for the loss of revenue volume.

9Here stock does not mean equity the rather the stockpile of the asset. The asset could be a bond, an investment in afund, or an equity.


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One can see marked effects of this in the table below, which lists the decline in the so-

called funding ratio (Pension Fund Actuarial Assets/Pension Fund Actuarial Liabilities)

between 2007 and 2012. The magnitudes of deterioration in the funding ratio are

substantial. The mean decline across the 50 states was 11.22 percent over the period.

Those hit hardest are shown.

The table above doesnt illustrate how valuation effects on the stock of assets may haveimpinged upon these measures or how much of the increases were the result of

underfunding under budgetary stress. Yet by 2012, equity market valuations had largely

recovered their pre-crisis levels, whereas pension funding levels had not. The transient

implications are therefore significant: strong negative macroeconomic shocks can set in

motion a dynamic that is very destructive and difficult to arrest even after asset

valuations have recovered from the downturn. In essence, liabilities keep marching on

and depleted stocks of assets have to work much harder to keep up.10

The macroeconomic disturbance that occurred in the aftermath of 2008 was exacerbated

by the transition at the federal level to fiscal austerity that emerged by 2010. The cut in

transfers from the federal government to state governments added further budgetary

pressures on the state and local scenes, and likely contributed to the marked change in

10Consider a simple conceptual exercise: assume that in the market, a nominal yield of eight percent can be earned on thepension portfolio. A ten percentage point decline in the asset ratio from say 70 to 60 percent of liabilities requires anincrease of yield on the asset to 9.33 percent to get back on the income track. Portfolio performance that does not keep upwith that leads to a further decline in the funding ratio relative to the ex ante scenarios and an even higher yield is then torequired to get back on a stable trajectory. A downward spiral can ensue where the asset base is too small and any realisticrate of return is not adequate to keep up with the continuously growing liabilities. To meet pension obligations it mayeven require a liquidation of assets to meet current payment obligations. The result is a downward spiral in funding.


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the trajectory of state and local spending that had been evident since that time. The

charts below illustrate this vividly.

See Chart 2 on following page


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One can see how at the beginning of the crisis the ARRA transferred resources to the

states to cope with the downturn caused by the financial crisis. But by 2010, the abrupt

withdrawal of support to state and local governments led to a marked deceleration in the

trajectory of state and local spending that increased stress in states and communities

around the nation.

In summary, it appears that three factors account for the emergence of the pension fund

crisis: 1) the mismanagement of provisioning in some key states and pension funds

before 2007, 2) the consequences of the financial regulatory failures at the federal level

that led to the crisis of 2008 and the associated downstream state and local

consequences for revenues, and 3) federal fiscal austerity which led to smaller transfers

to states.

Overcompensation of state and local government workers relative to their private sector

counterparts does not appear to have been a primary cause of the challenges before us.

Of course, even if excess compensation was not a substantial cause of the pension crisis,

it does not mean that there will be no efforts to trim future and even existing pension

benefits to respond to the challenge. The tension between tax hikes of one form or

another, cuts to subsidies or tax incentives, reduction of current services and the funding


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of pensions is in the cauldron of political struggle. The incentives of the American

money-driven political process may well produce the restructuring and imposition of

burdens that bear little relation to the causes of the crisis.11 Before looking at the

important and timely case of the Detroit bankruptcy, it is important to explore more

deeply two more dimensions of the environment pertaining to state and local budgetary

politics.

11See Lou Debose, Shock in Detroit: Workers Lose in Bankruptcy Court, Washington Spectator, accessed Feb. 24, 2014,http://washingtonspectator.org/index.php/Politics/shock-in-detroit-workers-lose-in-bankruptcy-court.html#.UwPQYHmRwlO.


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The State of Confusion

The relationship between labor and capital is shaped heavily by the efforts of

states to attract capital, and the conflict between labor and capital as such

becomes a conflict between labor and the state.12

As we look at Detroit and other state and local budgets around the nation, it is important

to consider them in the context of the challenges that all localities, states, regions and

nations now face in striving for prosperity. There is a fierce competition to attract

investment to each region, which is particularly important to budgets in local economies

because the scale of subsidies and tax incentives that are offered are often large in

relation to the size of the budget. Note that these budget allocations are not merely zero

sum transfers that can be taken away when the money is needed for pension

provisioning. In essence these subsidies and tax incentives are designed to enlarge the

revenue base, support employment, incomes, and property prices in the region or

locality that offers them.

There is a considerable literature on the performance of these types of budget

allocations, which raises serious questions about how effective they are in attracting new

business at the margin. The politics of campaign finance is likely to complicate matters

further as the social benefits to the community of attracting new employment and

commerce depends upon a skillful strategy of implementation. The refractory nature of

money politics, sometimes called rent seeking, may have the capacity to divert these

programs from their social purpose and to provide windfalls for existing entities that

provide campaign contributions and, as a result, deplete the revenue base of the

community in question and add to budgetary stress.

A question also arises of whether these incentives offer much to inspire new enterprise or

merely offset competitive disadvantages embedded in some other aspect of the tax code

in the community, or some deficiency in infrastructure or administrative quality. 13

The courtship of capital, both financial and technological, has become a fearsome force

all around the world. Critics worry that the relative power of capital has put us all into a

race to the bottom where tax revenues, labor conditions, environmental conditions,

and more are being eroded through interregional and international competition.14 This

process may resemble the famous prisoners dilemma in game theory: if all regions,

states and nations were to raise their environmental standards, labor standards, etc.,

then the arbitrage between regions would take place at a higher absolute level of social

12Wang Hui, Contradictions, Systemic Crisis, and Direction for Change:An interview with Wang Hui.Left China Review, accessed Feb. 24, 2014, http://chinaleftreview.org/?p=830 .

13For an excellent survey of the issues, see Peter S. Fisher and Alan H Peters, Tax and Spending Incentives andEnterprise Zones,New England Economic Review, (March/April 1997), accessed Feb. 24, 2014,http://bostonfed.org/economic/neer/neer1997/neer297f.pdf.

14See Chaos and Governance in the Modern World System by Giovanni Arrighi and Beverly J. Silver, University ofMinnesota Press 1999.


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conditions, though it must be remembered that the stability of such a cooperative

outcome is fragile and unstable. The temptation to cheat is very attractive and the

ability to coordinate such a level playing field is nearly impossible across the entire globe.

As a result, there are many times when, as Wang Hui describes, the interests of laborers

may appear to be in conflict with the governments efforts to attract capital. Rather thanserving as the mediator between labor and capital, the government seeks to compress

resources that raise the local communities living standards in the short run in the hope

of creating a more vital local economy in the medium term. This leads to a particularly

challenging set of policy considerations with regard to pension management and regional

development strategy. The temptation to underfund the pension for state or local

workers in order to enlarge the capacity to attract capital through tax breaks or subsidies

may be very substantial. In the medium term, these large unfunded pension liabilities

may raise the specter of a future tax hike to properly provision for the pension system

and deter enterprises from setting up shop or expanding capacity in the region. A third

factor is that the quality of the services, systems, and education arrangements for

families as well as ongoing training for members the workforce may be heavilyinfluenced by the compensation systems offered to teachers, administrators and law

enforcement officials. If the infrastructure deteriorates too markedly, it may become

untenable to maintain an enterprise in the locality in question. Typically, however, the

enterprises can move relatively easily, while the rest of the community cannot.

In Detroit, for example, the emergency manager is working to get pension liabilities

restructured. In this respect he is working to attract financial and technological capital

to a region that may fear tax hikes on local business to meet those future liabilities if they

are not reduced, while at the same time chasing away quality human capital from

working to make Detroit a more attractive place to locate. One can certainly ask whether

taking aim at pensioners, both present and future, is in the long-term interest of business

development in the Detroit metropolitan area. Strong societies need both financial

resources and high quality people, and finding the balance through the construction of

incentives is a very challenging aspect of regional development.


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Obstacles to Income Tax Increases

As states and cities attempt to meet obligations, raising the tax rate on corporations is

likely to meet with resistance on grounds that it will sour the investment climate as

considered above. Raising income taxes is an alternative source of revenue, but critics ofthis strategy warn that it might precipitate a migration of high-income individuals out of

the area in question and defeat the purpose.

An additional challenge to taxation derives from the toxic cocktail of the need for

campaign contributions on the part of those aspiring to elected office and the increasing

concentration of income that appears broadly evident in recent years in the U.S. It is a

reasonable guess that as fewer and fewer people make most of the income, the resistance

to raising income taxes in high brackets will be exacerbated. If income is evenly

distributed in a community, no one has the incentive to take on the fixed cost of the fight

against higher taxes. The fixed cost of a campaign against taxation is likely to be much

higher than the benefits of winning the campaign. But as income becomes concentratedin fewer hands, the benefits of mounting a campaign increase in relation to the fixed

costs. In that case, the resistance to taxation may be more formidable. 15

Furthermore, as wealth becomes concentrated and the courts condone innovative forms

of campaign finance that avoid limits to individual donations, elected officials and

aspiring elected officials have little choice but to abide by the wishes of this narrow

segment of the body politic. This amplifying feedback system between the concentration

of income and wealth, the need for campaign finance contributions and the policies

elected officials will consider to address fiscal challenges may close the door on tax

increases as a way to alleviate stress in a fiscal crisis. Between concentrated lobbying

and the financial interests of corporations on the one hand, and the narrow group of

wealthy people in the community increasingly able to block tax increases on the other,

the issue of making required contributions to pension funds may come down to a battle

between cutting current services and choosing a higher discount rate to pretend the

investment portfolio returns will reconcile the difference. This is especially likely to be

the case as the scale of the pension obligations grows and the ARC becomes large as a

proportion of the total current services budget.

15Again see the Sirota study for the Institute for Americas Future and the David Johnson article cited above in Footnote 2


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Alternative Assets to the Rescue

(Fixing or Digging A Hole?)

As we have seen, tensions at the state and local level have led to great stress in thebudgetary process. This can result in a high assumed discount rate becoming a

performance imperative, despite the unrealistic nature of such assumptions. As

government bond yields have declined to very low historical levels, the present value of

pension liabilities that should be provisioned for grow and threaten to crowd out current

services, while other forms of budgetary adjustment may be blocked by concentrated

interests. In such a scenario, the attraction of investment alternatives that are said to

have a record of substantial returns and are not closely correlated with the stock indices

has led to a substantial increase in the proportion of portfolios allocated to alternative

assets16

Alternative asset investments, primarily hedge funds, venture capital funds and privateequity investments combined averaged just below five percent in the portfolio allocations

of U.S. public pension funds between 1984 and 1994. For the period between 2008 and

2011, they have grown to nearly a 20 percent share.

16The measurement of results is controversial to say the least. Deep suspicions regarding the results reported byalternative asset classes are underscored in the Disclosure document filed with the bankruptcy judge on February 21, 2014regarding the Detroit bankruptcy resolution plan. The emergency managers report, which looks at factors thatcontributed to the underfunding of the pension plans states, Finally, it appears that a large portion of the assets of therespective Retirement systems is invested in alternative investments for which no recognized market valuation exists.(Special Information Regarding Pension Claims, 5).


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Given that historical data suggest low correlations with equity markets over the long

term and that substantial returns have been reported in these asset classes, it is easy to

understand the attraction of such investments to pension funds. Yet in times of stress, it

is unclear whether reaching for yield is a prudent strategy or reflects funding

desperation. Clearly, the very best hedge fund managers have been consistentgenerators of high returns. Venture capital, in contrast, has been much more volatile.

Private equity and direct real estate investments show very uneven returns based on

studies of the investment performance of public pension plans.

These new asset classes create challenges on the ethical front. The public taxpayer

obligations to pay defined benefit pensions and the assets in the pension funds are both

public goods in the hands of representative government. The logic of collective action

would suggest that these public goods could be abused without strict oversight, clear

rules, and vigorous enforcement. In Section II.A.2 of the Disclosure Statement With

Respect to the Plan for the Adjustment of Debts of the City of Detroit filed on February

21, 2014, Detroit Emergency Manager Kevin Orr states:

Serious allegations have also been made that various former officials of the

Retirement Systems accepted bribes and/or misappropriated assets of the

Retirement System for their own personal gain.

Around the country, forensic investigations commissioned to examine pension plans in

severe difficulty have raised some significant concerns, particularly about the

transparency of investments in these alternative asset classes and the incentives that

pension fiduciaries are subject to as part of the investment selection process. In cases

such as Rhode Island, Kentucky, and North Carolina, investigations have raised

searching questions about the conditions under which pension funds are allowed to

invest in alternative assets. In particular, it appears that pension investors are not

afforded the same access to timely and high quality information about the alternative

investment holdings and performance as other investors. Such a disadvantage could be

significantly detrimental to the returns that pension plans receive on their investments

relative to the published performance indices for alternative assets.

A second concern about alternative investments relates to the role of placement agents

who represent an alternative investment fund and the incentives they create for

fiduciaries in a particular state or locality to allocate pension investment capital to their

clients fund. 17Pay to play schemes in which agents give financial incentives to peopleresponsible for pension fund allocation decisions are a potential problem, as are

contributions to political funds that are used to support campaign for elected pension

officials in question. It is difficult to assess the impact of these influences on investment

decisions given the poor quality of disclosed information on the performance of

17See in particular, Report of the Independent Counsel to SEC: Placement Agent Abuses at Kentucky Retirement SystemMarch 2012, accessed on Feb. 24, 2014, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2112594 .


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alternative investments in public pension funds, but a series of cases raise deep

misgivings.

Scholarly evidence on performance of alternative assets augments the forensic

investigations and reveals a variety of issues of concern. In a paper on the role of private

equity investments for public pension funds, the authors find that private equityinvestors in venture capital and real estate exhibit a substantial home bias in states

that exhibit a political climate characterized by more self-dealing. The results are an

overweighting of in-state assets and a performance of 2 to 4 percent lower return on

these assets than either their investments out of state in similar asset classes or the

performance of out of state investors on similar assets within the state.18 Extensive

empirical testing using measures of the degree of state corruption find significant

evidence of such an effect.

Misalignment of the incentives of taxpayers and pensioners on the one hand, and the

officials investing the pension funds and receiving such financial support on the other,

seems fairly common. What appears to be a system prone to abuse suggests the need forsignificant reforms in the current stressful budgetary environment in order to realign the

incentives of pension officials responsible for the investment allocation decisions in

support of the taxpayers and pension recipients both present and future. Protection of

the pension assets, and therefore both the security of pension income and the taxpayers

contingent obligation, is a public good. Allowing corruption and/or ambition and

campaign finance to abuse this public good is a perversion of the old Chinese proverb

that crisis is opportunity. Rules and transparency in this sector will be difficult to

achieve state by state even enforcement of uniform standards will be difficult to

achieve. But a real reform agenda must include these provisions so that state and local

pension funds at least have a credible possibility to benefit from investing in the

ingenuity of hedge funds, private equity and venture capital.

A related concern that has raised questions from scholars involves the value of

investment advisory services that are purchased by many of the public pension funds.19

This research, based on a sample of investment advisors, suggests that advisors are very

influential in guiding investment flows but produce no discernable enhancement of

performance. While pension investment managers may receive an insurance-like

protection by consulting with reputable advisors, it is the pension fund that pays for their

services. At very least, it would be desirable to develop a public record of

recommendations from these advisors, so that hypothetical performance comparisons

become a factor in the advisors reputations that could be observed by plan managers

18See Yael V. Hochberg and Joshua D. Rauh , Local Overweighting and Underperformance: Evidence from LimitedPartner Private Equity Investments (October 2012), accessed Feb. 24, 2014,http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1798747 . See also Jeffrey R. Brown, Joshua Pollet, and Scott JWeinberger, The Investment Behavior of State Pension Plans, (September 2009), accessed Feb. 24, 2014http://www.nber.org/aging/rrc/papers/onb09-12.pdf.

19See Tim Jenkinson, Howard Jones and Jose Vincente Martinez, Picking Winners? Investment Consultants'Recommendations of Fund Managers, (Oxford University working paper: Dec. 2013), accessed Feb, 24, 2014,http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2327042 .


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before enlisting services. It would also be important to publish the costs associated with

these consulting services.


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Panic in Detroit20

In March 2013, an emergency manager was appointed by Republican Governor Rick

Snyder take over the restructuring of the City of Detroits finances. On February 21, 2014

he filed a disclosure document with the Federal Bankruptcy Court concerning the planfor the adjustment of the citys debt. This plan is the culmination of a long and painful

deterioration of what once was the fifth largest city in the U.S. All of the forces outlined

earlier in this paper, from macroeconomic shock to revenue collection investment

shenanigans and the politics of concentrated interests, are evident in what may be the

precedent-setting laboratory of state and local pension crises: Detroit, Michigan.

Long Term Forces Depressing Detroit

Detroit has been in secular decline for many years, with the city population decreasing

from 1.85 million in 1950 to 714,000 in 2010. This decline is important fiscally but

slightly deceptive to observers of the regions plight. Though the city population hasdropped sharply, the Metropolitan Statistical Area (MSA) of Detroit has been roughly

stable since 1970. The MSA had a population of 3.02 million in 1950 and is estimated to

be at 4.29 million currently.

Detroit offers the makings of a contemporary legend with the decline of the automotive

industry, the acceleration of racial tensions around the time of the riots of 1967, and the

blind eye turned by both the state of Michigan and the federal government to the citys

woes.21In the media, Detroit is painted as an urban other whose exclusion from

support from the federal government, or even the state government, is just and

warranted. 22 Detroit is now the great national metaphor for the politics of austerity,

exclusion and the various efforts to declare who and what is legitimate to sacrifice to

resolve the economic crisis.

Declining Revenues: State, Cyclical and Financial Shenanigans

Detroits declining revenues in recent years has several components. These include losses

associated with tension between the City of Detroit and the State of Michigan; losses

20The Detroit bankruptcy has received a great deal of media attention. Key documents the emergency managers report,accessed Feb. 24, 2014, http://www.detroitmi.gov/EmergencyManager/Reports.aspx and the very penetrating and insightful report by Wallace Turbeville, The Detroit Bankruptcy, (Demos: Nov. 2013),accessed Feb. 24, 2014, http://www.demos.org/sites/default/files/publications/Detroit_Bankruptcy-Demos.pdf.

21See Bernard Henri_Levy,American Vertigo: Traveling America In The Footsteps of Tocqueville. New York: RandomHouse, 2007.22The Detroit decline is portrayed as ruin porn in the media, including websites, books and photographic essays. On theWeb, see Detroit Ruin Porn, accessed Feb. 24, 2014, http://hyperallergic.com/16596/detroit-ruin-porn/ andFabulous Ruins of Detroit, accessed Feb. 24, 2014, http://www.detroityes.com/fabulous-ruins-of-detroit/home.php .See also Yves Marchad and Romain Meffre, The Ruins of Detroit, Steidl Publishers, 2011. For a serious history of Detroitsee Thomas J. Sugruem, The Origins of the Urban Crisis: Race and Inequality in Postwar Detroit, Princeton UniversityPress, 1996. See also Mark Binelli,Detroit City is The Place to Be: The Afterlife of an American Metropolis, Picador,2013.


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associated with the downturn, particularly after 2008 where declines in real estate

values, soaring unemployment and decreases in sales volume reduced tax revenue from

real estate, income and sales taxes; and losses associated with financial shenanigans in

which tax revenues were diverted to debt servicing and lost to the city.23

The highly fraught transfer of revenue from the State of Michigan to the City of Detroittook place in stages. First was the 1998 handshake deal by then-mayor Dennis Archer

and Republican Governor John Engler, which was to give Detroit $333.9 million

annually in revenue sharing funds for nine years. In return, Detroit would agree to cut

city income tax from 3 percent to 2 percent for city residents and from 1.5 percent to 1

percent for suburban commuters. In 2002, the state, facing an economic downturn, cut

the revenue sharing by $11.6 million. Thereafter, Democratic Governor Jennifer

Grandholm continued the cuts. By 2007, the end of the nine-year deal, the city claims to

have lost $220 million in revenue sharing and $433 to $508 million dollars in funds not

collected as a result of lowering the income tax.24

Another drama where the state cut down on transfers to the City of Detroit occurredagain in the period between 2010 and 2012. There are two aspects of the revenue decline

during this period. First, beginning in FY 2011, Detroit got a smaller share of state sales

tax revenue as a result of the 2010 census, which led to a cut of roughly $24 million in

city tax revenue per year. Second, the state legislature amended the statue for revenue

sharing for FY 2012 and cut an additional $43 million in revenue sharing. 25 This policy

decision should be viewed in conjunction with the governors decision to shortly

thereafter appoint the emergency manager Kevin Orr.

Between 2010 and 2013 over 47.8 percent of the total decline in city revenue was a result

of the decline in state transfers to the City of Detroit. When Detroit went over a cliff into

bankruptcy the state could be rightly accused of providing major a major shove.

23Wrestling between Detroit and the State of Michigan over transfers and tax rates in the City has a long and sordidhistory. See Melissa Maynard, Detroit and Michigan A Fragile Bargain,Stateline, accessed Feb. 24, 2014,http://www.pewstates.org/projects/stateline/headlines/detroit-and-michigan-a-fragile-bargain-85899402959 . See alsoDavid Ashenfelter, Detroit Bankruptcy: Handshake Deal between Governor John Engler and Mayor Dennis ArcherHaunts City,Mlive, accessed Feb. 24, 2014,http://www.mlive.com/news/index.ssf/2013/07/detroit_bankruptcy_handshake_d.html .24See calculations provided by the Center for MichigansBridgewebsite, accessed Feb. 24, 2014,http://bridgemi.com/wp-content/uploads/2013/03/Detroit-tax-calculation-chart.pdf.

25This is covered in detail in the Wallace Turbevilles report, The Detroit Bankruptcy done for Demos.


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To see this data as contribution to the change:

The second dimension of the loss of revenue related to the downturn in the economy can

be seen in the tables above. Sales taxes fell significantly and property taxes declined as

well. These are cyclical effects. Other revenue also declined sharply, in part due to the

business downturn and its impact on the Detroit Water and Sewage Departments net

revenue. This decline is also the result of the aftermath of the restructuring of the

disastrous and scandalous derivative trades done in relation to the Certificates of

Participation used to fund the pension fund shortfall. The extreme penalties associated


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with credit downgrades of the City Detroit led to an issuance of $1.16 billion of debt that

encumbered the revenues of the Sewage and Water Department. Roughly $547 million

of penalties were financed with this debt.

City Expenses

The City of Detroit has cut 2,350 jobs since the beginning of the Great Recession and has

reduced expenditure by $356 million in that time, despite $31 million of increased

financing costs related to a derivatives contract.26 During that period, so-called legacy

expenditures rose by roughly $63 million. Legacy expenses are related to financing costs

and to increases in benefits. Nearly half of the increase in legacy costs derives from the

same very questionable derivatives trade. (COP swaps plus COPs)27

The other large contributor to legacy expenses was a rise in healthcare benefit costs, an

increase that is not specific to Detroit, but rather a reflection of a nationwide healthcare

cost inflation problem. In fact, healthcare inflation in these Detroit benefits has grown

over the period at about 3.5 percent, a half percentage point below the average rate ofincrease over the same period in the nation as a whole.

Given that U.S. healthcare is the most expensive in the world and the World Health

Organization rates its quality at 37th globally, this is an area for savings across the nation

and a symptom of dysfunctional governance at the federal level that has been raging for

some time.

Were Pension Funds the Culprit?

For a close analysis of Detroits pension situation, Wallace Turbeville, Senior Fellow at

Demos, provides an excellent report, which we augment with data on the adequacy of

pension funding across the nation. The following data and charts make clear several

things:

1. Detroit public sector wages were not out of line with the wages and benefits being paid

to other major cities in the midwestern United States and are not a large per capita

burden when compared to other cities.

26Turbeville reminds us in the Demos report that the mayors financial manager, who was the major advocate for thosederivative transactions, left a few months after the deal and joined the firm SBS financial, which was a private sectorcounterparty to those transactions. Further controversy erupted recently when the individual in question was revealed tobe romantically involved with the CEO of SBS Financial. See Robert Snell and Chad Livengood, Close ties put Detroitpension deal brokers under scrutiny, The Detroit News, accessed Feb. 24, 2014,http://www.detroitnews.com/article/20140207/METRO01/302070042#ixzz2uGa07EDc.

27The Certificates of Participation were bond-like instruments set up to fund the pension obligation. Turbeville describestheir origin and suggests they may have been created to get around the constraints on issuing debt. In essence, theseinstruments were created on the belief that borrowing at a fixed rate and investing in equities would in the long-termaugment the citys finances. See the Demos rport on the COPs and Swaps and the Swap termination agreements.


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2. The two major pension funds in Detroit, the Detroit Police and Fire Retirement

System and the Detroit General Retirement System, were funded at 99.9 percent and87.1 percent as of 2012, according to the data at the Center for Retirement Research.

The actuarial value of assets for the DPFRS was $3.81 billion and for the GRS was $3.24

billion. As with all of the artful accounting practices associated with the choice of

discount rate, this may or may not be good prediction of the funding coverage. The

choice of a high discount rate may lead to a substantial undervaluation of the pension

liabilities and overstate the funding ratio. Too conservative a measure may lead to an

understatement of the pension liabilities overstatement statement of the funding ratio.

3. Detroit retirement healthcare plans do not appear to be excessively generous when

compared with other plans in our country:


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Some commentators are suggesting that the numbers on funding ratios (Item 2 above)

are overstated and advocate a cut in the Detroit pension and retirement healthcare

obligations.28 They argue that this is justified because city official issued securities in

2005 to correct underfunding of the pensions. At that time, city officials issued $1.45

billion in Certificates of Participation (COPs) and deposited the proceeds into the public

pension funds to reduce the underfunding of the Detroit General Retirement System(GRS).

Andrew Biggs at an American Enterprise Institute conference on February 18, 2014

entitled Detroit Bankruptcy: Conflicts and Implications, argued that perhaps the

Detroit pensioners should be given the current asset pool to meet the pension obligations

and thereby remove the defined benefit guarantee that city employees were given. They

seem to conclude that the pensioners, rather than the city government, were responsible

for bad management and therefore deserving of penalty. This line of reasoning is

dubious for several reasons.

First, the defined pension obligation of the City of Detroit is not changed by how the cityofficials chose to meet that requirement, whether they decide to raise taxes or issue

bonds to fund higher yielding assets. Planning errors or investment mistakes on the part

of city officials do not justify cuts to pension payments because the pensioners are not

responsible for the shortfall. Mismanagement by the government is the responsibility of

the public at large and is not in itself a basis for punishing certain citizens who receive

public pensions in return for their services.

Secondly, panelists discussed how pensioners lacked a significant co-pay compared to

the contributions made to pensions by their private sector counterparts. He also pointed

to how members of the General Retirement System of Detroit also receive Social

Security. These assertions must be considered in light of evidence highlighted earlier in

this paper that public officials often receive lower wages throughout their career and

higher benefits upon retirement. As a result, there may be an implicit dimension of co-

pay in lower wages that have not burdened the city budget during the working life of the

employee. In addition, Social Security recipients also make contributions to the system

throughout their working life, so this form of payment is not a free handout as implied.

Third, Andrew Biggs indicated that 13th check bonus payments were given to

pensioners at various times in the past between 1985 and 2008, and while such

mismanagement by city officials and payments to an earlier vintage of retirees are

regrettable past mistakes and worthy of disapproval, there is no reason why current andfuture retirees should be penalized. Of course, it would be interesting to find learn

exactly how much of those checks went into the pockets of current pensioners. But

28 See The Looting of Detroits Pensions, by Andrew G. Biggs at http://www.american.com/archive/2014/february/the-looting-of-detroits-pensions Also see the American Enterprise Institute conference entitled The Detroit Bankruptcy:Conflicts and Implications, February 18, 2014. It can be viewed on video at http://www.aei.org/events/2014/02/18/the-detroit-bankruptcy-conflicts-and-implications/


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absent that quantitative information, it is curious to view current and prospective

pensioners as responsible for mistakes made by others and benefits paid over periods

during the previous 29 years.

The Detroit facts are really quite simple. The revenue losses have resulted from declines

in real estate values, loss of income and loss of sales volume attributable to the crisisemanating from Wall Street after 2008. A drastic cut in state revenue sharing from the

state of Michigan to Detroit in 2012 occurred on the back of previous cutbacks from the

state to the city over nine years. The coup de grace was the derivatives transaction that

led to diminished other revenues from the Detroit Water and Sewage Department and

a swaps termination penalty that led to marked increases in cash flow demands on the

City of Detroit.29

The Emergency Managers Actions

Based on the disclosure documents filed with the United States Bankruptcy Court on

February 21, 2014, the emergency manager of the City of Detroit has reacted by seekingto:

1. Cut pensions of the General Retirement System by 34 percent

2. Cut pensions of the Police and Fire Retirement System by 10 percent

3. Write down General Obligation bonds by 80 percent

4. Continue to negotiate with financial institutions outside of the bankruptcy

process on the swap termination payments, and

5. Eventually privatize the Detroit Water and Sewage Department which could lead

to a further shedding of pension benefits as the privatization will likely lead to a

reclassification of pension obligations that make them subject to the less

stringent private sector restrictions on modification.

The emergency manager has made no known attempt to restore the state transfer of

revenue that was cut off by the state legislature in 2012 or before, nor has he attempted

to make any changes in the corporate incentive packages for downtown Detroit

development. 30 In addition, little consideration been given to increasing the water rates

charged by Detroit Water and Sewage to 3 million Michigan citizens who are served by

this utility.

The state legislature in this same difficult period has offered to support a new hockey

arena in downtown Detroit and the City Council has also voted to support it.31 This

29See Wallace Turbeville, The Detroit Bankruptcy, Demos, November 2013, accessed Feb. 24, 2014,http://www.demos.org/sites/default/files/publications/Detroit_Bankruptcy-Demos.pdf.

30See Turbeville, The Detroit Bankruptcy on the corporate incentives.31Joe Guillian, New Detroit Red Wings arena wins financing approval, USA Today, (Dec. 20, 2013), accessed Feb. 24,2014, http://www.usatoday.com/story/sports/nhl/wings/2013/12/20/detroit-red-wings-joe-louis-arena-downtown-financing-city-council/4150229/It must be noted that the downtown population of Detroit is now over 80 percent black and African Americans are notnoted for being patrons of ice hockey.


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crisis has little to do with the ability to pay: the structure of the Detroit bankruptcy is a

crisis of choice and the choice is not to pay pensioners.

Detroit is the perfect example of what one might call the operation of the Logic of

Collective Action. The proposal to cut the pensions and benefits of city workers does not

appear to be based on any proof of excess, or excessive numbers on the payroll. Ratherwe see reluctance to draw on the resources of the surrounding region (the so-called Tri

County area) or of the state as a whole to generate revenue. The proposed sell off of the

Detroit Water and Sewage Company make little sense. There is no federal contribution

to the adjustment and yet much of the deterioration in the citys finances is directly

related to national policy.

Pension restructuring is on the agenda, not because it is deserved or just, but because it

can be executed politically. Those who cite union representation on pension board of

trustees as evidence are acting as if those people control the pension funding and

investment decisions on behalf of the beneficiaries and therefore they should pay for

their errors. Pension fidiuciary boards, in Detroit and elsewhere have many memberssometimes including union representatives. Concentrated interests can defend

themselves and moneyed interests can alter the incentives of an ambitious politician

seeking to gain or to maintain office. They may also serve on pension boards of trustees.

The logic of this process is disturbing. It is a problem of governance. But it is all of our

problem. Not a problem to blame on the pensioners primarily.

Also note the long controversial history of stadium subsidies. See, David Cay Johnston,Free Lunch:How the WealthiestAmericans Enrich Themselves at Government Expense (and Stick You with the Bill),(Portfolio Trade, 2008), for anilluminating discussion of this history.


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Conclusion

The state and local pension crisis appears to be the result of several factors, some

internal to the state or locality and some external. The external factors that loom very

large are the shocks associated with the financial crisis of 2008, particularly as theyrelate to tax revenue at the state and local level, and the impact of federal fiscal austerity

on transfers to states. These stresses are manifest in the state and local budgets and in

the pressures that have in many cases contributed to underfunding of pensions.

As we have seen, the experience of public pensions is not uniform. The good news is that

a large number of pension plans appear to have been prudently managed, even through

the recent series of extraordinary challenges. The heart of the problem seems to be

located in a few states that simply did not historically provision enough for pension

liabilities. Once significantly underfunded, pension funds enter a downward spiral that

depletes the asset base to pay current pension obligations and weakens the fund for the

future. It may be, as some experts suggest, that many more funds are at risk of enteringthis death spiral because the threat of deterioration is masked by using an unrealistic

discount rate to reflect future returns rather than the riskless rate to estimate the present

value of pension obligations. It appears that a range of scenarios between riskless rate

discounting and rates that approximate historic returns should be regularly provided in

pension performance documentation.

The discount rate choice may play a role in enabling those overseeing pensions to deny

an emergency situation, but remarkably, the funds that were in trouble appeared to

provision for pension obligations well below the level required for sustainable funding

evenusing a discount rate that contains a substantial risk premium. In addition, it is fair

to ask whether governments are not in the place to earn the long-term benefits of the

premium on equity. This is where risk can be pooled if done honestly.

The main feature of what leading pension expert Alicia Munnell describes as bad actors

is a political process that does not meet its responsibilities. In order to avoid pension

crises in the future, it is necessary to understand what creates them and what role money

plays in their activities. In his famous book, The Logic of Collective Action, Mancur

Olson discussed how difficult it is for a political process to defend the common interest

against the pressure of concentrated vested interests. The case of Detroit, where pension

obligations are on the table for restructuring while the state and city are approving

money to fund a new hockey arena, is illustrative.

More broadly, the Illinois legislatures support of the reduction of pension benefits while

approving of a substantial decline in the corporate income tax suggests that pressures on

elected officials may reflect both the power of concentrated interests and concerns about

the role of taxes and subsidies in maintaining a revenue base when capital is very

sensitive to the economic environment and mobile both within the nation and globally.

Pension crises in the U.S. are not like corporate bankruptcies in which the capacity to


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pay is beyond the pale. These are crises of choice, and at times, the choices appear quite

arbitrary.

The issues surrounding U.S. pensions raise concerns about the responsiveness of the

political system to broad social concerns when income and wealth are concentrated and

electoral candidates need to raise substantial campaign finance. Under thesecircumstances, how do legislators call for tax increases when they are required? The

allocation of pension funds in the pay to play schemes represented by the use of

placement agents is a further cause for concern.

Numerous pension fiduciaries, trustees and attorneys general appear reluctant to take

action when public demand for transparent reporting on how pension assets are invested

and how specific alternative assets have performed is strong. This is particularly

worrisome. The evidence from forensic investigations on the relationship between

campaign support for fiduciaries or other officials and sub par performance may not

show a significant macro cause of the underfunding crisis, but the rapid increase in

alternative assets, particularly private equity and hedge fund investments, and thepressures to reach for yield out of despair when they are underfunded, may make the

lax policies on alternative asset disclosure and the use of placement agents a dangerous

practice of the first order in the future. While the long-term track record of alternative

asset classes is quite favorable, it is important to put in place policies that fortify the

integrity of the investment process. Those same returns should be available to pension

funds that invest in these asset classes.

Finally, the most important issues underpinning this discussion of dysfunctional politics

and pension reforms pertain directly to the future functioning of society. Pensioners,

present and future, are diffuse and politically weak. They may, therefore, bear the burden

of adjustment to a prolonged crisis that is not of their making. We are seeing the erosion

of the credibility of pension promises, along with the deterioration of the security and

compensation associated with public sector employment relative to the private sector.

Evidence shows clearly that private sector wages plus benefits are comparable to public

sector wages with the exception of highly educated workers, who are already significantly

undercompensated in the government sector a surprising fact given the medias

intense attention to the power of the teachers union.

The state and local government sector makes up about 14 percent of the American

workforce, a significant figure. Given the results of studies that suggest that both

government and private sector employees are quite sensitive to relative compensation,one could expect a substantial migration out of the public sector over time in response to

pension and health benefit cuts. This reduction in demand for government labor may

lead to a particularly strong outward migration from the public sector to the private

sector of the well educated. This could have several likely ramifications. First, it is likely

to drive down compensation in the private sector relative to returns to capital and

further exacerbate inequality in the American economy. In that respect, public sector

pay acts as a reservation wage that mitigates inequality. It provides an alternative place


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of work, with reasonable compensation, when the imbalances of negotiating power

between large organizations and their non-union workforce becomes extreme. Second, it

will likely lead to a brain drain in public administration and in our public education

system. This could reduce the quality of government services and the quality of human

capital we are investing in for the future. Third, the migration of workers will likely

make compensation and employment in the economy as a whole more volatile and mayincrease macroeconomic instability.

Public sector pension plans and their modification cannot be viewed in isolation. They

are embodied in budgets and as a result are in tension with other services and the

resistance to taxation. Yet when the obligations are agreed to, but not provided for, a

train wreck is set up. When the tensions are resolved along a political logic of might-

makes-right, people do not just sit down and take it.32 When pensions are negotiated to

protect the elderly and more senior at the expense of the potential new recruits,

employee contributions are lost in the future. It is not just the simple dogma and

resentments used in media campaigns that matter in the longer term. Society can do

harm to itself when the indirect consequences of a power struggle yield an unfortunatedesign.

The role of money power in governance wreaks havoc everywhere, from the exorbitantly

high costs of health care to protect insurance and pharmaceutical companies to a

dangerously ungoverned financial system and a lack of progress on reaching a social

price of carbon. These problems, along with distortions to the tax code and corporate

subsidies at the local level which impact pensions, all scream out for publicly financed

elections. Detroit is the canary in the American municipal coalmine, and might-makes-

right politics undermines the citizens sense of government legitimacy. On the right,

there is plenty of political dysfunction to point at to validate disappointment in

governance. On the left, romantic notions of government are in tatters, though one can

clearly see the fingerprints of the private sector and rent seeking in this dysfunction. On

the course charted by Kevin Orr, the Detroit emergency manager, we can see that

demoralizing dysfunction is unfolding vividly.

At this juncture, it is worth remembering Gil Scott-Herons famous lyrics:

That when it comes to people's safety

Money wins out every time.

And we almost lost Detroit this time, this time.

How would we ever get over over losing our minds?You see, we almost lost Detroit that time.

32For a different view, see the assertion by Andrew G Biggs at the AEI conference on the Detroit Bankruptcy in February2014 that the impact on labor mobility would likely be minimal in the aftermath of a Detroit pension restructuring makingpublic employees accept a defined contribution pension plan. He believes this will inspire other localities to follow theexample in Detroit. See his comment at the 1:47:50 mark of the video, accessed Feb. 24, 2014,http://www.aei.org/events/2014/02/18/the-detroit-bankruptcy-conflicts-and-implications/ . Biggs asserts that the publicworkers would likely accept the loss of having their pensions converted to defined contribution plans. I believe that faith inthe market would lead to different conclusions. The work of Borjas cited above suggests otherwise, particularly for themost skilled segments of the public sector workforce.


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What happens in the Detroit bankruptcy now, particularly as it relates to pensions and

retiree health benefits, will greatly impact the U.S. economic structure and the

distribution of income and wealth across the nation. Depending on what is decided,

future artists may be inspired to paraphrase Scott-Heron and say that in Detroit, We

almost lost America that time.

rj pensions 745p

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