The Commonwealth of Puerto

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1 Federal Focus The Implications of Puerto Rico s Pension Plan Crisis A Teaching Moment By Emily Swenson Brock GFOA is focused on ensuring that any federal support plan for Puerto Rico is specific to the island and does not include elements that would undermine the authority of mainland state and local governments to effectively govern and finance their pension plans. The Commonwealth of Puerto Rico s financial condition has been a matter of concern for several years, and efforts to devise a strategy that would return the territory to fiscal solvency and protect bondholders have been underway for months. As the U.S. Treasury Department, Speaker of the House, and Chair of the Senate Finance Committee have proposed options to address Puerto Rico s debt crisis, the Government Finance Officers Association (GFOA) is focused on ensuring that any federal support plan for the island is specific to Puerto Rico and does not include elements that would undermine the authority of mainland state and local governments to effectively govern and finance their pension plans. THE SITUATION Even after raising taxes and severely cutting its budget, Puerto Rico needs to close a cumulative fiscal deficit of $63.4 billion over the next 10 years, not including its estimated $43 billion in unfunded pension obligations. Puerto Rico s unsustainable debt load is significantly higher than that of any U.S. state. 1 As of March 1, 2016, Puerto Rico has repeatedly warned that it will have to modify its debts either by delaying payments or persuading creditors to accept less than they are owed. The territory doesn t have a mechanism for municipal bankruptcy and has asked Congress to create one for it. Puerto Rican officials have said that they need to restructure their debt burden but first need the protection of Chapter 9, which covers insolvent municipalities in the 50 states. Others say the Territorial Clause of the U.S. constitution may give Congress the authority to enact laws that would allow Puerto Rico to restructure its debt without declaring bankruptcy. This leaves the territory in a complex conversation about debt restructuring, with an electorate divided over any federal solution that smacks of neocolonialism, Congress divided along party lines over what elements should be included in such a solution, and creditors working to develop their own proposals to deter the government of Puerto Rico from accepting any federal support. FEDERAL PROPOSALS The U.S. Treasury Plan. The U.S. Treasury Department proposed a new legal framework in response to Puerto Rico s already defaulting on some of its bonds. Members of Congress and some financial experts say that Puerto Rico s troubles will become increasingly unsolvable if some kind of restructuring framework is not approved soon. Under the Treasury s proposal, Puerto Rico would be able to avoid bankruptcy, with the White House and Congress appointing members of a financial 50 Government Finance Review April 2016

2 control board that would oversee a comprehensive restructuring of the territory s overall debt. The Senate Plan. House Speaker Paul Ryan (R-WI) and House Natural Resources Committee Chairman Rob Bishop (R-UT) have organized a similar approach. Republicans have developed a different proposal. In the Senate, Senate Finance Committee Chairman Orrin Hatch (R-UT) has introduced the Puerto Rico Assistance Act of 2015 (S 2381). The bill aims to address Puerto Rico s potential bond default by slashing employee payroll taxes and extend targeted funding beyond addressing Puerto Rico s deb. However, the bill would include broad public pension requirements that are not germane to the underlying legislation and do not protect benefits, save money, or improve retirement system funding. S 2381 includes language from the Secure Annuities for Employees Act (SAFE), which would allow state and local governments to offer a new type of defined benefit plan consisting of individual deferred fixed-income annuity contracts. State and local government employers would purchase these contracts from annuity providers on behalf of their employees, and the contracts would be fully guaranteed by a state guaranty association. Also included in S 2381 is language from the Public Employee Pension Transparency Act (PEPTA), sponsored by Representative Devin Nunes (R-CA). A previous version of this legislation was sponsored by Senator Richard Burr (R-NC). This section of the Senate s Puerto Rico Assistance Act would require state and local governments to report their financial data to the U.S. Treasury Department using the so-called guaranteed rate of return in other words, as though they were invested only in U.S. Treasuries (which would earn approximately 3 to 4 percent), rather than the diversified portfolios actually in use (which earn an average 7 to 8 percent). This would create a false picture of the true condition of public pensions, creating a lower valuation in almost every case and drastically affecting the plans apparent financial health. PEPTA would create an additional expensive federal bureaucracy that only adds red tape to state and local government operations and diverts taxpayer resources from other priorities. GFOA S OPPOSITION As part of a coalition of state and local public pension associations, GFOA wrote to Hatch to express its strong opposition to the public pension requirements contained in the Puerto Rico Assistance Act of GFOA recommends severing the link between state and local pension provisions from S 2381 that relate to congressional oversight and assistance to Puerto Rico. In the letter, GFOA reinforced that these provisions are not limited to the territory of Puerto Rico, but instead impose a federal mandate on all state and local governments in areas that are the fiscal responsibility of sovereign states and localities and would be conflicting, administratively burdensome, and costly. The letter reiterated that the provisions of the Puerto Rico Assistance Act of 2015 are not germane to the underlying legislation and do not protect benefits, save costs, or improve retirement system funding. PEPTA would create an additional expensive federal bureaucracy that only adds red tape to state and local government operations and diverts taxpayer resources from other priorities. In February 2016, Hatch required detailed financial information from Puerto Rico s governor, Alejandro Garcia Padilla. Hatch outlined his concerns with the acquisition of recent verifiable financial information and what appears to be a large stock of severely underfunded public pension promises in Puerto Rico. 2 He sent Padilla a questionnaire that explicitly links Puerto Rico s fiscal distress to concerns about state and U.S. local pension systems in general, saying that the situation in Puerto Rico is analogous to pension plan crises in other parts of the United States. In question 5, Senator Hatch states, as with Puerto Rico, many state and local public pension plans are critically underfunded: aggregate estimates of underfunding range from around $1.3 trillion to over $4.0 trillion, with differences accounted for by varying assumptions. Moreover, underfunded public pension plans have factored into resolutions of a number of recent, large municipal bankruptcies and it is likely that future municipal bankruptcies will also involve, in one way or another, underfunded pension plans. This language is a matter of concern. April 2016 Government Finance Review 51

3 Hatch s statement is inaccurate on two fronts. Not only does it indicate that Puerto Rico s financial situation is comparable to that of other U.S. states and localities, but it also posits that future municipal bankruptcies will be caused by underfunded pension plans. This oversimplifies a wide landscape of highly complex funding, transactional, and legal processes. Because financing methods and assumptions can differ from one locality or plan to another, caution should be taken when making broad comparisons. THE REAL CONDITION OF PUBLIC PENSION PLANS The situation in Puerto Rico has provided Hatch and others with a simplistic and misleading soundbite, but examining the circumstances here allows us to provide a more accurate representation of U.S. pension plans. The true state of U.S. pension funds can be determined by examining information from the Pension Plan Database (publicplansdata.org), a free and publically available resource that is developed and maintained through a collaboration of the Center for Retirement Research at Boston College, the Center for State and Local Government Excellence, and the National Association of State Retirement Administrators. The database captures and reports key data for public retirement systems and plans that together account for more than 85 percent of the participants and assets in the U.S. public pension community. Congressional proposals to address the problems with public pension plans create a sweeping solution where no solution is needed. In other words, these policies are not limited to the plans that are in distress. Instead, they are designed to impose a federal mandate on all state and local governments in areas that are the fiscal responsibility of sovereign states and localities. When Congress makes broad comparisons across all pension systems, it is assuming that state and local governments are ignoring the problem, which is very much not the case. Because financing methods and assumptions can differ from one locality or plan to another, caution should be taken when making broad comparisons. While funded ratios among pension plans vary substantially in the aggregate, public pension funding levels rose steadily during the 1990s, largely because of strong returns in global equity markets, according to the Pension Plan Database. Since then, sharp market downturns in 2000 to 2002 and 2008 to 2009 negatively affected asset values and increased unfunded pension liabilities, requiring greater levels of contributions. A combination of the market downturns, insufficient contributions (for some plans), and increased benefit levels (also for some plans) resulted in an aggregate funding level of 72 percent in 2013, well below the 2001 peak of 103 percent. 3 A 2015 survey administered by the National Council on Public Employee Retirement Systems put public pension funding levels at 74.1 percent, up from 71.5 percent the year before. Among the nearly 200 public retirement systems surveyed, the average cost to administer the plans was 60 cents for every $100 managed, down from 61.1 cents a year earlier. 4 Not only are systems making policy changes to increase funding levels, but they are also decreasing their overall costs. The damage weathered by many systems through the tough fiscal years postgreat recession has not gone unnoticed by the fiduciaries of these funds. Nor has it been ignored by state and local governments. There is no fiscal epidemic threatening state and local pensions, but pension funding levels are still not close enough to peak funding. Some legitimate concerns still exist about the extent of underfunding in certain jurisdictions; however, in these cases, a modest increase in contributions to take advantage of compound interest, or modifications to employee eligibility and benefits, or both, will be adequate to remedy the underfunding problem. The data show that all state systems and many local public pension plans are enacting significant reform measures to remedy the underfunding problem. From 2009 to 2014, every state has made changes to pension benefit levels, contribution rate structures, or both. 5 In addition, state and local governments operate under a long-term time horizon, and they have taken, and continue to take, steps to strengthen their pension reserves. Furthermore, state and local government retirement systems do not operate in a vacuum they are established and regulated by state laws and, in many cases, further subject to local 52 Government Finance Review April 2016

4 governing policies and ordinances. This means that localized decision making and policy implementation are well suited to addressing the vast majority of pensions systems in the United States. Many of the policy changes governments have made were tailored to the unique needs of the pension stakeholders, without the need for ill-fitting federal mandates or interference. EXPLAINING THE COMPLEXITIES The Puerto Rico Assistance Act of 2015 comes at a pivotal point in pension reporting reform as a result of the freshly minted GASB Statement No. 68, Accounting and Financial Reporting for Pensions An Amendment of GASB Statement No. 27. Finance officers are in the midst of implementing this comprehensive reform of pension liability reporting and explaining the change to the press, to plan members, and to elected boards. Changing the liability figure based on the act s guaranteed interest rate methodology is likely to further confuse stakeholders while increasing the task and complexity of explaining the change and nature of the long-term liability to their constituents. Adding another number to the litany of conflicting numbers that describe the funded status of pension systems could be confusing or threatening to constituents retirement expectations, which will likely be an unintended consequence of this legislation. The Public Plans Database provides an annual summary of findings, including aggregated changes among plans across the country. Many GFOA members use this information to help explain funded status and changes in reporting to employees and to the media, and GFOA s Federal Liaison Center has suggested that congressional staff also use this data to educate themselves about examples of systematic and disciplined funding over the long term those that don t make the headlines, but should. GFOA s best practices also provide examples of sound local policymaking. GFOA also communicates this information to congressional offices. For example, a recent GFOA best practice, Sustainable Funding Practices for Defined Benefit Pensions and Other Postemployment Benefits, recommends that public officials and associated trustees should, at a minimum, adopt a funding policy that stipulates full funding (i.e., a target funded ratio of 100 percent or more). The funding policy should also stipulate that employer and employee contributions be made regularly. Failing to fund the plan s actuarially determined contributions during recessionary periods impairs investment returns by not providing enough money to invest when stock prices are low. As a result, long-term investment performance will suffer and ultimately require higher contributions. A disciplined and systematic funding policy that is endorsed by more than 18,000 GFOA members is an effective tool against broad, ineffective federal legislation. April 2016 Government Finance Review 53

5 CONCLUSIONS Continued scrutiny of state and local government retirement plans is expected to continue in GFOA, along with other Public Pension Network members, representing both state and local governments and retirement systems, will continue to educate members of Congress about the true fiscal condition of public pension systems, consider whether proposed initiatives provide the flexibility the public sector needs to provide retirement security to its employees, and oppose congressional proposals that undermine state and local governments authority to effectively govern and finance their pension plans. Often, congressional proposals to address pension problems are not limited to the plans that are in distress, instead imposing a federal mandate on all state and local governments in areas that are the fiscal responsibility of sovereign states and localities. These proposals are conflicting, administratively burdensome, and costly. GFOA will therefore continue to express its strong opposition to S 2381 and any attempts to introduce its components through other legislation. y Notes 1. Puerto Rico s Fiscal and Economic Crisis, Working Group for the Fiscal and Economic Recovery of Puerto Rico, March 1, The letter is available at hatch-letter-governor-puerto-rico. 3. Pension Plan Database, Quick Facts, National Data Overview. ( quick-facts/national/) NCPERS Public Retirement System Study, National Conference on Public Employee Retirement Systems and Cobalt Community Research, November State and Local Fiscal Facts: 2016, National Governors Association, National Conference of State Legislatures, The Council of State Governments, National Association of Counties, National League of Cities, U.S. Conference of Mayors, International City/ County Management Association, National Association of State Budget Officers, National Association of State Auditors, Comptrollers and Treasurers, Government Finance Officers Association, National Association of State Retirement Administrators, National Governors Association, EMILY SWENSON BROCK is senior policy advisor in GFOA s Federal Liaison Center in Washington, 54 Government Finance Review April 2016