Putting Philadelphia’s $149 million pension fund loss into context

It is not hyperbole to blame Philadelphia’s underfunded pensions for the city’s high taxes, dirty sidewalks, potholed-filled streets, and struggling schools. Every dollar the city has to contribute to fill the pension gap is a dollar that could have gone towards fixing one of those pressing problems.

It’s a problem Mayor Jim Kenney acknowledged in his budget address Thursday. “The City’s annual pension contribution has grown by over 230 percent since fiscal year 2001,” the mayor said. “These increasing pension costs have caused us to cut important public services while the pension fund’s health has grown weaker. In fact, our pension fund has actually dropped from 77 percent funded to less than 50 percent funded during the same time our contributions were so rapidly increasing.”

Philadelphia’s pension problem began 50 years ago under Mayor James Tate and worsened under his successor, Frank Rizzo. Over the subsequent years, few mayors tried to fix the problem, and one who did—Ed Rendell— arguably made it worse: His scheme to sell $1.29 billion in bonds to boost the pension fund backfired when the interest payments on the bonds outpaced the fund’s investment performance.

Last year Philadelphia’s pension fund floundered in the markets, taking a $149 million loss in the fiscal year that ended June 30th, 2016. That marked a 3.17 percent decline that followed the previous fiscal year’s anemic 0.29 percent return.

Meanwhile, the S&P 500 in those same periods posted a loss of 0.13 percent and a gain of 5.25 percent, respectively. The last two years haven’t been outliers for the pension fund’s investments. In 14 of the last 21 fiscal years, the S&P outperformed the pension fund’s investments, which are spread across stocks, fixed-income securities, asset-backed securities, and fee-heavy hedge funds.

“We recognized that things were not going the way we wanted to,” said city finance director Rob Dubow. In response to the poor performance, Dubow moved the fund’s investment portfolio further away from hedge funds and towards index funds, which invest in a portfolio of stocks so as to mimic a market index like the Dow Jones Industrial Average or the S&P 500 (the largest 500 companies traded on NYSE or NASDAQ).

Index funds have low fees, especially when compared to hedge funds, because they invest “passively” by blindly buying a certain list (or “index”) of stocks or bonds.

“We changed our style of investment to look a lot more like market than we used to,” said Dubow, who has been finance director since 2008. As evidence of that positive change, Dubow points to the fund’s performance during the first half of the current fiscal year: up 6.7 percent, just beating out the S&P’s gain of 6.64 percent.

But not everyone thinks this move to the markets is a step in the right direction. Where there are greater rewards, there are greater risks.

“Most public pension managers hope they will make a higher return by investing in riskier assets,” said Olivia Mitchell, a professor at the Wharton School at the University of Pennsylvania whose work focuses on pensions. “But what they are not acknowledging up front is that risky assets are risky, and you will lose 20 percent sometime.”

“Then, it’s an open question of who pays: Is it the taxpayers or the retirees?”

Mitchell’s question is rhetorical. If pension fund suffers a monumental loss, it’s the taxpayers that will foot the bill to make up the difference.

In Philadelphia, they already are. 

PENSIVE OVER PENSIONS

This fiscal year, the city will contribute $629.6 million to the pension fund to cover its minimum municipal obligation (MMO) to the pension fund. Most of that—$539.1 million—is an “amortization payment”: money going towards slowly filling the $6 billion gap between the actuarial value of fund’s assets ($4.9 billion) and retirement obligations ($10.9 billion). Sixteen percent of the city’s general fund goes to paying pensions.

If Philadelphia had a fully-funded pension fund, the city wouldn’t have to pay the amortization payment, which is more than the city collected in 2015 in property taxes ($536.5 million), business income taxes ($438.2 million), real estate transfer ($203.3 million), sales ($149.5 million), and other taxes ($102.5 million) combined ($455.2 million total).

If you prefer to spend rather than save, in just a single year the amortization payment would cover the price tag to build an 11-acre park over I-95 plus all of the Rebuild initiative bonds. It’s more than the city spends on Streets, Parks and Recreation, Public Health, Behavioral Health, and Human Services combined. If the city gave the $539.1 million to the School District, it would boost per-student spending by about $2,700 (from $12,570 per-pupil to $15,300, based on findings 2015 Pew report).

Under current calculations, the city’s pension fund is considered 45 percent funded: It has $4.9 billion in assets right now and expects to owe $10.9 billion to pensioners over the years. But both those figures are essentially made up: They represent actuarial values, which are calculated based on a number of factors.

The actual, current value of the fund’s assets is $4.3 billion—the $4.9 billion figure is calculated based on a number of assumptions, the most notably the fund’s asset return assumption, which the Pension Board just voted to drop from 7.75 percent to 7.70 percent.

The city’s actuaries use the asset return assumption to ballpark (“discount” in investment-ese) how much the pension fund’s investments will earn, and then adjust the real value of the assets to reflect the assumed stock market windfalls.

Like the assumptions brought to political debates, the assumptions actuaries apply can be more meaningful than the underlying reality. As with politics, reasonable minds can differ on what is and isn’t a reasonable assumption—whether $4.3 billion is enough to cover the estimated $10.9 billion in pension obligation depends entirely on the assumptions you bring to bear.

The higher the assumption, the better the funding gap looks: If you assume the pension kitty will triple in value thanks to some brilliant bets, then there’s nothing to worry about. But if you lower the assumption, the funding ratio worsens.

Lowering the investment assumption to 7.7 percent increased the unfunded actuarial liability by $51.2 million, which the city must make up for by increasing its contribution by $5 million a year.

Still, Wharton’s Olivia Mitchell called the city’s lowered 7.7 percent discount rate “much higher than what is financially sensible.” Noting that the federally-regulated discount rates for corporate pensions tend to fluctuate between four and six percent, Mitchell suggests that the city’s cost of borrowing—the interest rate on its general obligation bonds—makes more sense.

Philadelphia’s last general obligation bond offered 4.15 percent interest. Lowered to that investment assumption, Mitchell estimated that the pension funding ratio would be cut in half, from 45 percent to closer to 20 or 25 percent.

In other words, things could be direr than they appear and the city is woefully underfunding the pensions.

Dubow argues that the 7.7 percent rate puts Philadelphia on par with many of its peer cities; the national average assumed return was 7.58 in 2015, according to the Center for Retirement Research at Boston College. Dubow also noted that the assumed return rate fell more than a full percentage point since 2008, when it was 8.75 percent. But, for Mitchell, the fact that other cities are making the same mistake is cold comfort.

Performance-enhancing funds?

The better the pension fund’s investments perform, the sooner the city can dig itself out of this all-engulfing hole. Dubow said the city only hires external managers with track records of earning more, after fees, than some of the passive index funds out there, and that the city has fired managers that fail to meet this performance benchmark. From FY15 to FY16, five out of six hedge-fund managers met this fate, reducing investment management fees almost $13 million, from $28.7 million to $15.8 million; that’s more than the $10 million in sales tax the Kenney administration has contributed to the fund on top of the MMO.

Dubow’s move away from hedge funds and towards index funds follows a trend that’s rapidly maturing into conventional wisdom. In the 2016 edition of his famed annual letter to Berkshire Hathaway shareholders, Warren Buffett lamented how pension fund managers listen to “the siren song of a high-fee manager” or consultants instead of just parking assets in a “low-cost S&P 500 index fund,” the kind popularized by the region’s investment behemoth, Vanguard.

That’s what Nevada’s lone pension fund investment officer has done, firing all of the external managers and putting all $35 billion in assets in passively managed index funds. Over the last five years, that strategy has paid dividends, earning a 9 percent return and flattering coverage in the Wall Street Journal.

Index funds are generally considered safer investments than individual stocks or bonds or even a portfolio of a few dozen securities. Index funds enjoy natural diversification: The events that can wipe out an individual company, or even decimate an entire industry, rarely hurt the entire stock market (and, often, bad news for one company is good news to its competitors).

If you own apartments in just one seaside town, a single storm can ruin you, but if you spread your holdings across the Jersey Shore—or, better yet, to other states—no one hurricane can wipe away your wealth, or so the thinking goes. Theoretically, the only way index funds lose money is if the entire economy craters.

Currently, around 40 percent of Philadelphia’s pension fund is invested in stock index funds, up from 21 percent in 2012. Index funds simply purchase an “index”, or long list, of securities. An S&P 500 index fund, for example, buys shares in the largest 500 companies listed on the NYSE or NASDAQ, matching the S&P 500 index itself. The simple strategy means there are fewer stock analysts and brokers to pay, and those savings get passed onto the investor in the form of lower fees. So long as the economy does well, index funds do well.

So, would Dubow be better off splitting the fund’s $4.3 billion among a fistful of index funds and kicking his feet up like his Nevada counterpart?

Mitchell again warned against such a move. With stocks, and even corporate bonds, “some of the time you flop, and sometimes you win big,” she said. “Pensions should go into much safer assets.”

“I don’t think [Philadelphia] should be investing something this risky, especially with 45 percent funding,” she added. Mitchell advocates for a more straightforward strategy for the city’s pension: “The appropriate portfolio matches the promised benefits.”

“If you are intending, as a city or state, to really pay the benefits—to make them secure—then you should back them with assets that are secure,” Mitchell said. Stocks—ownership stakes in individual companies—are considered riskier investments than bonds, which are essentially just loans. But bonds can go unrepaid just as surely as stocks can tank, making them riskier than Mitchell would prefer for a city’s pension fund. Instead, the Wharton professor suggested a portfolio made mostly of municipal bonds, treasury bills, and other super-secure securities.

“I think in the long range if you do that you’ll get lower return,” Dubow said in response. “And we do want to generate return to help the health of the fund.”

So is Mitchell just an overly-conservative Cassandra crying from the ivory tower?

Investment history is littered with the scorched remains of past surefire bets. Index funds now make up over 30 percent of all stock, bond mutual fund, and exchange-traded fund assets under management. Some analysts have warned that index funds are susceptible to a bubble separate and distinct from the broader stock market, and may be less diversified than they appear.

Indeed, index funds’ blind bets on certain companies echoes uncritical investments in mortgage-backed securities in the lead up to the 2008-2009 financial crisis. In 2007, few people thought a geographically-spread portfolio of real estate holdings could result in major losses. But then the housing crisis hit, obliterating bank balance sheets and plunging the nation into recession.  

RETIREMENT ROULETTE

Are bets that Philadelphia can invest its way out of the pension crisis akin to trying to cover rent with scratch-off winnings?

Mayor Kenney has proposed a 13-year plan to bring the pension fund up to 80-percent funded by relying on increased city contributions to the fund out of sales taxes. The city chipped in about $10 million on top of the minimum municipal obligation this year, but the plan calls for that amount to increase over time.

The mayor also wants to reduce future pension obligations by switching employees to a “stacked-hybrid” pension plan. Kenney already successfully convinced DC33, the city’s blue-collar municipal worker union, to make the concessions in December. Next up will be the city’s white-collar union, plus firefighters and police.

Kenney still has to get City Council to sign off on his plan, which isn’t guaranteed. Kenney dropped a provision in his original proposal that would have enlarged the city’s often-criticized DROP program in response to council’s objections, but more negotiations remain.

Even if that all works, it may trade one problem for another: Kenney traded DC33 a big wage increase (11.5 percent over five years) for the less-generous pensions. Big pay increases for all the municipal workers would put a slightly more immediate pressure on the city’s coffers.

The greater risk will be what happens if the economy’s long and steady growth over the last eight years comes to an end. It’s easy to sock away for the future when things are relatively good, but in times of trouble, past Philadelphia politicians have proven unable to keep their hands off the piggy bank.