Charles Cowling asks what lessons can be learnt by the UK from problems in the US, following a number of high-profile municipal failures there
There is considerable concern in the US, most recently in Detroit, about the sustainability of public sector pension plans. With the Pensions Regulator (TPR) concluding its latest consultation process on the UK's funding regime, there are lessons it can draw from this.
The problems of US public sector pensions were brought to widespread attention on 14 December 2010 when a Wall Street analyst, Meredith Whitney, was interviewed on the US television programme, 60 Minutes. Whitney highlighted the huge indebtedness of US local governments to their pension programmes and suggested the debts were so great, many would have to default. She predicted "50 to 100 sizeable defaults" or more and, asked when the crisis would hit, said "it'll be something to worry about within the next 12 months".
Whitney's words turned out to be immediately prophetic. The day after the TV show was aired the US municipal bond market tumbled. People now knew there was a crisis.
Of course, the real problems had been around much longer. Between 2002 and 2008, US state spending spiralled and their debts almost doubled. At the same time, pension plans were systematically underfunded and, to make matters worse, pension plans' exposure to risky investment assets had risen from 23% in 1980 to 73% by 2010.
The state of US local government pensions was compellingly described in a Vanity Fair article "California and Bust" by Michael Lewis in November 2011. Things are now so bad in the US that this issue regularly makes headlines in the UK. Sadly too, there have been a number of high-profile bankruptcies.
Vallejo, California, is a city of 115,000 near San Francisco which crashed into bankruptcy in 2008, unable to sustain its pension obligations to police and firefighters. Three years of insolvency saw massive cuts, including to the number of police and firefighter jobs. But the city did not touch its payments to the $280bn California Public Employees Retirement System (CalPERS). It would soon rue this decision.
When Vallejo entered bankruptcy in 2008, its annual employer payments to Calpers were $8.8m. When it exited bankruptcy in 2011, annual payments to Calpers were just over $11m. By last year these payments had risen to $15m, largely due to changes in actuarial methodology and Calpers' decision to lower its annual projected investment return rate from 7.75% to 7.5%. Vallejo is now staring at a second bankruptcy. The only way it can meet its still rowing pension costs is to get more concessions from unions and cut services further. But they don't have much left to cut - other than pensions. Stephanie Gomes, the city's vice mayor, has said of Calpers, "It's the biggest part of my city's problem. I don't know any city that can afford it."
Vallejo is not alone. Stockton, California, a city of 290,000, filed for bankruptcy in June 2012 after a 70% decline in its tax base. Officials were forced to make huge spending cuts to solve a $26m budget deficit. The city cut a quarter of its police officers, a third of the fire department staff and 40% of all other employees. It also cut wages and medical benefits. But Stockton's largest debt is owed to Calpers. The city has kept up with pension payments at the expense of other spending, arguing it needs a strong pension plan to retain its workforce. Stockton's unemployment and violent crime rates now rank among the worst in the US.
San Bernardino, a city of 212,000, lies 65 miles east of Los Angeles. Its biggest creditor is also Calpers. Unlike Stockton and Vallejo, San Bernardino has attempted to limit its obligations to Calpers. It stopped paying Calpers its $1.2m bimonthly employer's contribution after it declared bankruptcy in August 2012. The attorney for Calpers was reported by Reuters as saying: "Calpers can't have cities financing their bankruptcy cases by just stopping making payments. You can't make not paying Calpers cheap and easy, because then it creates this tremendous incentive for other cities to file for bankruptcy and stop meeting their obligations."
Last month, the US Court of Appeal ruled Calpers can try to persuade the appeals court to overturn a lower court decision finding that San Bernardino was eligible for bankruptcy protection.
The problems are not limited to California. The state of Illinois faces crippling pension debts and Chicago in particular has had to impose savage spending cuts - 50 elementary schools were forced to close in Chicago last year. Then last year we also saw the giant Motown city of Detroit file for bankruptcy.
In the plans filed last month, police and firefighters will take a 10% cut to their pensions. The pensions of all other city employees and retirees will be cut by 34%. Neither group will receive future inflation increases. Bondholders can expect to receive about 20 cents in the dollar.
The picture is varied across the US. There are strong states and weak states. But as Michael Lewis notes in his Vanity Fair article this can exacerbate the problem. Companies are more likely to flourish in the stronger states; individuals will go to where the jobs are, creating a spiral of decline in the weaker towns and cities. In the 2010 census, Detroit had a population of 713 777, down 60% from its 1.8 million peak in 1950.
An alarming factor in all these bankruptcies is how low the levels of funding in public sector schemes have been allowed to fall. Indeed there is a lengthy list of pension schemes with funding ratios below 60%. The Chicago teachers' pension fund is roughly 54% funded. But it is better off than the city's municipal workers, police and firefighters' pension funds, which are estimated to be collectively 33% funded. This situation has arisen for many reasons other than simply market conditions:
? Sponsors failing to make recommended contributions when due
? Pension improvements awarded
? Future service benefits are protected
? Aggressive actuarial practices that result in deferral of costs/contributions.
Against this alarming backdrop, the US Society of Actuaries commissioned an independent report, which was published in February and made recommendations:
? Pension obligations should be funded in a rational and sustainable manner by funding benefits for employees over their public service career, following key principles of adequacy, intergenerational equity and cost stability and predictability
? The risk management practices of public pension plans should be strengthened to provide stakeholders with the information they need to make more informed and effective decisions about plan funding, including more comprehensive information about the current and future financial position of the trust and of the nature and extent of risks facing public pension plans. Specifically this includes disclosure of:
? Trends in financial and demographic measures
? Measures of risk to the plan's financial position
? Stress testing
? Undiscounted cash flows.
There are also recommendations on actuarial methods, including discount rates, amortisation periods, asset and discount rate smoothing methods and a number of recommendations on plan governance.
Lessons for the UK
The problems in the US are way beyond actuarial. In any rational system one would expect the stakeholders to adjust things to put the system back on track. But key stakeholders - politicians, plan administrators, trustees, professional advisers and unions - all benefit from the status quo and so are anti-reform. Even the voters are unempowered. Moreover there is little or no regulatory control. At a time when it needs the actuaries to stand up for what is "right", sadly they are unable to do so.
In the UK, we can point to technical actuarial standards and TPR's funding standards and maybe smugly claim that it could not get so bad here. However, there are still many important lessons we should take from the US experience:
? Simply telling clients what they want to hear risks being unprofessional. Actuaries have insight and understanding that they must share openly with their clients, particularly when that client is conflicted
? Actuarial methodologies that smooth or hide 'bad news' or simply push problems into the future have to be used with great care and many caveats
? Downside risks and bad future scenarios must be carefully explained to clients.
A financial institution as important as a pension scheme cannot be run simply on a basis that relies on a future continuing benign environment.
I am proud to be an actuary and proud that as professionals we strive always to do 'the right thing'. But there will be times when this is very hard and I hope we are all strong enough to make the right judgment calls when it really matters.