John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.E-mail: firstname.lastname@example.org
We were all "Enroned." No event since the collapse of the stock market in 1929 has so electrified the financial life of the country as the overnight sinking of the former gas pipeline company. With a cunning to slip around rules and the political muscle to bend them as needed, a dowdy utility morphed into an enormous unregulated hedge fund that made big bets with other people's money.
As the company collapsed and its stock followed suit, culpability spread like an oil slick around the sea of special interests and professionals that are wrapped up in the financial markets. Accountants, lawyers, investment advisers, market analysts, bankers and the rating agencies all took their lumps.
So did public pension funds and the state and local governments that back them. The collapse in Enron stock cost them an estimated $1.5 billion in investment losses. These losses amounted to less than one- tenth of a percent of all pension assets, although in some individual cases, they were as much as a half a percent. More dramatic was the general pall that the Enron collapse put over the entire market, a pall made murky by the large uncertainties surrounding the recessionary slump in the economy.
Public-sector investors, and particularly public employee pension systems, have huge stakes in how well and honestly the stock market operates and, most especially, whether values in it grow. The long and short of it is this: The Enron affair--along with the stumbling economy--has led public pension systems to a year of surprises, suspicion and an unfulfilled search for security.
Public pension systems were late arrivals when it came to investing in equity securities. Often hog-tied by old-fashioned restrictions on investments, pension funds were, in effect, coupon clippers: They sat for years on low-yield, if very safe, bonds. Once liberated from the old rules--many state legislatures lowered investment barriers during the 1980s--the funds took to equities with a passion, moving their portfolios by quantum leaps into the stock market. By the end of the 1990s, some 60 percent of public pension assets were in equities.
The timing could not have been better: As a class, public pension systems were able to ride the huge run-up in stock prices that took place during the 1990s. As fund values soared, the systems were able to reduce employer and employee contributions and still meet benefit demands.
Even before the stock market's bloom began to fade, skeptics noted that the massive shift into equities was not without risks. They were right, of course. What a difference a couple of years can make. By the end of March 2002, stocks in the two blue-chip major indices were running 12 and 25 percent below the values of that date two years ago. Stocks in the star-crossed NASDAQ lost a heart-stopping 70 percent of value.
The subsequent losses for public pension funds amounted to billions of dollars, but a year or two of negative returns is not a killer for the long-distance portfolio. More disturbing are the doubts about the length and depth of the bear market. For the past 20 years, starting in 1983, a dip in the stock market has been a reliable signal to buy. For the historically inclined pension-fund investor, however, there is the nagging recollection of the dreadful doldrums of the 1960s and '70s, when the stock market went nowhere for years on end. A glance at Japan is even more disheartening. There, the Nikkei Index plummeted from the lofty reaches of 1990 and, slug-like, it now putters along at one-fourth its level of over a decade ago.
All of which leaves pension funds and their investment advisers wondering where safety, security and a healthy return will be--and how they ended up in this tight a place.
Things have been exceedingly difficult for New York City, which has had to deal with the trauma of September 11 and its emotional and economic aftermath. On top of that, the city's pension system and its investments are turning into huge budget problems. The Big Apple is not alone on this score, but its difficulties are more quickly and better reported than most--and more visible.
The biggest problem can be traced back to the stock market's heyday two years ago. Riding high on substantial returns from the fund's investments in stock, the Giuliani administration projected that the city's pension contributions would be a bit under $800 million in 2003 and decreasing in the years ahead. The market's decline and other fiscal events, however, turned that projection on its head. Coming into 2003, the city's contribution to the $82 billion pension system will have to be more along the lines of $2 billion.
When he summarized the city's predicament in the New York Times recently, Robert North, the fund's chief actuary, took note of a deadly duo: "We gave lots of benefits and we had bad investments."
On the benefit side, the state (over the city's objections) granted additional cost-of-living benefits to retirees--something that seemed politically astute at the time but is now a substantial drag on the pension plans. On the investment side, pension money is very aggressively invested in equities, with nearly 70 percent of fund assets placed in such securities. That compares with the 32 percent in equities in 1986.
The increased exposure was a great course to follow when the markets were forging upward in the '90s, but now the risky side of the venture has come into play. The city lost more than $9 billion in 2001, and the rate of return sank to a dismal minus-8 percent.
And that leads to an unhappy bottom line: Given the assumed hefty rate of return to be earned by the money (8 percent), the city must contribute more to the system in order to keep it actuarially sound. The amount of the increase in city contributions will be about four times the sum it spends each year on parks.
The funding problem is especially acute for New York City's budget. A bad year in the financial markets, which are headquartered in the city, is also a bad year for tax collections, since they depend quite heavily on Wall Street's prosperity.
New York City's investment problems are being felt by most other pension systems, although perhaps not to as great an extent. According to reports from the Federal Reserve's Flow of Funds, total public pension assets declined during 2001, after years of healthy growth. The decline was led by the estimated $120 billion drop in the funds' equity holdings. Since the Fed attempts to adjust for market values and the funds continued to put new money into equities, the drop-off is due mostly to the markets' decline.
During the great stock bubble of the late 1990s, investors in the market seemed uninterested in the stocks of companies seeking real profits. Now they--along with public-fund investors--are having a devil of a time finding them again.
Two problems are depressing that search: First, what with the downturn in the economy, many companies have not been profitable. Second, many of those that had once appeared to be profitable are proving not to be after all. The first few months of 2002 saw a lot of retrospective body and fender work on reported incomes, turning many a BMW into a Yugo.
Much of this is fallout from the Enron debacle, which featured the most glaring example of misreported income. When Enron was forced in late 2001 to restate the profits it made in 2000, the revised earnings showed revenues of $8 billion--as opposed to the previously reported $100 billion. The market worried that Enron's departures from financial candor were not the only ones. And those anxieties were soon confirmed. Restatements of profits and major write-offs by other companies became numerous, particularly among power and telecom companies, and corporate profits drifted lower.
The future of profits and of the stock market are of vital interest to governments as both tax collectors and investors. From the public investors' perspective, the rediscovery of earnings as the basis for stock prices has, ironically, raised considerable alarm. This is so because, despite the decline in stock prices, the price-to-earnings ratios are still very high by historical standards--either because earnings are so low or expectations of future growth remain very high.
So the race is on. Will corporate profits recover fast enough to justify the current optimism implicit in the high P/E ratios? Or will investors' expectations decline, stocks return to historical ratios and prices sink to more sustainable levels? Hundreds of billions of dollars are riding on the answer to these questions. For state and local governments, it's not just a pension-fund investment issue. The answer means many billions of dollars in future taxes that either will need to be raised or not.
At the height of its manipulative madness, Enron went so far as to set up a room filled with fake trading operations to hoodwink analysts. And, we also now know that the supposed hedges provided by such Enron investment creatures as LJM2, Chewco, Condor and Raptor were, in effect, devices to inflate Enron's profits. As part of the fray, California's giant public pension fund, CalPERS, acknowledged that it had been approached to participate in one of the Enron investment schemes but had declined, saying that it did not like the looks of the deal it was presented.
Even with such a checkered past, the now-diminished Enron is asserting fraud on the part of those that advised it. And that's just the beginning of the accusations. It should come as no surprise that those harmed by Enron would be pointing fingers of blame at--and suing--Enron itself. The roughly $1.5 billion loss in Enron securities mobilized several pension funds into seeking recompense. While reassuring pensioners that their funds were safe, several state pension programs, including those of California, New York, Ohio and Washington, filed suits against Enron.
Enron is not the only target. The Florida pension board, which oversees the state's $94 billion fund, has authorized its fund directors to seek reimbursement from Alliance Capital Management, one of its investment advisers, for the $282 million the fund lost on its Enron holdings. Alliance had bought 2.7 million Enron shares for the state fund during the six weeks before Enron filed for bankruptcy on December 2 of 2001. In all, the fund was left holding 7.6 million shares, which were sold for a much-deflated 28 cents each. This past April, the board, which is led by Florida's Governor Jeb Bush, instructed the fund's lawyers to begin negotiations with Alliance over a settlement and, if these were not successful, to file suit.
Enron's crash hurt public investors other than the pension funds. Connecticut Resources Recovery Authority, which oversees the state's waste-to-energy plants, entered into what looked like a very favorable energy purchase contract with Enron that ended up being a disguised loan on which the bankrupt Enron has defaulted. As a result, the CRRA lost $220 million in future revenues, which means a reduction of about 30 percent of its approximately $90 million dollars a year in operating revenues. To make up some of the difference, the Authority tried imposing a 31 percent hike in the trash-disposal fees it charges communities. Enraged by the big loss and the rate hike, 70 Connecticut towns that haul garbage to the trash-burning CRRA's facilities have filed a lawsuit against the law firms that represented the authority in its dealing with Enron, charging them with negligence and carelessness in their advice. Meanwhile, CRRA's outstanding bonds have been downgraded by Moody's Investors Service in view of the severe reduction in operating revenues.
The credit-rating agencies, all of which missed calling the Enron debacle, have come in for a round of flak as well. Their role is once more under study by the Securities and Exchange Commission. Institutional investors fault the agencies for not being more diligent, while the agencies point out that the institutional investors' crack analysts were also misled by the Enron financial statements. Among the possible remedies being pursued are creating more competition in the rating business and establishing closer oversight by the SEC.
The performance and fate of the major credit-rating agencies--Moody's Investors Service, Standard & Poor's and Fitch--are particularly important to the public pension funds. Most of them have prudential requirements on their portfolios that restrict them from holding debt on entities whose ratings fall below certain rating categories conferred by the recognized agencies.
Of course, public pensions, with their promise of a fixed benefit, are only part of the grand scheme of providing for an employee's retirement. Plans that promise a defined benefit based on a predetermined formula still dominate in the public pension sphere, but like their corporate brethren, public pensions systems have increasingly moved toward the defined-contribution plan. In the private sector, these are popularly known as the 401(k). Originally, the 401(k) was seen as a means of supplementing retirement income, while regular pensions and Social Security did the heavy lifting in terms of guaranteeing a baseline income.
The advantages to a company of 401(k) plans over the defined-benefit pensions soon became clear. The 401(k) costs less to administer and avoids the risk that if investments do not perform well the employer will be on the hook to put more money in at some later date. Not only that, private-sector employers have found that 401(k) plans, where investments are self-directed by the employee, are a ready source of demand for a company's own securities, an advantage of which Enron and other corporations have availed themselves. The enthusiasm for the 401(k) approach and self-directed investing has been so great that it has served as a model for "fixing" Social Security.
President Bush's Commission on Social Security Reform represented the latest in a generation of studies of that knotty subject. While its thrust was avowedly to privatize part of the system, it failed to figure out just how to do so. Meanwhile, the increasingly sad state of the markets eroded the conviction that turning over decisions on investment to individual investors was certainly preferable to having the feds plow it into U.S. debt.
The ultimate victory of self-directed investment funds had appeared to be nearly assured by the late 1990s. Corporate America has been bailing out of fixed-benefit plans and trooping steadily toward 401(k)s. Its public-sector cousins, while still devoted to largely fixed-benefit plans, have also been edging toward fixed-contribution schemes. Here it isn't so much a question of being on the hook for investments gone bad. Much of the defined-contribution pressure in the public sector had been for a pension program that is portable--that is, one that employees could take with them if they didn't stay on the job long enough to vest in the defined-benefit program.
After the stock-market experiences of the past two years, the fixed- benefit argument for pensions may be making something of a comeback. There are two reasons: First, there is a serious policy implication in allowing people to make all their own decisions regarding savings for retirement. A core of individuals simply do not save, trusting in divine intervention or public programs to provide for their old age. These folks are joined by those who do save but are either imprudent or unlucky investors who blow their savings. While most politicians do not publicly embrace the concept of state paternalism, the burdens on the state of the improvident elderly could be significant in the future.
The other argument that is not much heard lately is that there are benefits in pooled savings systems, which act as a form of social insurance. In a pool, the survivors who live longest benefit from the contributions of those who die earlier. This insurance principle is missing in individual accounts such as 401(k), where each person must save enough to pay for an uncertain retirement period. The pooling principle is a powerful argument with large consequences. According to one estimate, individual provision for a level of retirement benefits is perhaps 20 to 25 percent more expensive than doing it through a pool. On a national scale, the use of a pool is worth hundreds of billions of dollars that would not need to be set aside for retirement. But it serves few political interests these days to talk about a return to the Social Security-like pool concept.
However, as the year of Enron illustrates, overlooked problems sometimes get a belated hearing. So it seems to be now, with more regulatory interest focused on ensuring basic requirements for operating fair markets, such as the need for strict accounting rules, independent audits, accountable boards and honest management that is not corrupted by poorly designed incentives. While cynics may stress the many failures of the recent past, the realists see that the true strength of the system is its ability to right itself. For the dreamers, there is always the hope that the NASDAQ will hit 5,000 again.
Most of the recent attention on public-sector investment has been focused on the long-term markets and the malaise of the stock market. But cash managers--those who look to short-term investments that pay interest--have had their woes as well. While higher interest rates can be a depressant to the stock market, short-term investors like them. And for general governments, keeping cash balances invested in short- term instruments has been a rather healthy source of revenue.
Throughout late 2000 and all of 2001, while the Federal Reserve was manning the monetary policy ambulance, the short-term Treasury-bill market went into a nosedive. As investors fled the plunging stock market and headed for the safety of short-term investments, yields plunged from about 5 percent in late 2000 to 2 percent by early 2002. Correspondingly, the returns that industrious cash managers had been raking in on their liquid portfolios sank drastically. While this was not the calamity of the loss of huge amounts of principal as happened in the stock market, for a lot of governments already facing declining tax revenues, it was a nasty shock--and a loss of much-needed revenue.
The markets may be in a slump, but some innovation is ever at hand. In Indiana, the state legislature has given local school districts the power to change their teacher retirement plans from defined-benefit to defined-contribution schemes. In order to do this, however, they must completely fund the older defined-benefit plans before they make the shift. But they have got to hurry, since the authority expires at the end of next year. The funding bonds, which must be sold on a taxable basis, could amount to $400 million in sales over the next year.
Since many of the state's 300 school districts are small, the Indiana Bond Bank is busily rounding them up to sell the bonds. It figures that it will bundle about 200 of them into Bond Bank issues. Use of the Bond Bank will reduce the costs of issuance and help guide the localities through the intricacies of selling taxable bonds, which typically sell at much better prices in large issues. While selling taxable bonds for funding liabilities has been done at the state level, Indiana's use at the local level is novel. The pension bonds carry certain restrictions, however. The bonds are secured on real estate and are restricted by the prevailing debt statutory limitations on school districts. Furthermore, the sales cannot lead to higher taxes. The legislation states that higher debt service requirements must be made up by reducing spending elsewhere so that taxes are not increased.
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