Rich City, Poor
City
"The future is already here," intoned William Gibson, one of my favorite cyberpunk science fiction
authors, "it's just not very evenly distributed." Paraphrasing
Gibson, the pension crisis is already here; it's just not very evenly
distributed. For the past two weeks we've been exploring the problems of state
pension funds. This week we will conclude our look at pension plans for the
nonce with a 30,000-foot overview of the states and then take a deeper dive
into one city: mine. This will give you at least one version of how to do your
own homework about your own hometown. But fair warning, depending on your
locale, you may need medical help or significant quantities of an adult
beverage after you finish your research. Then again you may be pleasantly
surprised and congratulate yourself on choosing a particularly adept hometown.
And be on notice that, no matter what your personal conclusion and how
well-grounded your analysis is, there will be people who live in your
neighborhood who think you are utterly full of, well, let's just say
"nonsensical matter" and leave it at that. This is a family letter.
I am
constantly asked where the future jobs will be, and I think hard about the
answer to that very personal question (it's crucial to those of us who have
young kids). Will we see Gibson’s dystopian world or Ian Banks' world of
abundance? The answer is, of course, that secular growth in employment will
come from the new, transformational technologies that are already being created
all around us, truly new industries that will change everything and create
opportunities for work that we can't even imagine yet, in the same way the
automobile or telecommunications or the McCormick reaper both took some jobs
away and created even greater opportunities. The transition is the thing,
though. It will be filled with opportunities for some and forced change for
others, while we wait for the future to become more evenly distributed. In the
next few weeks, you are going to get a letter from me that will tell you about
the newest addition to Mauldin Economics, the Transformational Technologies Alert, written by my longtime friend Pat Cox,
who is no stranger to readers of this letter. Pat and I have long wanted to
work together, exploring the future and especially biotech. He is the best, and
you will want to join us from the very beginning. We invite you to charge ahead
into the future with us, exploring opportunities that will begin to change your
own life right now. And now back to pensions…
Through the courtesy of one of your fellow
readers I've been given a treasure trove of data on 702 city pension plans. I
won't say that I got lost in the data, but the search and rescue teams sent to
find me had to go back for extra supplies. There were some very dark alleys
that it took a while to find my way back out of. Not to mention some twists and
turns that were totally surprising.
So first I need to say a big thank you to
Gregg L. Bienstock and Justin Coombs of Lumesis for giving me access to their
data. Gregg is a cofounder of Lumesis, and their signature software is called
(appropriately enough, given the oceans of data they plumb) DIVER. They've
compiled data on 54,000 issuers of municipal and state bonds from over 100
sources. They sent me an Excel file on the major pension plans of every state
and the pension plans of cities with populations over 100,000. And Justin was
kind enough to create multiple spreadsheets and graphs upon request and
patiently explain their data. The bulk of the data in this letter is from http://www.lumesis.com. The opinions are my own and should not
be attributed to Lumesis. From time to time we will also look at another fascinating study from
the Pew Charitable Trusts on
pensions and retiree healthcare in 61 cities.
As we have seen the last two weeks (here and here), the assumptions that states make about
their future investment returns are fairly unrealistic and generally nothing
like what they've achieved for the last 10 years. This makes their balance
sheets look far better than they really are, and for some states the
discrepancy is pretty stark. Witness Illinois, where unfunded pension
liabilities run north of $280 billion, give or take. That is more than $20,000
for every man, woman, and child in the state. And the bill keeps rising every
month as the state plows ever deeper in debt to its own future.
Keeping in mind the caveat that the
percentages may actually be worse than reported, let's look at a few graphs on
a state-by-state basis. This first graph shows the funded ratio of state
pension plans through 2012. (Note: on all the graphs the large
"island" below Louisiana is a representation of Puerto Rico. To its
left is Alaska, and both are obviously not to scale.)
Where in the World Is Your Pension?
The more appropriate question to ask is
"What percentage of my state's total future liability is unfunded?"
And here the color pattern of the map changes. If you can look at this map and
discern a political pattern, you are seeing something that
I can't find. "Red states" can be adequately funded or a disaster,
and the same goes for "blue states." This will also hold true when we
look at cities. There is simply no rhyme or reason as to why some cities are
paragons of virtue when it comes to funding pensions while others make drunken
sailors look virtuous.
By this measure, the seven most poorly
funded states are Illinois (24%), Connecticut (25%), Kentucky (27%), and Kansas
(29%), along with Mississippi, New Hampshire, and Alaska, which are tied at 30%
funded. At the other end of the spectrum, using a realistic assumption of
future returns suggested by both Moody's and GASB, Wisconsin, the most
well-funded state in the country, has just a 57% funded ratio, followed by
North Carolina (54%), South Dakota (52%), Tennessee (50%), and Washington
(49%). This is in spite of their claiming a much higher ratio based on
very aggressive assumptions. (Data is from a great report in
which you can see how your state fares.)
I have struggled to find a way to convey
the disparity among cities with regard to their pension programs. I suppose,
given the realities of city politics, which can be the most vicious of all
contact sports in America, the differences should not be surprising. Whether a
city is rich or poor, the personal assassination and endemic corruption can be
riddled through city politics like fat through bacon. It is a wonder that
anyone would want to go into city politics.
All real estate prices are local, we are
told, and the same is true of pension funding. Take Lexington, Kentucky, a town
full of Southern charm with a genteel feel sprouting in the midst of Kentucky
horse (and basketball) country. And for whatever reason, in Lexington they seem
to feel they should almost over-fund the city employees’ pension fund, at a
level of 91% (only outdone in the database by Gainesville, Florida).
And then go up the highway to their
neighbor (and basketball archrival) Louisville. There must be something
different in the water there, as they have decided to fund only 30% of their
firefighters' pensions, while assuming they will get 7.5% returns on their
investments, an unduly optimistic assumption that will surely make the true
level of their unfunded liabilities even more egregious.
We can go a little south to Nashville,
Tennessee, one of my favorite cities, internationally known for its devotion to
country music. Some of their pension programs are funded only to the tune of
20-25%. But their suburb Murfreesboro, a ZIP Code away, is 98% funded.
Arlington, Texas, home to the Texas
Rangers and the Dallas Cowboys and where I used to live and own a home, is
overfunded by 20%. And then there is Dallas, where I have just purchased an
apartment. The database tells me the city employees’ pension fund is 86% funded
and assumes an 8.25% future return on its investments. Not all that bad in the
grand scheme of things but nothing to brag about. Oh wait, you also have to
look at the Dallas police and fire pension fund, which is only 76% funded. And
they are projecting an 8.5% annual return, which puts them at the top of the
charts for optimism about the future. But those numbers tell only part of the
story.
I randomly selected about eight cities and
did further research on their pension funds. In almost every case there was far
more than meets the eye, both good and bad. So rather than pick on Chicago (far
too easy a target) or another random location, let's look at my new (as of
June) hometown of Dallas. I would encourage you to do the same type of analysis
on your own town or city.
Let me first put on my Chamber of Commerce
hat before I take off the gloves. Dallas is a thriving city with a history of
very active and effective civic leaders. While some freeway is always under
construction, it is relatively easy to get around the region. The Dallas-Fort
Worth airport is a dream. There are very few places in the world that I can't
get to with just one layover. I can walk out of my apartment in downtown Dallas
and be through airport security in less than 30 minutes. Try that in Chicago or
New York. The area in general and Dallas in particular has fabulous restaurants
that honestly rival those of any city I've been in. The area has more
live-theater venues than any city but New York (who knew?). From time to time
our local sports teams have been known to achieve some success. Admittedly, the
schools range from being ranked among the top in the nation to being complete
failures, but there are many options. Taxes are generally low, and the area is
a great place to do business. The infrastructure works, and the labor force is
educated and abundant. The women are legendarily beautiful, and all the
children are above average. Given that I could live almost anywhere, Dallas is
where I want to be.
And now, as Paul Harvey would say, here's
the rest of the story. Most of the world knows Dallas through the 1980s
television series Dallas, starring
Larry Hagman as a swaggering oilman. The show was replete with beautiful women
with big hair, stereotypical men in big hats, and lots of family feuds and
vendettas. The truth is a lot different, but there is a rhyme or two here or
there. And that brings up a tale that will lead us into the Dallas pension
story.
Back in 2007, some ambitious real estate
developers decided to build a fabulous jewel of an apartment high-rise in the
middle of what is known as the Arts District in downtown Dallas. Dallas civic
leaders have chosen to develop its major museums, symphony hall and separate
major opera hall, plus live-theater venues, in the center of town. They even
built a massive (and very expensive) park over a freeway entirely with private
money in the middle of the Arts District, which has become a gathering place
for the citizens. And then came the financial crisis.
Not to be deterred, the city went forward
with the building called the Museum Tower. And I will admit that it is one of
the more beautiful buildings in Dallas. When I was searching for places to
live, I did a little research on it and quite frankly decided not to even take
a closer look. Let's just say it was very aggressively priced. I ended up
buying a very similar property only a few blocks away with great views for a
fraction of their asking price. But there was another reason I didn't look:
there was a major lawsuit going on between the building and its next-door
neighbor, the Nash Sculpture Center, which is a truly wonderful venue
supported by all the don't-cha-knows of Dallas. It seems the glass Museum Tower
building reflects light onto the sculpture center, destroying the open-air
ambience, or at least that's what their lawyers claim. The story that it is
melting the sculptures is apparently bogus. It doesn't help that a few
"rogue" architects said during the planning sessions for the Museum
Tower that the problem would occur. Who would want to buy a place when you
don't really know what the homeowners' association fees are going to be?
So who funded this luxury high-rise
building? As it turns out, the Dallas Police and Fire Pension Fund did. To the
tune of $200 million. Leveraged. Six percent of the current value of the fund,
give or take. Which is already underfunded by around $1.2 billion, assuming they
meet their stated objective of 8.5% annual returns. Plus, they have other
unstated commitments to what are known as DROP accounts, which could become a
liability totaling hundreds of billions, by my back-of-the-napkin estimation.
Note: when you look at your city's or
county's pension fund, don't just look at the readily available public reports.
Sometimes you have to dig for the other, "off-budget" commitments of
the city. Some cities report pension and healthcare commitments separately. Of
the 61 largest cities in the US, 22 face larger unpaid bills for healthcare
than they do for their pension funds. An astonishingly large number of cities
have reserved next to nothing to cover future healthcare promises. Without
looking at the local politics, I can almost guarantee you that those cities
will end up shifting their liabilities to "Obamacare," that is, to
federal taxpayers like you and me, in the very near future. It's is the only
rational thing to do. Just like Walgreens and IBM did. Sort of. Just saying.
I have to admit that when I first saw the
data that suggested the city of Dallas expected to get 8.5% returns on their
pension funds, I was aghast. That is the highest level of projected returns for
any city I could find in the database. Here I have committed to paying taxes in
Dallas, and I am looking at a personal major unfunded liability. But then I
looked at the rest of the story.
As it turns out, the management of the
Dallas Police and Fire Pension Fund has actually returned 8.5% for the last 10
years. They rank in the top 1% of all city pension funds in the United States.
Last year they did 11.4%, and for the last three years they did 6.7%, although
if you go back five years and include the Great Recession, the returns have
only averaged 1%. Even so, a fabulous track record for a major fund. If any
fund could make a case, based on past performance, that 8.5% future returns are
possible, they could. So I began to wonder, how in the heck have they done so
well? You clearly don't do that through normal pension fund allocations. (Ask
Illinois.)
And of course they didn't. Fifty percent
of the fund is in real estate – far above the normal allocation. And they
manage the fund internally (which is both unusual and controversial). A fair
amount of the fund is in luxury real estate (totaling $400 million or over 12%
of the fund), some of which has been hammered. And they are saddled with lots
of legal problems, which, not surprisingly, appear prominently in the local
press. Why, the newspaper asks, is a supposedly safe police and fire pension
fund invested in luxury homes in Hawaii, homes that haven't sold for five
years? Why has the fund spent $1 million flying its executives around the world
to fabulous locations to look at real estate? Why wouldn't they fix the
building that is spoiling the ambience of the centerpiece of the Dallas Arts
District? And why would they hire a local PR firm to create false Facebook
posts (a ploy they claim no knowledge of, of course) and one of the most
aggressive law firms in town to go after anyone who criticizes them?
And yet, somehow management figured out
how to make 12% on its global fixed-income portfolio (while the Templeton
Global Bond fund returned a mere 7.6% the past year) and 16% on its global
private-equity portfolio (as of 3/31/13), for one year. On private equity 12%
seems to be closer to the average. I couldn't get details on the components of
those returns or the specific funds involved, but the surface returns seem
rather phenomenal. Wouldn't we all like to earn 35% above our benchmarks? Talk
about all the children being above average… Just saying.
And herein lies one of the instructive
lessons. The Dallas fund has significantly outperformed its peers by choosing a
course that is far from the norm. They have made what would be normally called
"alternative investments" a core holding. Not unlike David Swenson's
approach at Yale, although he does it with a different mix of alternative
investments. If I had the misfortune to be responsible for a large pension
fund, I would be arguing for much a larger allocation to alternative
investments. Real estate might not be my personal preference, but it is a good
one nonetheless.
The second lesson is that if you do it
("over"-allocate to alternatives) you're going to be heavily criticized,
and you probably need skin thicker than the glass on the Museum Tower. And be
just as able to reflect the glare of local criticism.
For all their overall success, the Dallas
fund's projections of future returns are still significantly higher than I
consider to be prudent. And even given their projections, the fund is
significantly underfunded, to the tune of $1.2 billion. Which is not small
change, even in Dallas. If I were depending on that fund to be the source of my
future retirement, I might well be asking the city of Dallas to pony up more
than the $100 million they are contributing each year. And the city of Dallas
might be thinking that the policemen and firemen should be offering to do a
little more as well.
All that being said, the average Dallas
police or fire department employee will not be getting rich on his or her
retirement. This is not a California prison guard retirement fund. It is rather
bare bones, from what I can see. And when you read all the social commentary
surrounding the fund, you come away with a strong sense of the local angst
involved. These are real people with real issues, both taxpayers and city
employees and retirees. And those issues are not different than in any other
city in any other state. If you start reading the stories on the bankruptcy of
Detroit, the situation is quite heart-rending, and logic flies out the window.
(See http://mobile.nytimes.com/2013/09/20/us/residents-of-detroit-go-to-court-for-pensions.html.)
"There is no room for
austerity," said one Detroit resident. Somehow, those in charge should be
made to come up with the money when they go bankrupt. But the politicians who
made the decisions that led to the bankruptcy are long gone from the scene.
Austerity is a consequence of prior decisions. If prudent decisions are not
made in the present, the future shows up all too quickly. Some cities have made
prudent decisions, others not so much.
Meredith Whitney is famous for telling 60
Minutes that 50 to
100 municipalities would default in 2011. I was quite skeptical when she said
it, and she was clearly wrong. But looking at the data, there are far more than
50 to 100 cities in potential trouble. Will a wave of defaults happen next
year? I highly doubt it, as cities have the ability to kick the can down the
road at least as well as Europe countries do. But would I want to live in
Houston or San Diego? Not based on their pension liabilities. Nor would I want
to live in Nashville or Louisville or any number of otherwise wonderful cities.
Most cities and states that are in trouble
still have the "luxury" of being able to deal with the problem in
advance of being forced to buy the markets. They need to take the time they
have to get their programs straightened out. Those cities and states that have
been prudent are to be congratulated, but they might want to worry about being
forced to fund their less prudent brethren from their own tax revenues. It can
happen, as it did in Texas when the judiciary forced shared taxes for school
districts even though voters and the legislature said no. Just when you think
you are safe…
Municipal bond markets are going to become
far more difficult places to make money in the future because of pension
issues. Municipal bonds make sense for certain investors, but it is going to
become very important to know who your municipal bond fund manager is. Can they
discern between good credit and bad local management? A small change in ZIP Code
can make a huge difference in returns.
Is this a national crisis? I don't think
so, but it can certainly be a local one. If I were you I would do little
research. And maybe it would be prudent for both of us to get a little more
involved with our local cities. I still have scars from getting involved in
city politics in Arlington many years and a couple of lifetimes ago, but maybe
I need to ask a few questions here and there. And perhaps
you should, too.
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