$6 billion short, no easy answers: Council pension Q&A (updates)

Philadelphia's $5 billion pension fund is an asset some city officials would love to direct toward investing in the city's rundown neighborhoods and prospective employers. (With updates 5/18. See also my column in May 30, 2016 Philadelphia Inquirer.)

Sadly, the city owes its pensioners a lot more than that -- $11 billion -- after years of underpayment and mixed investment yields. It's going to be tough to make up the difference in the years ahead. Maybe extra tough if we give the fund new missions, like local economic development.

The shortfall forces the city to spend more than $600 million a year, or nearly one-sixth of its budget, in hopes of shoring up the pension fund so it doesn't run out, which would leave taxpayers with a much bigger annual bill.

Most of City Council showed up Wednesday (5/11/16) to review pension prospects and pet projects. Here's what they asked and how pension chief Francis Bielli and city finance director Rob Dubow fielded their queries:

BIELLI gave the short report. He noted that the system's asset/liability ratio fell to 45% this year, from 46% last year, due partly to flat investment results that missed its 7.75% longterm target, in belated acknowledgement that few if any pension fund returns have averaged that high over the past 3, 5 or 10 years (as I noted in Sunday's Inquirer.) Cutting the target slightly, from 7.8%, also increased the reported deficit.

And, demographics: "We have 35,200 retirees, and (only around) 25,000 active employees (paying into the fund). Boston, Chicago, Los Angeles, Houston, most of them have more workers than retirees. Our investment returns are not the issue."

Hedge fund returns that once juiced Philly returns have dragged performance down the past two years. The board this year has voted to sell all but 2 of its 7 hedge fund investments.

16% of managers are "diversity" firms, Bielli noted. 12% of assets are "local."

DARRELL CLARKE, the council chair, asked how the pension system will "reduce management fees and costs."

BIELLI said hedge funds accounted for more than half the system's $28 million in yearly manager fees. With most of the hedge funds fired and the survivors' fees getting negotiated down, that number should drop, Bielli said.

CLARKE cited this Charles Schwab TV ad: "Why do we pay fees when we lose money?" 

BIELLI: "Great question... There are management fees and performance fees... We don't think it's justified unless the fund is making money." Especially with "alternative investments" where some fees are keyed to high profits. With most stock and bond funds, "you pay a much smaller fee," around 0.13% of assets managed/year, which Bielli noted is a lot less expensive than hedge funds (up to 2%, plus a share of profits.)

CLARKE asked how much money from the city sales tax extension was budgeted to the pension system.

BIELLI: It will "incrementally increase" to "$50 million by 2020." City finance manager Rob DUBOW noted the city five-year PICA plan calls for $180 million in sales tax support over that period.

CHERELLE PARKER praised Bielli and the pension plan for "managing the system" past the "vagaries associated with the market" despite what she regards as unfair attacks in the press, such as a failure to celebrate Philadelphia's cutting its assumed annual rate of return to 7.75% from even more unrealistic previous figures.

But she also noted pensions will eat up more than 15% of the next city budget. She noted that most "hedge fund and portfolio managers are white," and cited a McKinsey study noting that "diverse companies were more likely to provide financial returns above the medium."

BIELLI agreed, and attributed minority outperformance to the fact that "emerging managers" -- money newly invested -- tends to outperform larger and more established funds. He added that one of the city's two remaining hedge funds is a "diversity" firm.

PARKER said she's glad to leave it to investment pros to decide whether city pension funds should be in stocks or other investments, rather than shifting that responsibility to workers through "defined-contribution" or 401k type plans: "That's not what I do," and many employees don't feel qualified to make those decisions, either

ALLAN DOMB asked how much money would be needed to fund the city's controversial DROP early retirement program -- About $1.25 billion, Bielli confirmed. Domb noted how employees in Chicago and some other cities contribute more than Philadelphia city employees are currently made to pay their pension plans; asked when other city employees will join police and firefighters in negotiating to end overtime earnings from pension calculation; and suggested he will have "six steps to solve the pension."

BIELLI said he looked forward to Domb's suggestions, noted there is currently a union/administration task force laboring away on its own recommendations, and suggested Domb maybe coordinate.

Dubow later clarified for me that most of that DROP expense would be paid anyway to pensioners even without early retirement -- just at a later date. So what is the program's net cost? The city's last estimate -- a cumulative $230 million -- was calculated by Boston College experts back in 2010.  It's more by now, but the city doesn't know how much more.

Domb told me later: "What we need to do falls in four categories: Increased funding; Increased employee contribution; Reducing cost of living; Changing the benefit structure." Citing Pew research, Domb pointed to Atlanta's 2011 reforms, Chicago's 2013 reforms and Jacksnonville, Fla.'s 2015 reforms as models for Philadelphia.

"(Ex-Mayor Rendell aide and Comcast XVP) David L. Cohen and some other smart people tutored me and the other new Council members on pensions, and PICA (the city's state-oversight fiscal board) has made a lot of good recommendations, and they've made me an advocate of good ideas that have been developed by smarter people than me. 

"I know pensions are a sensitive subject. But this is a major problem -- along with (education and public safety) -- and it needs to get solved. A private business trying to run a plan with more retirees than workers like this, would be out of business. We have to make it so the pension will be there in 30 years, when people need it.

"So here goes: We have to look at making today's optional Plan 10 (bare-bones guaranteed pay, plus a 401k type plan) mandatory for new hires. We need to eliminate DROP (early pension payout program). We need to eliminate overtime for those jobs that still use it in calculating pensions. We ought to extend (non-union) vesting to qualify for a pension, from 5 years to 10 or more."

He's also not sure $600 million a year is enough for the city to be spending on pensions: "It's our responsibility to be there for the people who have served." 

DEREK GREEN asked about the plan's Opportunity Fund, which previous pension staff set up to find more new and diverse managers.

BIELLI noted it was the pension system board that set up that target. "The Board's first and foremost obligation is to hire good investment managers," he added, noting again that "emerging managers have outperformed established managers."

He noted that the board's new advisor, MARQUETTE CONSULTANTS of Chicago, holds an annual emerging-managers symposium that Philadelphia plans to attend again this year: "They have a very, very good outreach to minority managers."

HELEN GYM asked Bielli "for a list of managers and compensation." State investment funds publish that information, online, two to three months after the end of each calendar year. In Philadelphia you have to ask for it.
BIELLI said he'd send.

GYM wants the pension fund to list all "Investments in companies that have closed plants in the U.S. and opened in other countries," and asked if there are restrictions on investing in companies that hurt Philadelphia jobs. 
BIELLI noted that Pfizer, which considered merging with an Irish company to cut its U.S. income tax, is widely-held in U.S. stock-index funds, including some that Philadelphia owns.

GYM: What about "companies that have moved their corporate offices or subdidiaries overseas? It's important for us to understand which companies are invested in building (the economy here). We want to be thoughtful about companies that avoid payment of taxes."
Also, "how much do you have invested in companies in Philadelphia and Pennsylvania?"
BIELLI: "12.28% of the fund is invested in Philadelphia, a little higher if you count suburban."

GYM: "Is there any barrier to investing in our local economy?"
BIELLI: "We prefer to hire local," when choosing between two similar managers.
GYM: "But if 88% (of the city's investments) are going (to) outside (managers,) what exactly are the factors preventing money from going local?
BIELLI "Various factors..." Local firms might not respond to pension Requests for Proposals. Or local firms might "not be performing as well... If there are two equal managers, we will always go to the local one."

GYM: "But what are the barriers to (making) greater investments in Philadelphia? It sounds like we are in the area of guessing."
BIELLI: "They perform, or they don't perform..."
GYM: Which is it? The lack of local managers? Or that they don't perform? Or we don't know?
BIELLI: "I'm not confused. The bar is whether they are performing, or not?"

If Gym sounds persistent in pursuit of a local-investment agenda, she clarified later for me that she is still at the fact-finding stage: "My office is just starting to look at these issues. We are working to better understand our options and their limitations as we consider pension investments." 

DAVID OH: Asked about city controller Alan Butkovitz's suggestion that the city "buy out" pensioners with an upfront payment discounted from the alternate defined-benefit until-you-die checks.
DUBOW: Actuarial review suggests a "straight buyout" wouldn't significantly reduce the pension system's deficit.

OH: "I would be concerned about people cashing in needed retirement funds," but wouldn't buyouts work for people who had other pensions and weren't in danger of poverty?
DUBOW: "Could be."
OH: Asked if there should be more "professional pension managers on the pension board."
DUBOW: "We do have professional eyes looking" at the pension plan.

OH: "We need systemic change..."
DUBOW: "We can't earn our way out (of the pension deficit). We have to think of systemic solutions. It's not an investment problem."

PARKER: Maybe we should have a hearing on pension buyouts. Treasury and IRS have said these "are not allowed in the private sector."

She asked for progress on "revenue-generating solutions" such as using particular taxes or city assets to fund the pension plan. "I take this very personal. Most (pension) solutions should come through collective bargaining." 

She also asked about Maryland and New York City initatives to allow more people to "buy into" public pension plans.

BIELLI: "Pensions and Investments (magazine) in its May 9 issue writes about how Maryland now allows people without pensions to deduct into the state defined-contribution plan. That would be beneficial for people who don't otherwise have access...

"Our defined-contribution plan is approaching $1 billion. We have 20,000 participants, vs. 13,000 in 2009."

BOBBY HENON wanted to know about "international investments. Verizon (with 40,000 workers on strike) is offshoring its workforce, its call centers."
He also asked if the city pension plan faces a state takeover, since its assets are less than 50 percent of its liabilities.

DUBOW: "If you are below 50% funded you are taken over by state. But we are still exempt from that."

That's true, for now, but legislation pending in Harrisburg could result in Philadelphia merging its underfunded plan into one of the state-run systems. 

In a follow-up conversation, Bielli repeated city officials' contention that investment returns "have not been the problem" in causing the plan's shortfall. He blamed historic "underfunding."

The plan was last nearly solvent -- with assets 80% of liabilities -- in 1999, after borrowing $1 billion in an expensive and ill-timed bond issue. Much of that money was lost in the subsequent dot.com bust; taxpayers are still paying off the bonds.

After that, Mayor John Street for several years paid enough into the pension funds to keep the deficit down -- then reduced payments to the state-manded minimum in his second term. Nutter initially boosted pension payments, temporarily suspended them when tax revenues fell in that recession, and eventually paid the money back "with 8% interest," ahead of schedule, Dubow reminded me.

For all the explanations, the bottom line is that city pension assets are low and declining as a percentage of obligations, and the pension deficit is larger than the city's yearly budget. Thus the urgency to find more funds and cut costs.