The Golden Goose Lays an Egg: Fiduciary Issues with Public Pensions

(This is the second installment of a three part series.)

If the pension plan is a dinosaur, then the public employee sector must be Jurassic Park. In our previous installment, “The Rise and Fall of the American Pension,” (FiduciaryNews.com, August 26, 2014), we identified the various reasons for boththe ascendency and the virtual extinction of pension plans. It turns out, while the 401k plan may have been “the final nail in the coffin,” the death spiral of the pension plan began long before “company matching” became a popular catch-phrase.

“Congress changed the rules in about every act of legislation in the 1980s, making it extremely onerous for private companies to continue the funding of lavish pensions,” says Joe Gordon, Managing Partner at Gordon Asset Management, LLC in Raleigh-Durham, Chapel Hill, North Carolina. “In addition, the quasi-government agency, the PBGC, continued to be poorly managed, resulting in exponential increases in premiums for participants, all to mostly bail out plans of bankrupt union companies, mostly in the airlines and steel industries. Remember Pan Am, Eastern, United, at least twice, and US Steel?”

Yet, for all the eulogies we’ve heard pertaining to the corporate pension plan, public pension plans continue to thrive. Do they possess some immunity gene not found in theirprivate sector brethren? “The risks are the same for public and private pensions,” says Daniel J. Dingus, President and Chief Operating Officer and Director of Portfolio Management at Fragasso Financial Advisors in Pittsburgh, Pennsylvania. He goes on to say, “Currently, though, public pensions have more options to solve or (mostly) delay the inevitable problems.”

Ah, vive la différence! And what a difference the funding source makes. It is the difference between a never ending cornucopia of delights and a limited edition heirloom. One provides an infinite supply, while the other, by its very name, is limited. Robb Hill, President of R Hill Enterprises, Inc. in Aurora, Illinois, says, “The public plan is funded by taxes, which can be raised at will by our politicians. A private plan has no unlimited funding source.”

In that sense, some view the public pension as all upside and no downside. “Pensions are a great retirement vehicle as it allows predictable cash flow to retirees,” says Matthew Reischer, Esq., CEO of LegalAdvice.com in New York City. “Public pensions have lasted longer than private pensions because through the power of taxation the government simply taxes the private sector to shore up pensions accounts.”

Not only do public pensions appear to have none of the ill effects of private pensions, they also come with built-in advantages, too. “Public pensions have persisted much longer for several basic reasons,” says Dingus, “Municipalities have a tax base to rely on and their employees are a critical and unyielding voting force. Private firms have shareholders who represent a more critical voting base, which explains why private pensions have diminished in number so rapidly.”

The leverage of a voting constituency often makes it easier to sustain public employee pensions. Brent Leavitt, Healthcare and Financial Adviser, Nevada Benefits, Las Vegas, Nevada, says public pensions have outlived private pensions “because they are able to use new tax dollars to fund the under-funded accounts. This is why public unions and people fight so hard to keep them going. It only takes new legislation to come in and not pay those unfunded liabilities.”

However, this “positive” calls into question the very viability of the seemingly bottomless pit of a funding source. “The only mechanism supporting public pensions at the present time is taxation and borrowing,” says Reischer. “The ability to tax can ensure that pensions are perpetually funded up until the point where the growth of the private sector contracts. At that point the public sector has a problem funding pensions and simply borrows the money into existence and adds to the growing government deficit in the process. Eventually there is no real productive capacity to support the public pension system. There will one day be a reckoning.”

Private sector organizations avoided this day of reckoning because to ignore the looming funding problems meant financial ruin, bankruptcy, and, eventually, oblivion. Tom Scanlon, a financial advisor at Raymond James in Manchester, Connecticut, says, “Public pensions have lasted longer than private pensions because there is no profit motivation in the public sector. Corporations found extensive cost savings by shifting from the defined benefit plan to a 401k Plan. Additionally public officials get elected (or not) and one of their largest constituencies is public servants.”

“In a nutshell,” says Hill, “our government has an insatiable appetite for our money and they are not profit driven. In essence; there is no competition so they can pretty much do what they want as far as pay and benefits go.”

In the worst case, some see manipulative politicians using the lure of this public benefit to draw votes. Ilene Davis, Financial Independence Services of Cocoa, Florida, says, “They buy votes of employees and their friends and family and most legislators haven’t been honest with the public about the cost.”

It is this connection between the elected officials who negotiate with the public unions and the political lobbying of those public unions that calls into question the potential for a significant fiduciary breach. Lawrence J. McQuillan, PhD, author of the forthcoming book titled California Dreamin’: Resolving the Public Pension Crisis, explains how this conflict-of-interest works when he cites the three reasons for the tenacity of public employee pensions. McQuillan, a Senior Fellow & Director of the Center on Entrepreneurial Innovation at The Independent Institute in Oakland, California, says, “First is the strength of public employee unions to elect legislators who favor preserving generous defined benefit public employee pensions. Second is that politicians can promise lavish pensions to be paid in the future, win union support, yet not have to contribute much upfront in the early years. Politicians can take credit for the generous promised benefits while kicking the cost down the road. Third is that, unlike the private sector where competitive pressures are strong, governments have few competitors and soft budget constraints so they can reward supporters with outsized pension benefits.”

It is this never-ending self-serving cycle that defines this critical fiduciary issue. It threatens to turn this golden goose into a rotten egg. “Public pensions are popular because public employee unions pay to elect their chosen politician,” says Gordon. “When elected, he turns around and rewards them with lavish pensions. It is a pay-to-play scheme of the worst type because the victims, local or county, city, and state taxpayers have no clue they are on the hook. The only recourse is to vote with your feet, and move. Witness Detroit’s bankruptcy. Many elected officials are doing criminal time. The city has shrunk as people fled. No tax money left to pay the pensions or other services.”

Indeed current New York State Governor Andrew Cuomo made his political hay when he got former New York State Comptroller Alan Hevesi – the sole trustee of the New York State Retirement Plan – to plead guilty to charges of felony public corruption (see “The NY Pay-to-Play Rap Sheet,” Fortune, October 7, 2010). Clearly, between the amount of money involved and the extensive conflicts-of-interest, the temptation may be too great for the average human being. (In an ironic twist of fate, Andrew Cuomo’s current re-election bid is threatened by his own conflict-of-interest scandal. See “Cuomo fears the worst as first polls after scandal approach,” New York Post, August 4, 2014.)

Dingus says, “There is an inherent conflict-of-interest in those who vote for and receive the benefits versus those that pay for the benefits. The problem rests with the fervent former who votes versus the nuanced latter who generally abstains. Unfortunately the situation continues to snowball. Investment returns cannot solve the problem nor absolve the conflict-of-interest.”

Consider this: If the plan sponsor of a private sector company used retirement funds for his own personal betterment, would not the regulatory weight of the DOL come crashing down upon him? Davis says, “Public pensions are approved by politicians who don’t have to pay it out of their pocket, who can’t be held liable if problems arise in the future, and who usually don’t care about the future, just getting re-elected. It is politicians who approve those plans that vote on the laws overseeing both public and private plans. And people who don’t pay any taxes can still vote… Private companies have done the math and know that its either continue the company, or the pension plan, and their board and management, which can be voted out by the people who actually own the company (shareholders) if those owners see the company’s future being compromised by unrealistic benefit programs.”

Davis bluntly sums up this potential fiduciary SNAFU as “not a very politically correct response, but one I think is closer to the truth than most.”