bond market outlook - capital one

JUNE 30, 2016 | BOND MARKET OUTLOOK 1

BOND MARKET OUTLOOKBeach Reading Issue

No part of this document may be reproduced in any manner without written permission from Capital One’s Wealth and Asset Management Group. For full disclosures, see last page of document.

June 30, 2016

PROFITABLE RISKS / SM

UNPROFITABLE RISKS

Loss avoidance is a key to long term investment success. We deem certain risks profitable, to be exploited with sound research, while other risks are inherently unprofitable and should be avoided.

OUR RISK MANAGEMENT TENETS

A rigorous top-down approach toforecasting liquidity conditions is

an essential ingredient in fixed-income risk management

Active management of interest rate risk within modest limits is a cornerstone of successful fixed income portfolio management

Extreme variation from bench-mark duration is counter-productive

Yield curve, sector positioningand careful employment of creditrisk offer attractive cyclicalopportunities to add relativevalue

Opportunistic and modest em-ployment of high yield andinternational debt elements canadd significant value to a coreinvestment grade mandate

VIEWPOINT ERIC C. REYNOLDS Senior Portfolio Manager

TOUR OF A BREWING CRISIS: UNFUNDED MUNICIPAL PENSIONS

Investor vigilance, good governance, judicial precedents and taxpayer activism will separate well managed municipalities from those that slide toward insolvency

Executive Summary: The lesson from the 2008 financial crisis is that bad things happen when investors are not vigilant and quality governance is lacking. Conversely, problems can be resolved and crises can be avoided when vigilance is supported by good governance. Today, we face a potentially broad-based problem with underfunded municipal pensions. Capital One Asset Management is doing its part to express vigilance by limiting the access of municipalities that have pension funding issues to our clients’ capital. The flip side of this is that we also reward good governance through the movement of client capital. As time passes, we expect to be joined in our vigilance by other investors. We expect even greater scrutiny by the ratings agencies. And we expect that the market will join us in rewarding municipalities that address their issues. Finally, we believe that the best chance for better governance is a better informed and motivated citizenry that firmly demands better governance and drives the change that is in society's collective best interest.

Vigilance: One of the key foundations of our investment philosophy at Capital One Asset Management is that vigilance means not accepting risk when you are not compensated for it, understanding what it is you are buying and why, and refusing to make or hold onto investments that do not meet our standards. This basic principle was widely ignored by the marketplace in the years leading up to the financial crisis in 2008, as mortgage lending standards were non-existent and the mortgage-backed securities (MBS) market was not rationally priced. Inflated real estate prices and loans that required neither down payment nor documentation of income were prevalent. Despite the painfully obvious nature of these facts, the behavior of very few mortgage-backed securities investors was altered and the systemic risk that was developing was broadly ignored. Non-government-guaranteed or “private label” AAA rated MBS, many of which were sub-prime, provided almost no incremental income relative to the government-guaranteed Agency MBS. Given that both agency and AAA private label MBS were both secured by loans that lacked rational underwriting standards, the implication was that the guarantee provided by taxpayers to agency MBS was being given away for free. The immense value of this guarantee was revealed as the financia crisis unfolded. Taxpayer-guaranteed agency MBS returned a positive 8.3% in 2008, while many non-government-guaranteed AAA private label MBS experienced losses in the neighborhood of 25 to 30%, with some AAA s


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No part of this document may be reproduced in any manner without written permission from Capital One’s Wealth and Asset Management Group. For

full disclosures, see last page of document.

sub-prime floating rate securities losing close to 80% of their value1,2. While the guarantee protected agency MBS investors, the guarantee did nothing to keep many everyday citizens from taking on mortgage debt that they had little possibility of being able to repay.

CURRENT RISK ASSESSMENTS

Duration strategiesmodestly long v. benchmarks

ATTRACTIVE SECTORS: 5-7 Yr Treasuries for optimum

roll-down returns Investment grade Finance credits Super-senior commercial

mortgage-backed securities Short duration high-yield corpo-

rate bonds High quality Municipals with no

pension funding challenges

UNATTRACTIVE SECTORS: Emerging Market credit and

currency exposure Developed Market credit expo-

sure Long duration high yield corpo-

rate bonds

in

Lesson: There can be no crisis if there are no buyers. Had mortgage investorexpressed vigilance in 2008 and refused to own MBS, either agency or privatlabel, that were backed by loans of dubious quality, the scale and scope of thfinancial crisis would have been dramatically reduced. A forward lookinapplication of this lesson might be that the public sector employee’s pension ilike the government-guaranteed mortgage-backed security that because otaxpayer backing does fantastically well as things go dreadfully wrong. Just as thvalue of the guarantee on the agency mortgage-backed security was underappreciated prior to the mortgage crisis, today the size of taxpayer backing omunicipal pensions is under-appreciated. In fact, unfunded municipal pensioliabilities have been estimated to be larger than the entire $3.7 trillion municipbond market8. Also, similar to the lack of appropriate mortgage underwritinstandards prior to the financial crisis, today many municipal pensions broadly lacappropriate governance, be it legal, accounting or oversight. Further, manpension systems provide retirement compensation that far exceeds the level oretirement compensation that is available in the private sector. When fundinshortages occur, they are usually staggeringly large and the taxpayer is on thhook for all public pension shortfalls, even if it means funding pensions at thexpense of all other municipal services, such as schools, roads or safety. ThMunicipality also guarantees a high rate of return on the public employee’pension portfolio. However, because many taxpayers are not familiar with, or dnot fully understand the issue, they are often persuaded to support municippensions. Today, taxpayers are in dire need of some good old-fashionemunicipal bond investor vigilance. This means that municipal investors need ttake unfunded pension liabilities into account when making investmendecisions. If municipal investors ignore this problem as MBS investors ignorepoor underwriting standards before the financial crisis, then more and mormunicipalities will be suffocated under the weight of their unfunded pensioliabilities.

s e e g s f e -f

n al g k y f g e e e s o al d o t d e n

Governance: Investor vigilance is perfected by sound governance and this combination has great capacity for significant societal good. From our perspective, quality governance means making clear rules that set fair, rational and enforceable boundaries. Good rules facilitate the allocation of scarce and valuable resources to their best and most efficient use. Good governance also requires facing and managing problems as they present. Had rules and practices that encouraged rational mortgage underwriting standards been in place prior to the mortgage crisis, the financial crisis would have been radically diminished. Had good governance coincided with investor vigilance, the financial crisis would likely have been avoided altogether. Borrowers would not have been able to take on loans that they could not service and, as a result, their lives as well as society

__________________1 M0A0, The BofA Merrill Lynch US Mortgage Backed Securities Index, (2008) 2 Jeff Gundlach, CNBC TV Interview, (May 4, 2016) 8 Dr. Dan DiSalvo, Presentation, Pensions and Public Sector Unions. The Politics of Legacy Costs, (June 9, 2016)




in general would have been better off. However, in the period before 2008 investor indifference coincided with bad governance, a lethal combination which both enabled and amplified the crisis. For example, in April 2004, with the encouragement of the large investment banks, the Securities and Exchange Commission unanimously decided to change the net capital rule in a fashion that allowed the largest broker-dealers to increase their debt-to-net-capital ratios from 12 to 1 to up to 40 to 1 in some cases3. Permitting this type of leverage in the financial system has never been a good idea. Wall Street overestimated it’s collective ability to manage and control risk as their judgement was clouded by the allure of ever greater profits. A major effect of changing the net capital rule was the release of billions of dollars of reserves which had previously been held to cushion against possible losses. Much of the freed up reserves migrated into private label MBS and the types of mortgage credit derivatives that compounded the destructive forces of the financial crisis and which have been extensively chronicled in Michael Lewis’ book The Big Short4. Repetitive failures in vigilance and governance before the financial crisis point to the value and great need for good governance today. The perils evident in today’s municipal bond market demand a reminder that when poor vigilance is combined with bad governance it tends to lead good and well intentioned people to engage in terrible behavior, the consequences of which are often broad-based bad outcomes for both society and the financial markets.

Unfolding Crisis: Today, a lack of bondholder vigilance and poor governance are evident in the area of unfunded municipal pension liabilities. Once again, this dangerous combination is potentially enabling a systemic financial problem and encouraging bad and irresponsible behavior. Although an oversimplification, unfunded pension liabilities are created when the current year’s pension contribution is less than the actuarially required pension contribution. The unfunded liability becomes the long-term debt of the municipality and this debt must be paid off over time. These unfunded liabilities also grow over time as they accrue at the high rates of return embedded in the plan’s actuarial assumptions. As unfunded pension liabilities accumulate, making payments on this debt becomes increasingly difficult and crowds out other traditional municipal services such as schools, roads and safety. Over time, if unfunded pension liabilities are not adequately addressed they can lead to the eventual insolvency of the municipality. Where problems are acute, the major sources driving the growth in unfunded pension liabilities are the utilization of unrealistically high return assumptions, the ongoing under-funding of municipal pensions and the increase in pension benefit levels over time. These drivers are amplified by the low return environment that is prevalent in our post financial crisis world; by government accounting standards that understate the problem and by benefit levels which in many cases enable beneficiaries to earn more in retirement than they did during employment.

________________________3 Julie Satow, TNY Sun, Ex-SEC Official Blames Agency (SEC) for Blow-Up of Broker Dealers, (September 18, 2008) 4 Stephan Labaton, The New York Times, Ageny's 04 Rule Let Banks Pile Up Debt, (October 2, 2008)


________________________5 National Association of State Retirement Administrators, Brainard & Brown, The Annual Required Contribution Experience of State Retirement Plans, FY 01 to FY 13, (March 2015)6 The Pew Charitable Trusts, Brainard & Brown, State Pensions Funding Gap: Challenges Persist, FY 01 to FY 13, (March 2015)7 State Budget Solutions, Bob Williams, State Unfunded Pension Liabilities exceed $1 Trillion, Analysis Marks pension liabilities as root of Budget Crisis,, FY 01 to FY 13, (March 7, 2011) 8 Dr. Dan DiSalvo, Presentation, Pensions and Public Sector Unions. The Politics of Legacy Costs, (June 9, 2016)



Return Assumptions: To provide an idea of the importance of return assumptions and how fast unfunded pension liabilities are growing, consider the following. The annual dollar amount that a municipality needs to contribute to a pension plan to keep it on track to meet its future liabilities is referred to as the actuarially required contribution, or ARC. ARC is similar to a private citizen annually funding his 401K at a level adequate to fund his retirement. From 2001 to 2013, the required contribution, or ARC, for state plans grew by 9.9% annually. During this same period, the level of actual contributions to state plans grew by just 8.1% annually5. This funding gap helps to explain why a 2013 Pew Foundation study, which relies on municipal accounting standards, revealed that the nation’s state and local municipal retirement systems had a pension funding shortfall of more than $1 trillion6. The scale of the problem begins to come into focus when one recognizes that the entire municipal bond market is about $3.7 trillion. However, if states used accounting standards like those used in the Novy-Marx and Rauh studies, which use long term treasury rates in determining the value of unfunded municipal pension liabilities, the problem jumps to a $4 trillion unfunded liability7,8. Further, Dan Disalvo credits Lutz and Sheiner with estimating that other post-retirement municipal benefits amount to an additional $1.1 trillion of unfunded municipal liabilities, making the entire problem more than $5 trillion and significantly larger than the entire municipal bond market8. eOne reason that pension liabilities are underestimated stems from the fact that municipalities use their expected return assumption to discount the value of their pension liabilities and their return assumptions are unrealistically high, averaging more than 7.5%. Globally, central banks have used low interest rate policy to promote economic growth and to stabilize and bolster the price of financial assets. Central bank actions have clearly boosted the price of financial assets. This means central banks have effectively pulled investment returns into the current period at the direct expense of future period returns. This means that going forward the return assumptions used to assess the sufficiency of pension funding levels over the next decade or two need to be much lower, probably around 2.5% above long term treasury rates or about 5.5% as of 12/31/15. As bad as that sounds, making even minor changes in the assumed rate of investment returns significantly affects the size of the annual required pension contribution, or ARC, that is needed to properly fund pensions. To provide context, the Colorado Public Employees’ Retirement Association (PERA) published a sensitivity analysis showing the effect of reducing its return assumption by ½ of 1% from 7.5% to 7.0% on each of its 5 different plans. The analysis showed that this change would increase the plans’ annual funding requirements (ARC) between 11% for the least impacted plan to more than 25%quired

for the most impacted plan5. The effect of a 2% reduction in the return assumption to a realistic 5.5%, is 4 times the size of the above example and is akin to PERA having to increase their annual required pension contribution, or ARC, between 40 to 100%. Funding municipal pensions at the level required in our low return world would lead to an immediate, significant and in some cases a complete crowding out of all competing traditional municipal services, such as schools, roads and safety. Our low return world also demands that a taxpayer contribute dramatically more to his 401K to fund his retirement, but he will have less money to do so because he is being handed the tax bill to fund the shortfall in municipal pension plans.

Unfunded Pensions: Another reason unfunded pension liabilities are growing is because many municipalities chronically underfund their pensions. Puerto Rico, the insolvent Territory, is the poster child for underfunding pensions and is a prime example of investor indifference and ignoring poor governance and economic reality. Puerto Rico’s municipal debt has been unfit for investment for years. Its economy has experienced an average annual contraction of -1.06% since 2005. From 2009 through 2014, Puerto Rico’s population, its tax base, contracted at an annual rate of 2.2%9,10. Puerto Rico’s ability to service its traditional municipal debt is impaired and when the need to also service its unfunded pension liability is taken into account Puerto Rico is simply disqualified as a viable municipal investment. $70 billion is the amount of debt cited when the prospect of a Puerto Rican debt restructuring is discussed in the press28. If Puerto Rico were able to write-down its debt by half, or $35 billion, a number considerably larger than what has been discussed thus far, and the restructuring of its debt was handled in a principled fashion with losses allocated appropriately among its various creditors, the leadership in San Juan might say, Hurrah, things are going to be alright. But they would be wrong. Puerto Rico would still be non-investable because the Territory would still have an unfunded pension liability in excess of $43 billion29. What is particularly appalling is that Puerto Rico has not funded its pensions year after year and when it has made a pension contribution, much of it has come from the issuance of pension debt. As a result, its pensions are funded at a rate below 5%! To be absolutely clear, the Puerto Rican government is the villain in this story, but they were facilitated by epically non-vigilant bond investors that are reminiscent of the non-vigilant mortgage-backed securities investors prior to the financial crisis. If Puerto Rico’s debt is restructured without also addressing its grotesquely unfunded pensions, then just like Greece, Puerto Rico will need to be bailed out again and again and again.

The Right Signal: The resolution, known as PROMESA or the Puerto Rico Oversight, Management, and Economic Stability Act, currently being worked on

5 National Association of State Retirement Administrators, Brainard & Brown, The Annual Required Contribution Experience of State Retirement Plans, FY 01 to FY 13, (March 2015)9 U.S. Census, Per Census, (2014)10 State Budget Solutions, Bob Williams, State Unfunded Pension Liabilities exceed $1 Trillion, Analysis Marks pension liabilities as root of Budget Crisis, (March 7, 2011) 28 The New York Times, Mary Williams Walsh, Puerto Rico Debt Crisis Explained, (June 27, 2016) 29 Reuters, Nick Brown, Uneasy Island Puerto Rico's other crisis: impoverished pensions, (June 27, 2016)




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JUNE 30, 2016 | BOND MARKET UPDATE OUTLOOK 6



in Washington would be terrific if Puerto Rico’s problems were limited to one or two municipal issuers, but Puerto Rico’s insolvency affects the entire Territory and ensnares as many as 18 different municipal issuers. An enduring solution probably requires a comprehensive financial reboot of the Territory which seems beyond the scope of what is currently being contemplated. Investors in Puerto Rican bonds probably need to sustain material and in some instances complete write-downs of their investments. The first reason for this is so that post-reorganization Puerto Rico will have a chance to be economically viable. The second reason is so that bond investors will learn to be respectful of their capital and thereby be moreavigilant in the future. This is not said lightly as many of the parties that will be hurt by this are private citizens that do not have government pensions and the funds written down represent a loss of a lifetime of savings that were intended to help provide for them in retirement. However, how losses are allocated to various municipal entities and their creditors is critical and needs to be principled in order for the resolution process to be effective. Most importantly, the priority creditor status of Puerto Rico’s unlimited general obligation bonds needs to be upheld in the process. Central to municipal bond investing is the notion that the claims of unlimited general obligation debt are senior to all other unsecured general creditors. In the case of Puerto Rico, this presumption seems irrefutable because of strong constitutional protections. However, it has been politically popular in many instances to place the claims of pensioners in front of all other creditors. As the situation in Puerto Rico is addressed, if unfunded pensions are not addressed or if pensioners fare better than the holders of general obligation debt, this would promote broad-based distrust of the municipal credit resolution process. It will also discourage investment in general obligation debt. The impact will be most acute for local level municipalities that show signs of difficulty in funding their pensions.

Solution: Achieving a resolution that prevents Puerto Rico from being a chronic and ongoing problem like Greece probably requires a complete write-off of Puerto Rico’s unfunded pension liabilities and a write-down of Puerto Rico’s traditional municipal debt that is sufficient enough to allow Puerto Rico to become economically viable. Achieving this might be possible if the U.S. were to agree to fund all or a material portion of Puerto Rico’s reported $43 billion unfunded pension liability in exchange for converting their pension plans to defined contribution plans (401K-like). A path to statehood that is dependent upon good and sustained financial behavior might also be the type of change that drives closure. In the absence of achieving and sustaining good financial management, Puerto Rico would lose its status as a U.S. Territory. This is the antithesis of kicking the can down the road. The solution being worked on in Washington calls for the creation of a financial control board in exchange for allowing Puerto Rico to restructure its $70 billion in debt. While there is little specific discussion of addressing unfunded pensions, there is open-ended language suggesting the plausibility of appropriate resets of pension liabilities. It is interesting to note that when Congress addressed Washington, D.C.’s financial problems in the mid-1990s it first employed a financial control board similar to the option being discussed for Puerto Rico. However, it was not until structural reforms were added to the mix, including the federal government’s absorption of D.C.’s $5 billion in unfunded pension liabilities that things began to turn around in


prome________________________12 Brooking Institute, Bouker, DeRenzis, Friedman, Garrison, Ravlin, Yound, Building the Best Capital City in the World, Appendix 1, (December 18, 2008)13 National Center For Policy Analysis, Gokhale, Measuring the Unfunded Obligations of European Countries, (January 2009)14 The Economist, America's Greece, (December 20, 2014)



in D.C12. It is also interesting to note that today Washington, D.C.’s pensions are fully funded and that, as a firm, we have purchased D.C. income tax secured revenue bonds for our clients. The argument being put forth here is that fully addressing Puerto Rico’s problems the right way and now is likely the lowest cost remedy that provides the most sustainable and best long-term solution. A comprehensive resolution would also likely include some non-pension relief. It should cost U.S. taxpayers less than $50 billion to resolve and would give Puerto Rico a chance to become a state and a viable economic entity.nIt would treat pensioners with more respect than the Puerto Rican government has and it would prevent future pension funding shortfalls from ever again being transferred to the U.S. taxpayer. To provide context, Greece’s economy is roughly 2.5 times the size of the Puerto Rican economy. Europe has probably already spent in excess of $125 billion on Greece, or 2.5 times the cost of addressing Puerto Rico’s problem. Regardless, Greece continues to be an ongoing and seemingly unresolvable problem. Greece has no path forward and its unfunded social obligations, which include unfunded pension liabilities, have been estimated at 875% of its economy (GDP). This implies that Greece’s problem is roughly a $2 trillion problem, or 40 times the size of Puerto Rico’s problem13. In this light, the situation in Puerto Rico seems finite and resolvable. Puerto Rico is a U.S. Territory and Congress is bestowed with the authority to resolve this situation.c

State Level Debt: Some worry that allowing the debt of Puerto Rico to be restructured will set a bad precedent as states are not allowed to file for bankruptcy. This concern is misguided because, in the absence of reform, unfunded pension liabilities will eventually push some states into insolvency whether they are allowed to go through the bankruptcy process or not. For example, as of June 2014, Illinois had amassed $111 billion in unfunded pension liabilities. And even though Illinois does not fully fund its pensions, it still devotes 25% of its current tax dollars to funding pensions, an amount that is in excess of the amount it spends on primary and secondary education14. However, Illinois’ problem is almost certainly much worse. According to Stanford University finance professor Joshua Rauh, Illinois’ true unfunded pension liability is $250 billion14. Illinois’ eventual fate is probably sealed because the courts have ruled that proposed changes to municipal pension benefits violate the state’s constitution. Court rulings that remove the ability to modify and manage municipal pension benefits seem questionable. This leads to the perception of possible conflicts of interest by parties that rule on pensions.

Local Level General Obligation Debt: While the absence of reform is likely to eventually push a handful of states that protect public employee pension benefits to insolvency or near insolvency, local municipalities are where the

problems are already presenting and are where they will be the most acute. This is because local level municipalities simply have fewer available options to handle financial adversity than states do.

Chicago: Our nation’s third largest City has chronically underfunded its pensions with annual contributions running below 50% of ARC. Chicago also uses unrealistically high return assumptions, ranging from 7.5- 8%30. Like the story of A Christmas Carol, Chicago serves as a warning of things to come. In 2004, Chicago’s actuarially required contribution, or ARC, was $550 million. By 2014 the city’s revenues had grown by 23%, but the annual ARC had grown by more than 200%15. To help solve this problem, in 2015 Chicago enacted one of the largest property tax hikes on record for a major American City. It is estimated that the tax hike will generate $543 million of additional annual revenue when fully phased in. Every dollar of the tax increase will go to funding pensions; nothing to schools, roads or safety16. But the real problem is that this tax increase is still about $400 million short of simply treading water and hence is not close to resolving Chicago’s pension funding shortfall17.To help close the gap, benefits in two of the City’s four plans were restructured, but a state court ruled the changes were unconstitutional. Finally, Chicago’s unrealistic return assumptions almost certainly materially underestimate the size of the problem. Given these facts, Moody’s downgraded the City of Chicago’s credit rating to junk status following the May 2015 State Supreme Court affirmation that municipal pension benefits are constitutionally protected in Illinois.

Houston: Like Chicago, our nation’s fourth largest City has underfunded its pensions with annual contributions running at about 75 to 80% of ARC since 200620. Like Chicago, Houston uses unrealistically high return assumptions with 2 of its 3 plans using 8.5%, which is the highest return assumption for a major plan in the United States18. Further, while pension benefits are not protected by the Texas State constitution, all three of Houston’s plans have fossilized their benefits by going directly to the State legislature and having their plans adopted as State statutes. The legislation codifies pension board of trustee membership and benefit levels, making the passage of new legislation the only means by which to make material changes19. Pension reform will occur in Houston, but because of this codification, the process will likely be slow and cumbersome and therefore far more expensive than it should be. The pension problem in Houston has been clearly understood by city officials for well over a decade. The problem has also been clearly laid out and politely articulated by the well-informed Arnold Foundation, the Greater Houston Partnership and the City’s former chief pension executive, Craig Mason. Each has encouraged the city to act on pension reform as its unfunded pension liabilities are growing rapidly. Moody's and S&P




________________________15 Bloomberg Brief, Municipal Market, Top Court Dashes Chicago's pension Overhaul, (March 28, 2016)16 Bloomberg News, Chicago Faces Record Tax Hike as Pensions Compound Deficit, (September 22, 2015) )17 Moody's, Chicago’s Delayed Pension Funding Is Credit Negative, (June 6, 2016) 18 Laura And John Arnold Foundation, Swamped: How pension Debt Is Sinking the Bayou City, (August 2015) 19 Texas Public Policy Foundation, Overview of Local Retirement Systems Under State Governance, (January 2013)

20 Plan Websites, www.hfrrf.org, www.hmeps.org, www.hpops.org, (ongoing)30 Plan Websites, www.meabf.org, www.labfchicago.org, www.fabf.org, www.chipabf.org, (2004 to 2015)

downgraded Houston’s credit rating in March of this year, with both agencies leaving Houston on outlook negative. The reality of what is happening in Houston is not polite and far more urgency is required. From June 2014 to June 2015, Houston’s unfunded pension liability increased by $1.45 billion, from $3.94 billion to $5.39 billion20. With fiscal 2016 year-end at hand, it is a virtual certainty that Houston’s pension plan returns are going to be closer to zero than to the plans’ assumed 8.0-8.5% returns. Given market returns over the past year, this means that another material increase in the size of the unfunded pension liability is baked in the cake. There is no time to waste in Houston.

Excessive Benefits: Excessive benefit levels contribute to unfunded pension liabilities. For example, in 2001 the City of Houston and the trustees of its various retirement plans supported legislation that resulted in dramatically increased pension benefits. Self-interested and member-controlled pension boards voted to increase pension benefits. They used self-appointed actuaries to calculate the cost of the expanded pension benefits. It has been reported by the Houston Chronicle that the pension boards assured the City of Houston that plan investment returns would cover the costs of the increased pension benefits and that the City would only need to contribute about 15 to 20% of budget annually to the plans. Despite warnings from a State-commissioned analysis, Houston’s chief administrative officer, who reportedly nearly tripled his benefits in the process, dismissed the State’s cost concerns as did then-Mayor Lee Brown and other City officials. No second opinion on the cost of providing the increased benefits was obtained and the bills making changes to Houston’s pension benefits were ratified by the Texas legislature21. By 2003, the costs of the more generous benefits pushed Houston’s unfunded pension liability from a state of being nearly funded to just less than a $2.5 billion unfunded liability. Thereafter, cost projections were adjusted shockingly higher in subsequent years22. By statute, all 3 of Houston’s municipal pension funds are run by boards controlled by self-interested fund members and beneficiaries. In contrast to Houston’s other two plans, the statute for the Houston Firefighters’ Relief and Retirement Fund (HFRRF) does not require the fund’s board to meet or confer with the City. The City of Houston has used the meet and confer process to help control the benefit costs of Houston’s two other plans. However, the Firefighters have a history of increasing benefits unilaterally and refusing to meet with the City. By statute, the Firefighters’ member-controlled board dictates how much Houston must pay into the fund, and Houston has no input or redress other than appealing to the state legislature. Still worse is the fact that the Firefighters withhold disclosure of data and metrics used to calculate the annual pension bill that it hands to the City of Houston under the guise of confidentiality23. This is not far afield from predatory lending practices in which a consumer gets a really

________________________b20 Plan Websites, www.hfrrf.org, www.hmeps.org, www.hpops.org, (ongoing)21 Houston Chronicle, Falkenberg, Houston Chronicle, Old Promise, rich pensions and deep problems, (February 13, 2016)22 Greater Houston Partnership, The City of Houston’s Finances Let’s Be Clear about Where We Are, (July 25,

2015) 23 Plaintiff's Original Petition and Application for Injunction, City of Houston V. Houston Firefighters' Relief Fund,

(January 22, 2014)




bad mortgage loan with no disclosure of how his payments are calculated and his mortgage payment can be increased by vast sums annually by the lender. Left untreated, the cost of servicing Houston’s pension deficit will syphon more and more funds away from traditional taxpayer-supported services such as schools, roads and safety until Houston drifts toward insolvency. The threat of crowding out traditional services is veryrreal. Consider the example that Pennsylvania’s auditor-general Eugene DePasquale provides about how Jefferson County, Pennsylvania often has just 2 police officers patrolling the county because it can’t afford police officer benefits24. In terms of square miles, the City of Houston and Jefferson County are close in size. Houston has a relatively short window to rectify its pension problems before the exponential math of a nearly $7 billion pension deficit, growing at 8.5% annually, which cannot be covered by investment returns nor contained by tax increases, takes over, a la Chicago31.

Houston’s Pension Benefits Have No Relationship to Member Contribution or Their Length of Service: In simple terms, Houston’s pension benefit levels are extravagant, and by our measure, as much as 400% more generous than the 401K benefit with a 100% employer matching contribution that is available to a hypothetical private sector taxpayer. How did this happen in Houston? Benefit increases enacted in 2001 created the ability for Houston Police, Fire and Municipal employees to receive dramatically more in retirement than they can while working. A standard defined benefit pension is 80% of the average salary for the last 3 years of an employee’s earning history. Earning more than 100% of your salary in retirement is broadly referred to as spiking. While spiking can be achieved by a variety of methods, a common practice is plan language that enables pension beneficiaries to manipulate things such as overtime or vacation pay in order to inflate compensation levels for short periods, which then serve as benchmarks for retirement benefits. Spiking can also be the result of underestimating the cost or generosity of benefits when designing pension plans. Regardless of how spiking occurs, it is a relatively common occurrence among municipal pension plans. Houston’s former chief pension executive estimated that on average, Firefighters with 25 years or more of service that retired in 2011 received 58% more in retirement benefits than their salary during employment. The simple average pension benefit for the 269 Houston 25-year plus Municipal, Police and Fire employees that retired in 2011 was about 30% above salary25.

As illustrated in the chart below, the retirement compensation for Houston taxpayers that have a 401K is upside-down relative to the pension benefit of a faaa

Recommendations from Gov. Wolf's Task Force, (June 9, 2016)25 Houston Chronicle, Chris Moran, Some employees' pensions exceed salaries, city exec finds, (June 12, 2012)

31 Likely near zero plan returns and current year underfunding of the pensions implies that the growth of the unfunded liabilty will be similar to the 1.45 billion increse experienced in fiscal year 2015. This implies that the unfunded pension is likely about 7 billion.




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City of Houston Police, Fire or Municipal employee. To make this point we compare the retirement compensation of a hypothetical private sector taxpayer to the retirement compensation of a hypothetical municipal employee, each having identical earnings and savings histories. Specifically, each starts with a salary of $36,000, each receives a 3% annual raise, each contributes 9% of their salary to their respective retirement vehicles and each retires with exactly the same ending salary on 12/31/15 after 30 years of service. Our private sector taxpayer’s portfolio is invested in a standard 60% stock and 40% bond portfolio and he earns the market rate of return26. At retirement, the private sector taxpayer’s 401K is worth just less than $1 million (Column 1). If our private sector taxpayer wanted to purchase an annuity that is the equivalent to a standard municipal employee pension that is based upon their same exact length of service and salary history and is based upon 80% of the average salary received for the last three years ofttheir careers plus a 3% annual cost of living adjustment with annuity payments lasting for 30 years, it would cost our taxpayer about $2 million or 2 times the value of his lifetime 401k savings (column 2). Column 2 estimates the value, or more specifically, the net present value, of the hypothetical municipal employee’s retirement compensation at retirement. Similar to Novy-Marx and Rauh, for the purpose of this example we we use long-term treasury rates as of 12/31/15 to determine the value of the guaranteed 30 year annuity.

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1 2 3 4

Source: Capital One Asset Management, LLC

If the private sector taxpayer wanted to buy an annuity that has the same characteristics as the standard pension with the exception that it pays him 30% more than his average salary during his last 3 years of service, it will cost him over $3 million or more than 3 times the value of his lifetime 401K savings (column 3). If our private sector taxpayer wanted to buy an annuity that has the same characteristics as the standard pension with the exception that it payshim 58% more than his average salary during his last 3 years of service, it will cost him just "________________________26 Return is blend of 60% S&P 500 and 40% Barclays Aggregate Bond Index, (1986-2015)




less than $4 million or about 4 times the value of his lifetime 401K savings (column 4). The point of this example is that the hypothetical private sector taxpayer and hypothetical municipal employee have identical salary histories, they each save 9% of their salary to their respective retirement vehicles annually, they both work for exactly 30 years and each has a 30 year retirement, yet the municipal employee receives retirement compensation that is 2 to 4 times more generous than what the private sector taxpayer receives. Our observation that the hypothetical Houston Firefighter retirement compensation is 4 times as generous as our hypothetical private sector taxpayer’s retirement compensation is consistent with points that the City makes in its lawsuit against the Firefighters. Specifically, the suit states, “The statute requires Fund members to contribute 9% of their salary per year. By statute, Houston must contribute at least twice that much: 18% of member payroll, plus any additional amount required by the Fund’s Board……For fiscal year 2015, Houston’s projected contribution rate is over 34% of member payroll (which is almost four times what the members contribute)”23. Further, below the level of management, the salary compensation for public sector employees is generally similar to or better than their private sector peers. This conclusion is supported by the Yankee Institute for Public Policy, which recently reported that after controlling for education, experience and other factors, Connecticut State government employees receive salaries that are essentially equivalent to those of similarly qualified private sector workers27. As the massive pension funding shortfall in Chicago has shown, this is not a problem that can be solved by higher taxes alone. Asking taxpayers to approve large tax increases that go entirely to shoring up unfunded pension benefits without first addressing the problem of spiking and benefit levels is unreasonable from the perspective of a vigilant bond investor and is not in the best interest of taxpayers or municipalities. The problem of unfunded pension liabilities does not stop in Houston. This problem has the potential to spread to a municipality near you. To see this, all one has to do is to look to our nation’s fifth largest city, Philadelphia, which has pensions that are funded at less than 50% of benefit levels and their use of high return assumptions means that actual shortfalls are likely meaningfully understated32.

________________________23 Plaintiff's Original Petition and Application for Injunction, City of Houston V. Houston Firefighters' Relief

Fund, (January 22, 2014)27 Yankee Institute for Public Policy, Unequal Pay: Public Vs. Private Sector, Compensation in Connecticut,

(September 2015)32 Plan Websites, www.phila.gov, www.pgworks.com, (2004 to 2015)





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Unless otherwise noted, all performance and return data sourced from Bloomberg, LP, June 30, 2016.

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