Providence Budget Illustrates Pension Charade

The word from the heavily live-tweeting crowd at Providence Mayor Angel Taveras’ budget presentation is, as Ted Nesi writes, “Taveras budget for 2012-13 doesn’t hike taxes but targets pensions in effort to keep Providence out of bankruptcy.”  Meanwhile, City Councilmen Michael Solomon and David Salvatore have taken to the opinion pages of The Providence Journal to tout the proposed pension reforms.

Those reforms are real, and they’re not insignificant, but something is missing from Solomon and Salvatore’s essay that shows Taveras’s budget (and the entire pension reform project in Rhode Island) to be a feat of accounting rather than wise budgeting and conservative financing: the discount rate, or projected rate of return.

Of the 32 experience studies turned in to the state by the April 1 deadline for locally administered pension plans, Providence’s assumes the second highest rate of return.  At 8.25%, Providence is still assuming investment returns at the level that the State of Rhode Island abandoned last year (moving to 7.5%), thus setting off the “crisis” that General Treasurer Gina Raimondo led the way in attempting to solve.  Once all of the municipal actuaries’ recommendations take effect, only Smithfield fire will join Providence over 8.0%.  Three communities will have lowered their rates to 6.75%.

The dirty little secret of Rhode Island, right now, is that long-term experience seems to have been maxing out at around 5% returns, on average, with the state’s five-year percentage coming in at 2.28%.  The investment advisors to whom pension managers hand these large assumptions are going to have no choice but to chase riskier investments if they are to have any hope of coming close to their goals.

Providence bears that out.  Speaking in very general terms, there are four classes of investments:

  • Cash and equivalents are the safest, but have no returns.
  • Fixed-income investments, mainly bonds, have lower risks, but lower returns — well below even 5%.
  • Equities, mainly stocks, are next, with a wide range of returns and risks, maxing out in the 8-9% return range.
  • Alternative investments are wildcards, including hedge funds, real estate, and other tangible assets.

The City of Providence currently has the second-highest reliance on alternative investments, at 17%.  Thirteen percent of the city’s investments are in hedge funds, making Providence the only municipal pension system to list hedge funds in its target portfolio.  (Not all reports provide portfolio information.)

When the actuaries determine whether a given discount rate is “reasonable,” they do so based on the predicted range of returns, but that only tells half the story.  Obviously, if high-risk investments could be relied upon to fulfill their promises, there would be no need to invest in safer vehicles, like bonds.  And indeed, for longer-term investments (like 20- to 30-year pension amortizations) the consideration of risk must be even greater.

All of this goes to indicate that even reform-heavy budgets are little more than accounting tricks disguising both future tax increases and future slashes in retirement benefits for employees who are even now planning their futures on the basis of wishful thinking by public officials.