In the months since the passage of PROMESA and the implementation of Congress’ Federal Oversight Board, Puerto Rico’s woefully underfunded pension systems have taken center stage in discussions concerning the island’s fiscal reform. While there is no disputing that the Commonwealth’s pension plans have to be reformed and that steps must be taken to ensure their future solvency, how and when to do so is a matter of some dispute.
Some want to read Congress’ landmark legislation as prioritizing pension funding. However, it says no such thing; PROMESA does contemplate serious pension reform, in recognition of the fact that significant structural reforms are necessary to bring order to Puerto Rico’s finances and to comply with PROMESA’s other objectives. Various parties have seized on the pensions’ $49 billion funding shortfall—as well as the meager $4 billion balance in the pension funds—as evidence of a looming collapse, and suggested that the first priority should be to bolster the funds above all else.
The fact of the matter is that it is years away from insolvency: as is the case with most pension issues, the truth is a little more complicated than the balance alone would indicate. The $49 billion shortfall represents the present value of estimated obligations above and beyond projected future revenues across the three different retirement systems that are funded, at least in part, by Puerto Rico’s central government: the judiciary retirement system (which has a shortfall of roughly $500 million), the teachers’ retirement system (underfunded by $15 billion), and the government employees’ retirement system (underfunded by about $33 billion). The latter is especially complicated, consisting of a multi-employer system with four separate pension plans that draws about 60 percent of its funding from the central government and the rest from various public corporations and municipalities.
The government employees’ pension shortfall is especially complicated: for instance, a substantial portion of it (approximately 10 percent of its total) consists of “system administered benefits,” which are additional benefits that come in the form of what are essentially semi-annual or annual bonuses, along with cost of living adjustments, minimum death benefits, and certain healthcare benefits, all of which were afforded to beneficiaries in special legislation and are not a part of their employment agreements (in contrast to base benefits that are tied to years of service and salaries).
The estimated liability of the Puerto Rico government pension is also a function of the discount rate applied, and that discount rate—which is tied to the tax-free municipal bond index—has plummeted in recent years, although that may reverse itself soon, if recent treasury rate moves are any indication. A lower discount rate does not change the amount of money owed to future retirees but it increases how much needs to be set aside to ensure there will be enough money at hand when the time comes.
What’s more, the actuarial calculation for the ERS reflects an accounting gimmick that reduces the plans’ assets—$2.78 billion as of June 30, 2015—by more than $3.1 billion in liabilities for “pension bonds” that have no recourse to such assets and adds another $600m to the headline number of pension liability, thereby overstating the total pension liability by more than 10 percent.
The complexity involved in just understanding the status of the pension funds suggests that it is going to take a while for the board to come to grips with the extent of the problem and then devise viable reforms for the three plans, which is fine because there is no imminent threat to its solvency. However, the low pension balance has led the outgoing governor, Alejandro Garcia Padilla, to declare that the shortfall constitutes a crisis and that they need to put money into the pension fund even before any reforms take place.
He furthered this crisis narrative by calling an ongoing, last-minute special legislative session during which he proposed over 100 pieces of legislation, the result of which would divert hundreds of millions in government funds to the island’s pension systems. This is in line with the governor’s recent Fiscal and Economic Growth Plan, which the nascent Oversight Board summarily rejected in one of its first actions.
The PROMESA rescue package signed by President Obama in June called for “adequate funding” of pension plans while tasking the oversight board with analyzing the sustainability of existing benefits. In no way did it reprioritize pension liabilities ahead of bondholders or change any existing laws regarding debt prioritization.
Under current law, public employers make contributions to pension systems after debt service on the Commonwealth’s public debt and legal contracts in force. Governor Garcia Padilla’s plan inexplicably interprets the law to mean that pensions must receive full funding at current benefit levels, an option that is simply not sustainable over the long term and clearly contrary to congressional intent. His inference is at best a grave misunderstanding of the statute, and at worst a deliberate defiance of Congress.
The reality is that the pension systems have more than $4 billion in their coffers, and the last few years have been approaching cash-flow neutrality, owing to recent increases in employee and employer contributions. The funding problems the systems face, while real, won’t come due until the baby boomers finish retiring in a decade or so. To boost funding for the pension prior to any reform puts the cart before the horse, and would lessen political support for very necessary changes.
The Oversight Board deserves the time to craft and implement a pension reform and do so as directed by PROMESA, without having to first undo the outgoing Governor’s eleventh-hour political maneuvers.
It took Puerto Rico a long time to get into its current fiscal straits and it may take a while to get it out of it. The important thing is to come up with a structurally sound plan that points the island to the path of solvency and eschews any quick, politically popular reactions. After all, that is the entire point of empowering an outside Oversight Board in the first place.
Ike Brannon is president and Logan Albright is director of fiscal studies at Capital Policy Analytics.
