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Thursday, October 18, 2018
A Solution to Underfunded Public Pensions by Barnet Sherman
“…A Fresh Approach: …The state [of Connecticut] inventory of real assets on its books, such as office buildings, parking lots, raw land or highway right-of-ways, identifies nearly 7,000 properties. An initial estimate is that these assets could have an overall value in the billions. If the state were to include certain state enterprises, such as toll-roads, that number could reach even higher.
“A question arose: In lieu of cash, can the state donate any of these real assets as an in-kind contribution to its pension funds?
“At first blush, the potential positive outcomes seem to make this very compelling. Obviously some of these assets don’t qualify—the state isn’t transferring any of its public parks any time soon! However, many of those assets that might qualify have been on the state’s balance sheet for years. Correspondingly, book values are far below current market values. Transferring those assets from the state’s balance sheet to the pension funds investment portfolio re-categorizes their value from book to current market. That’s an immediate mutual gain to the pensions and the state: the pensions get a boost in asset values and the state gets a lower pension liability with no cash outlay.
“Theory to Reality: Transferring billions in state assets isn’t something one does in haste. It is a complex venture with a host of political, financial and operational considerations. To analyze all aspects of the policy and make recommendations as to how to proceed, the Connecticut General Assembly created the Connecticut Pension Sustainability Commission.
“The Chair of the 13-member Committee is State Representative Jonathan Steinberg (D-Westport, 136th District-CT). He is clear-eyed and unflinching about the serious problem the state faces with the growing pension underfunding. As a four-term legislator, he is keenly aware that reducing the liability is a top priority if the state is to extricate itself from its persistent budget problems. The pension underfunding burdens the state with underlying, long-term structural financial issues that need to be addressed in a systemic way. He is direct: short-term fixes or deferrals don’t provide true solutions—and that includes further spending cuts and tax increases.
“With options limited, the asset contribution proposal has his full attention. Acknowledging there are a myriad of factors that have to be balanced, Representative Steinberg put three at the top of the list: identify the highest opportunity assets, determine the value of those assets, and establish what organizational structure might be best for the pensions to hold those assets.
“Identifying Assets: To appropriately identify the highest opportunity assets, the optimal framework focuses on assets that maximize value for the pension as well as lower costs for the state. Key targets are property or land that is currently underutilized but, if transitioned to its highest and best use, could increase in value considerably.
“Equally interesting are state enterprises. Often affiliated with infrastructure projects, such as toll roads or parking garages, these offer generally stable, long-term cash flows and potential asset appreciation consistent with the long-term liabilities of the pensions. This has considerable precedent. In Europe, it is common for public pensions to own interests in as well as fund improvements or expansions to state infrastructure enterprises.
“Valuation: This is not the first time public assets have needed objective valuations for transfer or sale; there are numerous experts, best practices, market standard methodologies, and metrics to guide in that process. Wisely recognizing that valuation is critical to accurate accounting as well as maintaining the legislature’s role in due diligence and oversight for the public, the Chair is holding hearings and inviting experts to offer their views. Michael Bennon of the Global Project Center at Stanford University is one such expert, with successful experience internationally in public asset valuation and transfer. Models exist based on completed transactions that maximized values for all stakeholders. Even so, it’s always challenging, he noted in his testimony to the Committee. ‘There will always be ‘ex-post’ reports,’ says Bennon, which only ‘adds to the difficulty of valuing these assets.’ Apparently, even in pension asset valuations, there are armchair quarter backs.
“Organizational Structure: Since the pensions can’t hold physical assets directly, determining the pensions’ ownership in any separate entity holding transferred assets has to be vetted. One structure being actively considered is putting assets in a separate trust. The trust would be a private entity, hiring private managers to run the business or develop the property. While Representative Steinberg noted that a trust structure where there would be shared risk was appealing, ‘the criteria we might use to determine what to donate to an independent trust is still very much open for conversation.’
“A High Impact Ancillary Benefit: Given the pressures on the state budget and the pensions, nearly everyone is focused on the immediate impact the transfer would have there. Overlooked is the enormous economic stimulus this transfer policy could have around the state.
“Conversion to highest and best use of property or raw land opens up opportunity for renovation, refurbishment, retrofitting, and expanded development. For example, an office building can be re-purposed to address needs in high impact sectors such as affordable housing, business incubators, senior care, or satellite medical centers. Clean energy and LEED certification are a component of retrofits, which could include matching Federal or foundation grant dollars for solar panels and micro-grids. Not only does this create construction jobs immediately, but also permanent jobs working in the completed re-purposed buildings.
“A National Following: Other states and cities facing pension shortfalls are quickly picking up on the implications of this. Calls have come in from numerous state officials making inquiries about the process Connecticut is considering. Since every state and city has some assets on the balance sheet that are either underutilized, can be combined, or simply cost more to own than an alternative, having a mechanism to transfer those to the pension is potentially truly a win-win.
“Time Line: While the committee’s report is due January 1, 2019, it might take as long as two years to put everything in place before the state can even begin to create a schedule of asset transfers and start to execute on the plan. For those impatient for a solution, that may sound like a long time given liabilities are accruing at millions of dollars a day. But considering it took nearly 100 years to get to where things are now, two more years isn’t unreasonable considering the solution could have a dramatic corrective impact.
“What legislators and public administrators understand is that, with skeptical capital markets and an equally skeptical public, a careful, prudent approach rebuilds confidence and demonstrates that policymakers are serious in their intent to fix the problem.
“Moreover, because this is as much a political process as a financial one, there will always be disagreements as to whether the actions are sufficient or right. However, tangible actions towards a solution—albeit initially modest—is a far better alternative than stagnation. It is a sign that the state of Connecticut is transitioning towards stabilization.”
Heartfelt thanks to Les Richmond, ASA, EA, MAAA, FCA, Vice President and Actuary at Build America Mutual Assurance Company for his invaluable guidance and endless patience in walking me through the intricacies of the pension section of Connecticut’s Comprehensive Annual Financial Report for 2017.
This article is for informational purposes only and is not intended to solicit an investment, nor constitute investment advice. The information being presented has been compiled from both internal and external sources. From time to time, Neighborly Investments’ clients may hold security positions or other interests in companies, issuers or borrowers mentioned herein.
Barnet Sherman has over 30 years of investment experience in the fixed income markets in credit analysis and portfolio management. Barnet Sherman. Director of Municipal Impact Credit Research, Neighborly Investments. Mr. Sherman's perspective comes from his over 30 years of municipal bond market experience.