Puerto Rican Gothic: Can Promesa Save Pension Plans?
By Eva Llorens & Rosario Fajardo
With the passage of the Puerto Rico Oversight, Management & Economic Stability Act (Promesa) and its immediate signing by President Barack Obama, Government Employees & Judicature Retirement Systems Administrator Pedro Ortiz Cortés is optimistic the initiative will provide the much-needed mechanisms to save the ailing retirement systems from completely going insolvent, which could happen as early as next year.
Promesa creates a “territorial oversight board” that will require Puerto Rico to follow fiscal plans and have balanced budgets. For example, Title II of the law calls for the board to create a fiscal plan that takes into account several factors, including adequate funding for the public pension systems.
“For us, the key here is how it is going to be put into practice. The problem with the law is that there is really not any guarantee that there is going to be any funding guarantees for the system going forward. When you take into consideration that we pay out $1.3 billion in benefits every year and you factor in the impact to the economy, any contraction of benefit payments due to lack of resources affects the broader economy…. It has a multiplier effect on the business community and the economy,” Ortiz said in an interview with Caribbean Business.
However, he admitted that for all intents and purposes, the Employees Retirement System (ERS) is already insolvent and has been treading water for years, primarily because it still has assets, which provide liquidity.
“With an accounting and actuarial perspective, [the system] is insolvent. The only reason the system keeps going is because it has to go to its growth assets and find liquidity to comply with its benefit payments…. There is still a liquid portion in that portfolio, but it is a dwindling portion of around $700 million, which does not get you a year of benefits,” he explained.
At the same time, Ortiz noted that the pension reforms enacted in 2013 have not been effective, as the commonwealth has failed to meet its contributions. The reforms’ main elements, among others, included benefits accrued by all retirees that were grandfathered; employee contributions to the system that were increased to 10% from 8.275%; and active public employees who were granted future benefits based on a defined contribution plan, which will be paid through a lifetime annuity, according to the Government Development Bank.
Since 2014, government employers were supposed to have paid at least $367.6 million in lump-sum payments to the system, in addition to the regular payments. However, as of April 2016, only $22.7 million had been paid, according to a recent report by Reuters.
“To the extent the government is not able to meet or fulfill payments—that is when we really have an issue…. Somebody will have to find a way to fund that,” Ortiz said, noting that the pension systems and its problems are deeply entangled with the commonwealth’s $70 billion debt crisis.
What needs to be done to prevent insolvency? While Ortiz said he is aware the ERS has to compete with essential services such as health and public services, in the context that the government has a limited pool of resources, he said at the end of the day, the government needs to pay what is required into the system.
“Everything goes back to the government making its contributions…. And Promesa finding something to fund this long term and stabilizing the system, so the system will gradually recover over time,” he said.
Ortiz said he does not expect the government to impose a new tax to help fund the retirement systems. “Any scenario must include the government fulfilling its obligation,” he said.
Crisis building up
According to the most recent 2014 audit of the ERS, unless much-needed contributions are made to the system, the retirement plan could be completely insolvent and run out of money in about a year.
The audit of Puerto Rico’s largest of its three retirement systems was conducted by KPMG and covers the fiscal year ending June 30, 2014.
At the time, the audit found that “the plan’s fiduciary net position as a percentage of the total pension liability was 0.27%.” A fully funded pension system would have a 100% fiduciary net position. Therefore, this means that the system only had 0.27% in net assets to pay out the projected benefits.
In 2014, the plan was also carrying $30.2 billion in unfunded pension liabilities. However, it should be noted that this figure does not include the Teachers Retirement System (TRS), so when taking this into account, the combined unfunded liability balloons to some $43.2 billion.
“[I]f measures are not taken to significantly increase contributions, the system will become insolvent by fiscal year 2018, depending on the timing of the receipt of contributions and the system’s ability to dispose of illiquid assets,” KMPG said in its report.
“[F]uture employers’ contributions have been pledged for debt service; consequently, further depletion of [the] system’s assets could result in an inability to pay benefits. Our opinion is not modified with respect to this matter,” KPMG added.
Ortiz said the ERS has 121,000 retirees and 120,000 active workers contributing to the system. And while the system pays out $1.3 billion a year, it receives $600 million in return, representing a clear imbalance. “There are more pensioners than active employees,” he said, adding that this trend will likely continue in the future.
Promesa to the rescue
Faced with a nearly 10-year economic depression, the Puerto Rico government has been grappling with a $70 billion public debt load and, in recent months, has already missed some debt payments. The most recent was July 1, when the commonwealth defaulted on roughly half of the $1.9 billion due July 1, including $780 million in general-obligation bonds and $87 million tied to the Infrastructure Financing Authority.
The U.S. House of Representatives passed HR 5278, the Puerto Rico Oversight, Management & Economic Stability Act (Promesa) in early June and the Senate passed it last week. President Obama quickly signed and enacted the bill on June 30, one day before Puerto Rico was scheduled to make about $1.9 billion in debt payments.
Promesa creates a territorial oversight board for Puerto Rico, along with mechanisms to restructure much of the island’s public debt. Title II states that one of the duties of the board is to “respect the relative lawful priorities or lawful liens, as may be applicable, in the Constitution, other laws, or agreements of a covered territory or covered territorial instrumentality in effect prior to the date of enactment of this act” when drafting a fiscal plan.
Most bondholders, such as those belonging to Main Street Bondholders, want constitutional debt to be a top priority, and they want to be paid first before retirees.
However, Ortiz said retirees are creditors, too, and any cuts in pension systems would be detrimental because pensioners in Puerto Rico receive much less than their counterparts in the States. The average pension in Puerto Rico is about $1,200 a month. He emphasized that retirees already made sacrifices when the commonwealth government cut benefits in 2013.
“You have to account for Puerto Rico being different from other states…. The benefits that we pay out in most cases are lower. For some people, the minimum pension is $500 a month. Police officers do not have the Social Security safety net and must cope with the fact that they have a questionable pension in the future,” he said.
By comparison, in the United States, the average retirement income is slightly over $1,500 a month, or about $18,000 annually, according to the Pension Rights Center.
In terms of the raw numbers, he said that if the $1.3 billion in benefits is not paid out, it would represent at least 2.2% of Puerto Rico’s total purchasing power and would have a multiplying detrimental effect on the local economy.
Promises on pensions
As part of the control board’s powers, detailed fiscal plans would be developed between the board and the commonwealth government. The plans would include how to maintain the legal rights of creditors while analyzing the pension systems, with the aim of stabilizing the system and preventing insolvency. Promesa does not prioritize pensions over creditors, but treats pensions as among the top priorities, almost on par with creditors.
However, it should be noted that after analyzing the pension systems, the board’s options include making cuts to pension benefits and/or identifying funding sources. Still, to the extent that Promesa enables the island to restructure much of its debt, funds could be made available and these could be earmarked for the pension systems.
“If the Oversight Board determines, in its sole discretion, that a pension system of the territorial government is materially underfunded, the Oversight Board shall conduct an analysis prepared by an independent actuary of such pension system to assist the Oversight Board in evaluating the fiscal and economic impact of the pension cash flows,” according to Section 211 of Promesa.
The analysis would include “(1) an actuarial study of the pension liabilities and funding strategy that includes a forward-looking projection of payments of at least 30 years of benefit payments and funding strategy to cover such payments; (2) sources of funding to cover such payments; (3) a review of the existing benefits and their sustainability; and (4) a review of the system’s legal structure and operational arrangements, and any other studies of the pension system the Oversight Board shall deem necessary,” according to Promesa.
The White House says Promesa provides retirees protections they would otherwise not have. “Public workers in Puerto Rico have little protection for their pensions in the absence of Promesa. Puerto Rico’s Constitution prioritizes payments to bondholders. Unlike bondholders, Puerto Rico’s pensions have no explicit protection or payment priority under Puerto Rico’s Constitution,” said Jeffrey Zienst in a White House blog.
“Additionally, pensioners—unlike many bondholders—do not have a claim on specific tax revenues for repayment. If pitted in a race to the courthouse against Puerto Rico’s creditors, the retirement security of Puerto Rico’s pensioners would be in serious jeopardy,” he added. “With Promesa, Puerto Rico will be required to provide adequate funding to support the pensions of hundreds of thousands of individuals. Puerto Rico will be expressly prohibited from balancing its budget by short-changing pensions.”
The White House struck a warning note that without Promesa, the underfunding of the pension system will likely get worse. “In contrast to Promesa, which protects pensions, a disorderly default puts pensions at serious risk,” Zienst said. “Without this legislation, Puerto Rico’s workers do not have the protection they deserve.”
Efforts to shore up the system
Ortiz said he has made changes in the retirement system to extend its life. For instance, he eliminated the mortgage-lending program that allows public workers to borrow money for a new home using their retirement savings as collateral.
“Managing a mortgage portfolio is very complex and takes time and resources. Obviously, at this juncture, this is something we do not have an excess of,” he said. “The management of the program was lax. Some loans were not deducted properly…. Many people left the system…. It has a noble purpose but it wasn’t making sense for us,” he said.
The ERS, however, has maintained a separate personal-lending program. Both programs represent about $700 million in the system’s portfolio. The personal-loan program has a 12% yield and the payments are deducted from the employees’ paychecks. The personal loan has a $5,000 limit. Over the 20 years that this personal-loan program has been operational, more than $3 billion has been put in the local economy, Ortiz said.
If the pension system goes insolvent, it would also have repercussions on government agencies and municipalities because the pensioners will have a legally enforceable claim against their former employers since the obligation does not go away, he indicated.
Decades in the making
The difficulties of the commonwealth’s pension systems are not new. Since the 1990s, different ERS officials have sounded the alarm that the retirement systems were heading toward disaster. Changes to retirement system law were made in 2000, which established a defined benefits program for new government workers. The changes in 2013 cut benefits for all future retirees.
Ortiz said there also have been a couple of actions throughout the years that have hurt the system. He mentioned Act 17, an early retirement window approved in 2011 that was “detrimental” because the retirees were immediately absorbed into the system and the benefits were immediately paid out, but the system is still making the payments today. The employees who entered the system before 2000 can get 75% of their highest salary and their pensions are for the rest of their lives.
Three bond issues, totaling $3 billion, which were authorized by former Retirement Administrator Juan Cancel in 2008, caused losses because they coincided with a drop in the stock market. The Legislature did not allow for the liability to be absorbed by the general fund and this liability is being assumed by the ERS as a lien that falls over all retirement contributions.
“If there is any government restructuring, it will help to take this liability from the ERS,” Ortiz said.
In Puerto Rico, several initiatives are taking place from the Legislature’s standpoint.
Both houses recently passed House Bill (HB) 2757, which proposes an early retirement program for public workers who are at least 61 years old and have over 20 years of service, but critics say there is no money for this.
The 2016-2017 fiscal year budget earmarks $320 million for the central government’s pension system and $100 million for the teachers’ system. The House’s version of the budget earmarked $55 million to the commonwealth retirement system, an increase from what La Fortaleza had proposed, which was $45 million. The House also earmarked $45 million for the TRS, while La Fortaleza proposed $30 million.
Meanwhile, a House report analyzing the island’s retirement systems said the central government owed the ERS around $192.8 million, noting that most agencies and municipalities have payment plans in place.
The highest retirement system debtors are the Medical Services Administration, Metropolitan Bus Authority, Maritime Transportation Authority and the municipalities of Gurabo, Loíza, Patillas, Ponce, Toa Baja, Villalba and Yauco.
The report made several recommendations, including the approval of HB 2845, which would create the position of a retirement-affairs coordinator, and HB 2857, which would allow the retirement system to create a separate entity for loans.
Editor’s note: As this newspaper was going to press, the government finally released its long-awaited audited financial statements, also prepared by KPMG, which state that the retirement systems do not have sufficient cash flow to meet their liabilities, noting that the systems could be completely insolvent between fiscal years 2018 and 2019.
The date of complete insolvency will depend on the systems’ ability to dispose of its illiquid assets and whatever additional contributions are made on an annual basis.