Providence Pension Could Bankrupt Rhode Island City
The financial condition of the City of Providence, Rhode Island certainly looks precarious. The municipality may need to seek bankruptcy protection in the near future primarily as a result of its over $1 billion in unfunded pension obligations.
As indicated below, the Mayor of Providence agrees with this dire analysis.
According to the Comprehensive Annual Financial Report (CAFR) of the City for the fiscal year ended June 30, 2019, the Employee Retirement System of the City (ERS) had a funded ratio of only 25.83%. That is, ERS had approximately $367 million in assets to cover its total $1.4 billion pension liability.
ERS, which secures the retirement of 3,658 retired participants and their beneficiaries, as well as 2,889 active participants, is severely underfunded by more than $1 billion. Since 2014, the pension unfunded liability has grown from $872 million and the funding level has fallen from 29%.
For the city’s 178,000-plus residents, the unfunded pension liability alone is more than $5,600 per person. With a median household income of $42,158; a poverty rate of 26%; and 61.9% labor force participation, there appears to be no way city residents can satisfy even ERS’s stated liability. Further, for the reasons indicated below, in my opinion, the pension liability is likely understated.
The investment return assumption used by ERS is 8%, which according to Rhode Island General Treasurer Seth Magaziner is the highest of any active public pension plan in the state. The investment return assumption for the Employee Retirement System of Rhode Island (ERSRI) is considerably lower, at 7%. According to the National Association of State Retirement Administrators (NASRA), a public fund survey found that 96% of surveyed public pension plans have lowered investment rate of return assumptions since 2010, with reductions resulting in a decline in the average return assumption from 7.52 percent in fiscal year 2017 to 7.2 percent in fiscal year 2020. The Pew Charitable Trusts has estimated that the median 20-year investment return for a typical public pension portfolio will be far lower than these optimistic assumptions, at 6.4%.
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If ERS’s investment return assumption were reduced to the ERSRI level (7%), or even to the national average for state and local plans (7.2%), the pension’s funding ratio would also go down (and unfunded liabilities would go up) significantly. According to Providence’s 2019 CAFR, the city’s net pension liability would increase by nearly $200 million, to $1.2 billion, if it were calculated using a discount rate which was 1 percentage point lower (7%) than the current rate.
In a May 2018 Report of the Advisory Council for Locally Administered Pension Plans, the Advisory Council (chaired by the General Treasurer) created a “report card” for each local pension. ERS’s funded status was rated as “critical” since it was less than 60% funded.
As noted in the Overview to the Report, “Generally speaking, the promised benefits of a pension plan can be considered more secure the higher the funded status of the plan.”
ERS’s high investment return assumption also scored poorly. The Overview warned, “Plans that have investment return assumptions that are too high have the potential to understate their liabilities and increase the odds that employer contributions will not be large enough to adequately fund plan benefits. The reasonableness of this assumption is one of the most important considerations in developing a strong funding plan.” In the Report’s Findings it was stated, “Many plans have investment return and payroll growth assumptions that may not be realistic.”
Federal pension law (Pension Protection Act of 2006) designed to address alarming funding problems encountered by many multiemployer corporate pensions establishes three categories (or zones) of plans: (1) Green Zone for healthy; (2) Yellow Zone for endangered; and (3) Red Zone for critical.
These categories are based upon the funding ratio of plan assets to plan liabilities. In general, Green Zone plans have a funding ratio greater than 80%, Yellow Zone plans have a funding ratio between 65% and 79%, and Red Zone plans are less than 65% funded. Each plan’s actuary must certify the plan status every year and participants and employers must to be notified of the status of the plan. Each Yellow Zone plan must adopt a funding improvement plan designed to increase its funding percentage and Red Zone plans must adopt rehabilitation plans designed to allow the plans to emerge from critical status within 10 years.
Under the federal pension scheme, ERS—which at 25.83% funded is deep into the Red Zone—would be required to notify city workers of the dangers and adopt a rehabilitation plan to improve funding.
Unfortunately, state and local pensions are not subject to federal pension protections.
Worse still, ERS’s Investment Policy indicates the Board adopted an asset allocation strategy that authorizes up to 16% to be invested in higher-cost, riskier so-called “alternative investments,” such as hedge and private equity funds. The values of these investments, which are not publicly traded, may be difficult to determine. Alternative investment asset values are often inflated by investment managers since they are compensated through asset-based fees. The higher the values, the more the investment managers get paid. Inflated alternative investment values may also result in understated unfunded pension liabilities.
In recent years, the state pension (ERSRI) has lost nearly $1 billion recklessly gambling on high-cost, high-risk alternative investments, such as hedge, private equity and venture funds. The state pension continues to roll the dice on costly alternatives, even as the Treasurer claims to have moved assets “Back to Basics.”
Providence Mayor Jorge Elorza recently publicly stated that the city’s Actuarially Required Contribution (ARC) to the pension system each year is “unsustainable” and that he fears the city may need to file for bankruptcy in the future if it doesn’t alter pensions or receive an infusion of cash to stabilize its pension system. Robert Flanders, a former state Supreme Court justice who was the receiver of Central Falls when the city filed for bankruptcy in 2011, said Providence may have to consider bankruptcy in the future, “Bankruptcy should be a last resort, but it should never be taken off the table,” Flanders said.
David Salvatore, a member of the Providence City Council, noted in a September 10, 2020, Providence Journal opinion piece that 26% of the city’s 2021 tax levy is owed to the underfunded pension system. Further, recent decisions from the Rhode Island Supreme Court “will increase the city’s pension obligations” as well as “the likelihood that pension obligations will crowd out vital city services, jeopardize retirement security and could lead to a municipal bankruptcy.”
Finally, Providence Finance Committee chairman John Igliozzi reportedly recently called the city’s finances “bleak” citing money owed to the pension and substantial shortfalls in tax revenue. Igliozzi stated the city will have to start thinking about taking some serious frugal measures to combat the effects of the COVID-19 pandemic.
The pandemic is a blow to this and many other city finances no doubt, but Providence’s fiscal woes started long before COVID-19.