Sunday, May 20, 2012

Public Pensions ... Phantom Investments and Phantom Returns

My friend Sid from Illinois sent me a heads up on how Illinois public pension benefits have been "boosted" over the years. This is one story that has to be read to be believed.

In my view, it's a simple case of defrauding the unsuspecting and uninformed Illinois taxpayers.

In simple language, here's the essence of the taxpayer scam revealed in Pair of professors propose alternative state pension plan:

"It is that interest rate that Brown (college professor sounding the alarm bell) set his sights on in order to reduce the pension costs of tier 1 employees (public sector pension plan participants). Since 1973, SURS (State Universities Retirement System) or the comptroller has assumed interest rates between 6.5 percent and 10 percent, amounts Brown believes are "a huge and hidden taxpayer subsidy to pensioners."

"They take your contributions, they act as if the state has actually matched the contributions and then they gross it up and credit it with an annual rate of return," Brown said. "I don't know about you, but to get what essentially is a risk-free return of 8 or 10 percent is way above any appropriate risk-adjusted measure that anybody else can get in the marketplace."

Discussion, Analysis and Summation

Real world investing involves both real money and accepting the uncertainty of assumed future returns on the money invested.

If we invest our real money today in hopes of realizing a substantial return on that investment in the future, we must take a risk to achieve what we hope and expect will be a reasonable future reward for having taken that risk. This is commonly known as the risk to reward ratio. We accept risk in order to receive a future reward. At least that's the way the real world of investing works.

But not in fantasy land Illinois where taxpayers apparently have been taken to the cleaners again by a "kind and caring" government working hand in hand with public sector union leaders to "take care" of public sector employees while fleecing Illinois taxpayers.

Illinois has stood the simple risk-reward concept of real world investing on its head. It pretends to invest its "allocated" but unfunded contributions alongside employee contributions and then further pretends to earn a risk free return of up to 10% annually on the risk not taken on the funds not contributed. Only in the Land of Lincoln!

And to make a bad situation even worse, it's an ongoing double dip. Here's what happens to the taxpayers.

Public employee #1 works and "earns" an outsized pension benefit funded with phantom monies which also generate phantom  investment returns on the risk free phantom "investments." When employee #1 retires, employee #2 replaces employee #1 and earns the salary previously paid to employee #1. Employee #1 then collects the largely unfunded pension benefit from the state for the rest of his life.

But money to pay employee #1's pension wasn't set aside during his career, so now taxpayers pay both the employee #1's outsized pension  and then pay a salary to his replacement, employee #2. And unless this silliness is stopped, employee #2 will likely proceed to "earn" a phantom return on a phantom investment to "boost" his retirement income down the road as well. Unless and until there's a taxpayer revolt in Illinois, that is.

Why would our kind and caring Illinois public officials encourage or at least permit this "fraud" on the Illinois taxpayers? Well, my guess is it's in large part because they think they can get away with it.  And here's how they've done it all these years.

Governments use the cash as opposed to the accrual method of accounting, so they don't have to tell taxpayers in real time what they've promised the taxpayers will have to do in the future.  Only what they're spending. Cash outlays, in other words.

In this case, they contributed no money, invested none and earned none either. They "only" made unfunded promises on behalf of Illinois taxpayers about future payments to public employee pensioners.

Thus, the politicians promise, pretend and don't bother or even dare to ask the taxpayers to fund the promises with real money. And the taxpayers don't get the news until years later.

Meanwhile, the politicians can grant higher wage increases to state employees, since they aren't spending any real money funding future pension benefits.

Is it any wonder that Illinois is broke?

With phantom investing "certainty" in place of uncertain real world investing, the public pension plan participants receive high salaries and prepare for their leisurely "golden years."

Meanwhile, the taxpayers have to work hard to pay the bills and continue to get screwed.

And it's not only happening in Illinois, my friends. We'll keep digging for the truth.

Thanks. Bob.