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Portfolio > Investment VIPs

Is New York the next Detroit?

By Megan McArdle

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(Bloomberg View) — The New York Times has a lengthy and dismaying article on the problems with New York City’s pensions:

“Next year alone, the city will set aside for pensions more than $8 billion, or 11 percent of the budget. That is an increase of more than 12 times from the city’s outlay in 2000, when the payments accounted for less than 2 percent of the budget. 

But instead of getting smaller, the city’s pension hole just keeps getting bigger, forcing progressively more significant cutbacks in municipal programs and services every year. Like pension systems everywhere, New York City’s has been strained by a growing retiree population that is living longer, global market conditions and other factors. 

But a close examination of the system’s problems reveals a more glaring issue: Its investment strategy has failed to keep up with its growing costs, hampered by an antiquated and inefficient governing structure that often permits politics to intrude on decisions. The $160 billion system is spread across five separate funds, each with its own board of trustees, all making decisions with further input from consultants and even lawmakers in Albany.”

The core problem is that returns have not tracked with the city’s optimistic projections. In 2012, the city finally lowered its projected return to 7 percent from 8 percent, but after decades of excessive optimism, that left it with a giant hole; the payments had to be stretched out over more than two decades in order to minimize the fiscal hit. Yet this still may not be enough; it’s possible that 7 percent is still too rosy.

Like many state and local pension funds, the city has tried to make up the difference between its projections and what the market actually delivered by plunging into higher-risk investments. Those more complicated investments came with higher fees… and the possibility of big losses. The city seems to have taken at least one major bath, on a private equity fund that closed in 2011.

A lot of people would like the city to return to more conservative investments managed by in-house managers; former Mayor Michael R. Bloomberg (who is, full disclosure, my employer as the founder and majority owner of Bloomberg LP, the parent company of Bloomberg News) oversaw an effort to move in that direction a few years back. But one major thing is standing in the way: politics. It’s not just the fiscal hit that the city would take from adopting a less risky, more realistic approach; it’s also opposition from unions.

In theory, unions should be leading the charge for more conservative accounting standards; after all, it is their job to make absolutely sure that their members will be able to count on those pensions in their old age. In practice, unions often have other priorities. Witness Detroit, where the unions did nothing to stop the absolutely grotesque mismanagement of the city’s pension funds.

In New York, reports the Times, the unions don’t want to move to more conservative pension accounting, because if they do, the city will be required to put more money into the pot… and the taxpaying public might mobilize against the union workers who put them in this spot.

Of course, putting it off will ultimately just make the problem worse; the inexorable logic of compounding is just not very forgiving. Over the next few decades, we are going to come face to face with more problems like Detroit’s: pensions that must be paid, legally and morally, but cannot be paid while still offering an acceptable level of government services. Taxpayers’ wallets are not an inexhaustible resource, and cities and states that demand too much will see their citizenry depart for more fiscally responsible climes.

The problem is that at any given time, it always looks better to delay — and the worse a crisis gets, the more attractive a delay looks, because the reckoning is already very painful. New York’s new mayor has so far said little about the city’s pensions, and it’s probably in his best political interest to keep mum. It’s too bad that the interests of future pensioners — and the city’s — are so different.

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