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Monday, February 22, 2010

Grand Rapids Income Tax Increase: It's the Pensions, Stupid.

The Grand Rapids City Commission voted last week to place a 15% income tax increase on the ballot May 4th. The vote was 6 to 0 in favor, showing a remarkable lack of leadership and critical thinking on the part of any of the city commissioners. I guess replacing Jim Jendrasiak in the 1st ward didn't matter after all. This tax increase request will be on a typical low turnout election day, which is always by design. It's easier to manipulate election results that way. Surely the city will mail out fliers listing the "benefits" of the proposed tax increase, without any obvious "vote yes" language, to get around state campaign financing laws.

However, the bottom line is this: 100% of the tax increase will go directly into the city's retirement pension system. This system is rapidly becoming unsustainable for a couple of reasons, which I'll outline below. The city manager is trying to make the case that this tax increase will somehow increase fire department coverage downtown, but that's a smokescreen to distract voters from the real fiscal disaster waiting in the wings.

The first, and most obvious reason for the sudden pension crisis is, of course, the current Great Recession. We're lucky in that the city publishes lots of information on their pension plans. You can peruse the information here: City of Grand Rapids - Retirement Systems. We can glean several things from the monthly pension reports. The graph below summarizes the balances of the pension funds.




The city maintains two pension funds. One is for the police and fire employees, the other (general) for all other employees. As of December 31, 2007, the combined balance of both funds was $753 million. As of December 31, 2008, the combined balance was $493 million, a stunning loss of $260 million, or -35%. This tells us important information. Much of the city's pension funds are clearly invested in risky assets, probably equities (stocks). For comparison, the S&P 500 stock index dropped 38% during the same period. This is an example of how the city's bureaucrats can promise bigger and bigger pension benefits during the good times. Since the pension fund obviously is sensitive to the market's ups and downs, the good times inflate the value of the pension funds, making it look like it's easier to offer better and better benefits without having to increase the city's costs.

But, then comes reality, crashing things down. When the market began to tank in 2007, it took the city's pension fund with it. This sort of drop slaughters the pension fund's solvency, and this is why the city must now contribute much more money just to keep the fund afloat. Of course, you'll notice that the fund has recovered, as of December 31, 2009, to the level of $590 million. This is an increase of approximately 20%, while the S&P 500 increased by 27% during the same period. The problem is that the current market rise has run out of steam. Over the last three months, the market is essentially flat and appears to have entered a new down trend.

If the city had simply invested in safer and more stable securities, such as US government bonds, the funds would be in far better shape. For instance, if the pension fund were invested in 30 year treasury bonds, the annual return would have been about 4.5%. Compounded annually, the city's pension funds would stand at about $836 million today, instead of $590 million (or a loss of around $246 million). But, a safe and secure growth rate like this would have constrained the city's ability to offer greater and greater levels of benefits. A conservative and thoughtful path of sustainable benefits was possible, but the city's leaders chose not to got that way.

So, what are the real consequences and costs of this problem? The graph below shows us the increase in the city's pension system contribution costs.



As you can see, the pension contribution cost is estimated to be $5.009 million this fiscal year (2010). This will increase to an estimated $26.66 million cost in 2015. That's a whopping 532% increase in just five years. Again, that's assuming a 7.5% stock market growth rate, so the reality may be much worse. But the important point of data is the difference in pension contribution costs between the current year and next year (2011). As stated, the current year's pension cost is about $5 million. Next year's is estimated to be $12.019 million. An increased cost of $7.01 million. Wait a minute. Where have I heard that number before? Ah, yes. Here:

News Headline: "Grand Rapids income tax increase could raise $7 million"

What's the logical conclusion? The entire tax increase will be spent on pensions. Oh, and that's just the first year. In 2012 the increased pension cost will be another $4 million. The year after that, an additional $3.5 million, and so on. By 2015, the city will have to raise taxes by $21 million a year, or three times more than the proposed tax increase, just to pay for pensions.

Are you ready to pony up?

But wait, there's more. Before readers try to make the argument that things would be fine without the current stock market conditions, please look deeper into the pension funds' built-in collapse. That's right - built-in collapse. This is the second reason for the current pension crisis.

It's been in front of our city leaders, but they have chosen not to deal with it. What am I talking about? The city receives an annual report on the pension system's health. You can read these reports here. The chart below is taken from this report (click on the chart to view it full size).



This chart shows us the number of active employees at the city who are participating in the pension plan versus the number of retired employees who are drawing benefits. This is generally referred to an active/retired employee ratio. In 1975 there were approximately 2.6 active employees for each retired employee. This means that the contributions made on behalf of the active employees were likely higher than the benefits being drawn by retired employees. Contrast this with the current ratio of close to one active employee for each retired employee. This means that active employees' and the city's pension contributions are likely just going straight out the door to pay for currently-retired employees. This trend will result in failure. It's the same principal as a Ponzi Scheme. Current "investments" just go right out to the door to pay benefits to others.

The following chart (from the same report) shows us the cost of pension benefits as a percentage of current employees' payroll (click to view full size):



This is the cost of unsustainable defined-benefit pension plans. As you can see, in 1975, the city contributed $5 for every $100 in payroll. This cost has ballooned to nearly $45 per $100 of payroll cost. You are now seeing exactly why the city budget has been squeezed. Even with fewer employees and a relatively flat budget, the city continually runs out of money and is forced to cut services.

We, as citizens, are seeing a degradation of basic city services so that pensions can be fully funded.

To put a cherry on top, the below is an excerpt from the pension report (Page B-1):
Voluntary Retirement. A member may retire after 30 years of service regardless of age, or after attaining age 62 and completing 8 years of service. Effective January 1, 2001, members covered by the Emergency Communications Operators Bargaining Unit, after attaining age 55 and completing 8 years of service. [emphasis added]

This means that if you're 62 and have worked for the city for only eight years, you get a lifetime pension. If you're part of the Emergency Communications Operators union, you can retire at 55 after only eight years of service. And you'll notice that this was approved as recently as 2001 by our city's leaders. The problem was compounded that recently. Now they think that citizens should pay for this through higher taxes.

The end result is that, due to our city leaders' absolute failure to manage finances well, they are trying to push the cost off onto taxpayers without doing anything to address the underlying problem. The politicians find it easier to raise taxes than deal with angry unions - and that's exactly what they are doing again. The city commission is afraid to tackle the real problem, so the easier path is to "kick the can down the road" and try and deal with it later. The problem is that eventually you are forced to deal with it. Instead of dealing with the issue when it was easy to manage, the city has gone beyond the point of being able to fix it without disruption. The current path of the city's pension fund is bankruptcy.

It's easy to spend and make promises when the times are good. But now the residents (and taxed non-residents) of Grand Rapids are being asked to pay for the politicians' and bureaucrats' inability to think ahead and act in their fiduciary capacity as representatives of the citizenry. Who do they work for? The city's unions or the city's citizens?



10 comments:

  1. Good summary. Try reading their 498 page operatng plan. Smoke & mirrors. I know someone that works for the city and sees the budgets. It's a shell game, the 7mil will go to the police and fire then be transferred out. Not to mentioned is the 85k or the special election.

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  2. I agree with your premise that the city has not been investing their money well with the pensions; however, there are some things you did not cover which you may want to mention to be "fair and balanced."

    You are right, some employees can obtain a pension after eight or ten years. What you did not mention is the amount of the pension. If you worked for only eight years the monthly payout is very minimal, I'm talking "beer money" minimal. The pension payouts are based on the persons years of service to the city. This is called a multiplier. That monthly payment is not adjusted for inflation, rather it continues at the same rate.

    Also you're not mentioning that, at least for the police and fire pension, the city only contributed to the fund three out of the past fifteen years. This is due to the pension fund being "over funded" based on contract language. Several years ago the city was advised to contribute to the funds, but they decided to spend it other places. You eluded to that by stating that they mismanaged their money, which it pretty obvious.

    One last thing, again at least for police and fire. The city does not contribute to the social security system. That means that police and fire do NOT get social security when they retire unless they obtained enough credits at another job. That is why there is a pension. Not contributing to social security for police and fire saves the city close to 2 million dollars a year. Just imagine if they just put a portion of that money into the pension plans.

    As most investments the pension fund will rise and fall. I agree with you that they should have made more conservative fund choices. Saying that, as you stated in your article, the fund has mostly recovered from the hit. When the fund does recover the city will go back to contributing what it has the past 15 years, mainly nothing.

    Unfortunately, the city is trying to balance their historical monetary mistakes by blaming it on the employees. The fault for this rests in the executive offices.

    I understand why you do not wish to see your taxes raised, I truly do; however, the fact is if the income tax is not raised the police and fire layoffs will become permanent with probably more to come. The only people who will notice are the employees who will be expected to do the same, quality work with less people; and the citizens who will not get the same, quality work because it's impossible with less people.

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  3. You make good points, but I think they address the periphery of the problem. Defined benefit pension plans, be they run by the city or the federal government (social security) are inherently unsustainable and they will collapse under their own weight eventually. They are essentially Ponzi schemes that require more contributors than payees. As I pointed out in my article, the ratio of contributors to payees has flipped and essentially no matter what is done, the pension plans will fail.

    As of December 2009, the funds were still about 21% below their peak and the markets have been pretty much sideways since then.

    This problem isn't going away. The taxpayers of Grand Rapids shouldn't be paying for the poor financial decisions of the city administration and unions. They need to convert to defined contribution plans now, or else bankruptcy will be on the horizon. The citizenry will not tolerate such a large portion of the government's revenues going solely to pension plans.

    Look at Illinois and the City of Chicago to see our own future if this problem is not addressed, at a fundamental level, very soon.

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  4. Response to ScottMarch 17, 2010 at 6:34 AM

    Scott, Police and Fire will not get social security, but they also don't have it deducted from their paychecks every pay period. Thats money they are free to invest in IRAs and live off their fully funded city pension. Overall the average city worker pays 10% or less of their benefits when the national private sector average is 20%. I would like to see Citizens for a Safer City show us the numbers that if every city worker paid 20% of health care, what would that save the city?

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  5. [...] Oh, and of course the city is claiming that they need a $7 million tax hike in May, 100% of which will go straight to the city’s underfunded pension plan. [...]

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  6. From Sundstrom's MouthMarch 30, 2010 at 6:57 AM

    The truth is starting to come out: 'While supporters have put the emphasis on the return of public safety, $5 million out of the $7.5
    million tax increase would be set aside for the Parks-and-Recreation Department.
    According to Sundstrom, 63% of the department's budget has been eliminated in recent years'.

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  7. [...] the ballot May 4th. For more information on that subject, see my posts on the income tax increase (Grand Rapids Tax Increase: It’s the Pensions Stupid, and Grand Rapids Fires Police, Firefighters, Keeps Parking Lot [...]

    ReplyDelete
  8. [...] at a point where more than 100% of the income tax increase will go solely to the pension plans (as I demonstrated, using the city’s own numbers). If the income tax increase passes, it will go straight from the wallets of city residents to the [...]

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  9. It's clear from this article that GR taxpayers have to stand up for themselves. A NO vote on the tax increase will send a clear message that there needs to be accountability in the GR City governmet.

    http://www.mlive.com/news/grand-rapids/index.ssf/2010/04/burdensome_pension_costs_are_l.html

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  10. A year later we see the truth of the GR Income tax increase. 6 mil of the 7.5 raised will now be going into a Transformation 'slush' Fund. Citizens for a Safer City sent a flier of how the 7.5 mil would be spent. What a joke.

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