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October 21st, 2014

The Regulator Movement

The Regulator Movement was an uprising in the colonial Carolinas that presaged the American Revolution. It is also a fitting description for the last six years’ political trend with respect to financial services. Certainly, some of the problems seen in 2008 were the result of absurd risk taking or simple grifting that deserved regulators’ attention. The great lesson of 2008 and most other financial panics is how they could have been diminished by a regulatory dosing of common sense. In the aftermath of 2008, laws requiring careful credit analysis of home buyers have been created. In the 2005-2007 era of “No Doc” mortgages, a prescient regulator or legislator could easily have predicted the consequence of such feckless loans and banned them.

The Detroit bankruptcy and pending resurrection offer regulators, who have been multiplying like spores, the opportunity to review the amply documented autopsy of Detroit’s finances. Detroit’s errors can be used as a sextant to help other cities better navigate the same fiscal shoals, which at present embody a $3 trillion shortfall. Instead of the typical teeth gnashing post-crisis regulatory process, the Detroit situation offers a chance to prevent or to mitigate the next Detroit.

It is useful to conduct a brief review of some of Detroit’s pre bankruptcy practices, in five critical areas, which are still being used by many other cities: Aggressive actuarial assumptions Board composition Comingling of pension and other assets Contracts being signed independent of proven funding Board liability for breach of fiduciary duty Although discussion of actuarial work for any amount of time is a remedy for insomnia, it needs discussion. Upon exiting bankruptcy, Detroit plans to operate on a plan that assumes a 6.75% annual rate of return and the plan funding percentage is assumed to drop from 74% today to 65% over the next thirty years. In the following decade, Detroit relocates to the Pacific Coast, employment skyrockets and funding rises to 100%. These actuarial assumptions read like a prescription to return to Chapter 9. The yearly pension payout after the bankruptcy will exceed twice the city’s annual income tax receipts, indicating the city will not fill the inevitable gap.

The composition of many municipal pension boards largely consists of employees from the beneficiary pool. That democratic sounding method guarantees that amateurs are in charge of the pension fund. No pensioners would put a committee of their peers in charge of their healthcare; they would have doctors. The pension assets deserve similar care. In the case of Detroit the amateur board actually paid out annual earnings above the actuarial rate of return as a holiday bonus pension in any years the rate was exceeded. These payments were made despite the pension fund being woefully underfunded and they were a violation of the pension contract. These “holiday bonuses” totaled $1 billion, or nearly one fourth of the current shortfall.

Comingling or mixing of pension assets with any other assets needs to be criminally forbidden. In Detroit’s case, the Board decided to offer a savings plan to employees comingled with the pension fund and guaranteed to earn 7.9% in an era when savings accounts were likely to earn .25%. Any year the pension fund did not earn 7.9% the Board took money from the pension fund and handed it to the savings accounts until 7.9% return was reached. In 2009 the pension fund declined 24%, yet it was used to fund a 7.9% return on the savings accounts.

The negotiation process for increases in pension benefits cannot be complete unless funding for the benefits is demonstrated and blessed by Federal authorities. To date, contracts for higher benefits are executed with no proof of financial viability.

Boards must be liable for breach of fiduciary duty. Stories of theft and favor granting are rampant in the private pension world, but they are not as great a crime against beneficiaries as the irresponsible management has proven to be in Detroit. Board members should be well paid, and at risk if they are not prudent.

This blog was set in Chiste, based on an old-style Roman face that was used for Cardinal Satira’s tract “Es Increible” in 1438. The Schreiber Monotype Co. of Redding, PA brought the forms to the United States in 1924.

I’m Rob Morris and I approved this blog.

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