1 FUTURE FORSAKEN: PENnscam and the Demise of the Commonwealth John D McGinnis About the Author John D McGinnis is currently serving a second term in the Pennsylvania General Assembly as the state representative of the 79th District. He is an Associate Professor of Finance Emeritus at the Pennsylvania State University. From 2006 to 2012, he was the host of “Open Mic,” a radio talk show on WRTA-AM in Altoona, Pennsylvania. Dr. McGinnis’s field of professional training is in financial economics. In addition to writing articles for popular publications, he has published articles on compensation, agency costs, and other topics in finance and economics in highly rated, peer-reviewed international journals. He has also earned the professional designations of CFA® and CFP®. Dr. McGinnis earned a B.A. from the University of Notre Dame in 1976, an M.S.B.A. from Indiana University South Bend in 1987, and a Ph.D. in finance from Penn State University in 1993. He has worked nearly 40 years in the field of education both as a teacher of students from the 7th grade level to graduate studies and as a university administrator. He resides in Logan Township, Blair County with his four borzoi dogs— Flare, Rugai, Annushka, and Vaskana. Front Cover Design: Jeffrey Metzler © 2015 John D McGinnis. Published under the Creative Commons Attribution License 4.0. http://creativecommons.org/licenses/by/4.0 ii Dedicated to the taxpayers—past, present, and future—of the commonwealth and to S. a talented and dutiful public servant, whose children and their children (not yet born) should not be billed for the retirement benefits she has already earned. iii TABLE OF CONTENTS PART I: PROLOGUE 1 CHAPTER 1 INTRODUCTION 2 CHAPTER 2 THE FOUR HORSEMEN 7 PART II: DESIGN 16 CHAPTER 3 HOW A RETIREMENT PLAN SHOULD OPERATE 17 EXHIBIT 3-1 27 CHAPTER 4 HOW PENNSYLVANIA’S PENSION PLANS OPERATE 28 CHAPTER 5 A DC FIX AND ITS ENEMIES 36 PART III: MANAGEMENT 44 CHAPTER 6 REPORTING PERIL: WHERE’S THE RISK? 45 EXHIBIT 6-1 53 EXHIBIT 6-2 54 CHAPTER 7 MORAL HAZARD AND MANUFACTURING RISK 55 CHAPTER 8 VALUE SUBTRACTED 65 EXHIBIT 8-1 75 EXHIBIT 8-2 76 EXHIBIT 8-3 77 EXHIBIT 8-4 78 PART IV: FUNDING 79 CHAPTER 9 FUNDING FANTASY 80 EXHIBIT 9-1 90 CHAPTER 10 THE MAN BEHIND THE TREE 91 EXHIBIT 10-1 98 CHAPTER 11 HUNTING SASQUATCH: THE TALE OF HB 1471 99 EXHIBIT 11-1 111 CHAPTER 12 HB 900 VERSUS THE EXCUSE MACHINE 112 iv PART V: INERTIA 123 CHAPTER 13 THE COMB-OVER 124 CHAPTER 14 THE BLAME GAME 134 EXHIBIT 14-1 143 CHAPTER 15 THE FANTASTIC FOUR 144 CHAPTER 16 LIES, DAMN LIES, AND ANALOGIES 154 CHAPTER 17 THE EVOLUTION OF A GOVERNOR 162 CHAPTER 18 PENNSYLVANIA’S PUBLIC PENSIONS: A CASE STUDY IN GOVERNMENT FAILURE 170 CHAPTER 19 A PRIMER ON PENNSYLVANIA’S PUBLIC PENSION PROBLEM 177 PART VI: EPILOGUE 185 CHAPTER 20 EPILOGUE AND EPITAPH 186 PART VII: APPENDICES 190 APPENDIX I REFERENCES 191 APPENDIX II INDEX OF NAMES 197 v Part I: PROLOGUE Chapter 1 INTRODUCTION “For they have sown the wind, and they shall reap the whirlwind: it hath no stalk: the bud shall yield no meal: if so be it yield, the strangers shall swallow it up.” – Hosea 8:7 Scam, verb: to cheat or defraud; noun: an act of cheating or fraud Is it too harsh and hyperbolic to describe as scams the Pennsylvania state pension systems--the State Employees’ Retirement System (SERS) and the Public School Employees’ Retirement System (PSERS)? I don’t think so. They are devolving into Ponzi schemes because they are badly designed, badly managed, and badly funded. What is worse, with each passing day, which includes $12 million more in pension debt, it gets more difficult for elected officials to recall the Frankenstein they’ve created. Many episodes of the television show, American Greed, feature real-life stories about scam artists running pyramid schemes to steal from their clients. A surprising number of these cases begin as honest efforts by the operators to provide goods or services to customers, but then, due to liquidity or cash flow problems, the operator begins using funds from new clients to reimburse old. Before long, it’s a full-fledged Ponzi scheme with seemingly no way to return to legitimacy. Each episode ends with the death, disappearance, or detention of the scammer. This devolution, from financial soundness to financial catastrophe, appears to be what is happening to our state’s pension systems. They are designed to be pre-funded; that is, retirement benefits earned by employees each pay period are supposed to be fully funded each pay period. However, since at least 2003, significant portions of the benefits earned by Pennsylvania’s public sector employees have not been funded as earned; in effect, this develops into a pyramid scheme over time, where dollars from present taxpayers are being used to cover costs from the past, and dollars from future taxpayers will be used to cover costs from the present. The character, Amanda Wingfield, in Tennessee Williams’ The Glass Menagerie, has the problem diagnosed, “the future becomes the present, the present becomes the past, and the past turns into everlasting regret if you don’t plan for it.” Chapter 1: Introduction Perhaps, more alarming is the acceptance of the pyramid structure our pensions have become. For example, Theresa Ghillarduci, the director of the Schwartz Center for Economic Policy Analysis at The New School for Social Research in New York City, in an op-ed about a proposed Pennsylvania legislative pension reform measure (SB 1) wrote, “…shifting new employees to 401(k)-type plans drains contributions from Pennsylvania's traditional pensions.” If she and others really believe that new employees are necessary to supply funds for current employees and current retirees, then they must believe our pensions are pyramid schemes. That’s what the pensions have become, but they are not supposed to operate that way. There are two differences between the scams going on with Pennsylvania’s pensions and those on American Greed. First, the new clients being defrauded in the television show are involved voluntarily. In most cases, if they had done due diligence or just not been so greedy, they could have avoided being scammed. Pennsylvania taxpayers, however, have no choice in the matter besetting them other than to leave the state. As we will see, many are doing exactly that. In fact, the pension crisis may be making young people, and our future with them, the commonwealth’s chief export. Second, while the scammers in the television episodes are aware of their misdoings and have some sense, at least in part, that a day of reckoning is coming, the officials responsible for our state pension crisis act with legal impunity in their scam. The day of reckoning that is coming is coming for taxpayers and not for the perpetrators in elected office. It is the worse type of moral hazard. Debt is the drug of choice for politicians, and like most illicit drugs it makes the abusers feel good in the short-run; also like illicit drug use, in the long-run there will be severe consequences. Pennsylvania’s state government has been piling up massive pension debt over the past 10 to 12 years. The unfunded accrued liabilities (UALs) of SERS and PSERS are reported at actuarial values totaling nearly $57 billion, and their actual economic value is over $125 billion, nearly $10,000 of debt for every man, woman, and child in the state. If a family of four were to leave the state, they would immediately receive $40,000 of debt forgiveness; a family of four who moves into the state will get hit with $40,000 of debt for services they never received. Which way do we think the migration is going to go? Although I have the perspective of a state representative and get an up close look at our state government (with the same fascination a pathologist has for disease), I write this book simply as a concerned citizen. It is too late to avoid real and significant damage to Pennsylvania’s future, but my hope is that there is still an opportunity, if we act urgently and decisively, to mitigate that damage and rescue a good portion of Pennsylvania’s future. Make no mistake, our state pensions are on a path to financial catastrophe and place the future of the Keystone State in doubt. ******** 3 Future Forsaken I am not an alarmist ordinarily. History has provided one rebuke after another to the Chicken Littles, who engaged in predictions of doom. In Adam Smith’s The Wealth of Nations, which began the modern study of economics, he wrote: “The annual produce of the land and labour of England, for example, is certainly much greater than it was, a little more than a century ago, at the restoration of Charles II. Though, at present, few people, I believe, doubt of this, yet during this period, five years have seldom passed away in which some book or pamphlet has not been published, written, too, with such abilities as to gain some authority with the public, and pretending to demonstrate that the wealth of the nation was fast declining, that the country was depopulated, agriculture neglected, manufactures decaying, and trade undone. Nor have these publications been all party pamphlets, the wretched offspring of falsehood and venality. Many of them have been written by very candid and very intelligent people, who wrote nothing but what they believed, and for no other reason but because they believed it.” The doomsday industry is hardly a modern construct, and skepticism is usually warranted for those who project gloom, doom and disaster for our future.