Pension Reform in Providence: Part One, The Reform Process

Pensions are a key issue in Rhode Island’s governor’s race. Providence Mayor Angel Taveras praises his city’s reform plan, but deficits remain.

Providence Breaks $700,000 Pension Link Joining Insolvency Fight

Angel Taveras, mayor of Providence, center, signs an ordinance to overhaul the city’s pension system and reduce its cost, in Providence, Rhode Island, U.S., in this handout photo, taken on April 30, 2012. The change suspended annual pension increases and capped payouts, which labor leaders say is illegal. Source: City of Providence via Bloomberg EDITOR’S NOTE: EDITORIAL USE ONLY. NO SALES.

Via Bloomberg

Providence, Rhode Island, would likely have followed its fellow municipalities of Central Falls, Rhode Island, and Stockton, California, into bankruptcy if it hadn’t moved to reform its pension fund and reduce pressures from a pension deficit in 2012. Since then, Providence Mayor Angel Taveras, an up-and-coming figure in the Democratic Party, has been pointing to the success of pension reform in his primary run for the Ocean State’s governor’s office. But the reform effort failed to make the kind of changes many thought were necessary, the city is currently suing its longtime pension auditor, and the plan requires steady, robust growth in Providence’s economy to be successful.

The city’s reform legislation stands in contrast to changes made to Rhode Island’s similarly challenged pension fund. Like Providence, Rhode Island faced a dangerously underfunded pension fund that was draining the state budget. The solution included reducing benefits across the board and adding a mandatory defined contribution fund in 2012.

In Providence the cuts were less drastic. The most significant change was a freeze on the cost-of-living adjustment (COLA). Whereas labor beneficiaries are still fighting the state plan in court, the changes to Providence’s system have been accepted, though the plan still faces significant obstacles to solvency.

In this, the first of a three-part series on the Providence pension reform effort, Institutional Investor takes stock of the city’s postreform funding situation. The following installments will tackle investing and the politics of pension reform.

Taveras’s strongest opponent for governor is Rhode Island Treasurer Gina Raimondo. The two are currently locked in what appears to be a dead heat in the Democratic gubernatorial primary race; whoever wins the September 9 primary is expected to win the November general election.

Raimondo championed the state pension reform bill, which became law with the support of incumbent Governor Lincoln Chafee and the state legislature. Little divides Taveras and Raimondo in terms of policy; both are regarded as business-friendly Democrats with impressive résumés and private-sector experience. As a result, their differing approaches to pension reform have taken on greater prominence. Hit by criticisms and challenges from organized labor, the state reforms have come under significant scrutiny while Providence’s plan has received less attention. Providence pays into both funds, but it’s the city’s pension that raises continuing concerns about its future fiscal health.

Unlike the state, Providence had to negotiate with unions before reforms could be passed into law. There were certain key concessions, such as switching to defined contribution pension funds, that labor refused to accept. Given those restraints, Councilman Samuel Zurier, who served as vice chair to the City of Providence Subcommittee on Pension Sustainability, outlined reform measures in April 2012 made possible, he says, after “an agreement [with labor] was reached, which provides a path to solvency and stability.”

Success will rely on prudent action by all stakeholders — not aggressively improving benefits or failing to pay obligations, as in the past — and, over time, escalating contributions from the city. If Providence’s fiscal health nosedives, the pension fund could become a greater burden than it was before. If all goes well, however, the reforms could help Providence get to a 70 percent funded status. The strategy, Zurier agrees, “requires economic growth for Providence.”

This June, in a move greeted with enthusiasm by Taveras and announced in a press release on the city government’s web site, ratings agency Standard & Poor’s upgraded Providence’s BBB rating outlook from stable to positive, citing “recently strong budgetary performance and improving general fund balance.” However, S&P also noted that the rating “reflects Standard & Poor’s opinion of the city’s very weak budgetary flexibility and Standard & Poor’s view that the city’s fiscal and management conditions remain what it considers weak due to past deficits and a still-challenging budgetary environment led by high pensions and other post-employment benefit liabilities.”

Here is how the Providence pension fund stacks up: According to the 2013 valuation, produced by Segal Consulting, as of June 30, 2013, the fund had assets under management of $380.5 million. The funding ratio decreased from 31.94 on July 1, 2011, to 31.39 on July 1, 2013, but on a market-value basis the funded portion actually rose from 31.44 percent to 32.43 percent. Segal estimates that Providence will have to pay $66.5 million into the fund for fiscal year 2015, 8 percent more than 2014, and $71.6 million in 2016.

According to these estimates, the underfunded liability will be paid off by 2041, with total pension costs to the city growing to $162.8 million in 2040. Providence’s total governmental-funds balance as of June 30, 2013, was $91.4 million. The city government ran a $1.57 million surplus in 2013. Providence’s total expenditure for fiscal year 2014 was estimated at $662 million. Although the recommended amortization payments are calculated to increase only 3.5 percent a year, owing to 2009 investment losses and other issues, they will go up by 8 percent for fiscal year 2015 and 7.66 percent for fiscal year 2016. The city cannot raise property taxes, its most significant source of annual revenue, by more than 4 percent a year without approval from both four fifths of the city council and Rhode Island’s auditor general. That limits the city’s fiscal flexibility.

In fact, the city’s pension system may have less than $380.5 million. That figure includes $57 million in fiscal year 2014 contributions, an accounting practice that Segal’s report recommends the city discontinue. In July, Taveras’s office was forced to clarify the valuation of the fund and confirm a lower, $323 million figure after Michael Riley, a Rhode Island investment consultant and critic of the current pension system who made an unsuccessful 2012 congressional bid, questioned the use of the higher number in a bond offering document.

The pension fund is also using an assumed rate of return of its assets of 8.25 percent, reduced from 8.5 percent. Speaking at an April 28 meeting of the Locally-Administered Pension Plans Study Commission — set up as part of the 2011 state retirement reform act in response to concerns about the funding status of Rhode Island’s municipal pension plans — Deputy State Treasurer Mark Dingley pointed out that other communities have adopted a lower, 7.5 percent assumed rate of return and warned that “the city’s numbers are greatly impacted by their assumption of greater investment earnings.”

The Providence fund returned just 0.97 percent for fiscal year 2012 and 5.7 percent for FY 2013, though it is up more than 8.5 percent for FY 2014 so far. Governmental Accounting Standards Board rules that come into effect this month for FY 2015 will require Providence, as well as many other states and municipalities, to use a lower discount rate. Riley, who is also vice chair of the Rhode Island Center for Freedom and Prosperity, has estimated that under the new GASB standards the city plan will be only 20 percent funded. Taveras’s spokesman, David Ortiz, told a Providence news channel that Segal had said that the accounting standard changes “are not expected to affect the Providence Retirement System’s liability as long as the city continues to make its full annual contribution into the pension fund.”

The son of immigrants from the Dominican Republic, Taveras, 43, was born in Brooklyn, New York, but grew up on the South Side of Providence. He attended Providence public schools before receiving an undergraduate degree from Harvard and a JD from Georgetown University. In 2007, Providence’s then-mayor, David Cicilline, appointed Taveras an associate judge on the Providence Housing Court.

Four years later Taveras succeeded Cicilline and inherited a fiscal mess, or in Taveras’s words, a “Category 5 fiscal hurricane.” Because of the 2008 financial crisis and other factors, Taveras confronted a $70 million structural deficit for FY 2011 that grew into $110 million in 2012. After a series of reductions and austerity measures — Taveras cut his own pay by 10 percent — Providence was able to end the 2012 fiscal year with an operating deficit of only $15 million. In late 2011, Taveras and city lawmakers turned their attention to the pension fund. The auditor general of Rhode Island had labeled the fund one of the highest-risk plans in the state.

As the city council’s five-member Subcommittee on Pension Sustainability found, there were plenty of reasons why the fund was in trouble, including a funding ratio of just 31 percent. Over the years, Providence had agreed to generous retirement benefits, including a relatively high COLA of 6 percent, liberal disability increases and early retirement-age requirements. The city had also not been making its annual mandated payments into the pension.

Unless the structural deficit was closed, the April 2012 report determined, the city would “run out of funds and ultimately be forced to initiate a shutdown of essential city services and enter bankruptcy.” Under terms of the April 2012 legislation passed by the city council and signed into law by Taveras, Providence would suspend the COLA until the funding ratio reached 70 percent. Retirement benefits were capped at 150 percent of state median household income, and the rich COLA was eliminated.

The adjustment to the COLA would immediately boost the plan’s funding from 31 percent to almost 40 percent and “result in a $240 million reduction of the underfunded pension liability from $900 million to $659 million,” said the city’s pension ordinance.

The unions, which were already fighting proposed changes to their health benefits, immediately took the COLA adjustments to court and eventually settled. Under that settlement, which Rhode Island Superior Court Judge Sarah Taft-Carter deemed “a laudable example” for other cities and towns, beneficiaries agreed to accept a freeze on the COLA for ten years. Yet those changes to the agreement, the market environment and other circumstances mean that Providence is saving less than originally anticipated. Rather than going up to 40 percent, the funding ratio for FY 2013 was just over 32 percent. Although the city’s fiscally required 2012 annual contribution was reduced from $58.9 million to $53.7 million, Providence’s actual pension contribution, made in October 2012, was only 90 percent of that restated number, according to the city’s internal auditor.

To crunch the numbers for pension reform, Providence had used its longtime auditor, New York–based Buck Consultants, which testified to the city council subcommittee that suspending COLA payments would produce the most savings. Buck’s calculation, however, assumed that the 2012 COLA had not been paid; in fact, it had, and according to the suit that the city subsequently filed against the firm, “because of Buck’s elemental error, the city’s pension liabilities increased by $10 million over what was projected and relied upon when the city was negotiating modifications for the pension.” Buck has filed a countersuit alleging that Providence was “merely looking to get the best deal that it could” regardless of Buck’s figures. The litigation is ongoing.

Taveras and his office estimate that the city will save $390 million over the next 27 years from the pension reform agreement. Despite the plan, Providence still faces escalating pension costs that can only be met if the city grows. Given its precarious fiscal condition in 2011 and 2012, as well as the lack of options available for striking any kind of agreement that would meet with union approval or withstand challenges from the courts, the changes Taveras and the council secured may well have been the best Providence could have hoped for.

But with the funding level still well below 35 percent, Providence’s pension crisis is far from over. The same is true of many of the state’s other local pension plans, a number of which have taken steps similar to Providence’s.

If Taveras succeeds in his bid to become the next governor of Rhode Island, in part by having taken less drastic measures to fix Providence’s pension fund than others and gaining the support of union voters, he may well have to confront this ticking time bomb of underfunding again, this time from the governor’s mansion.

Follow Imogen Rose-Smith on Twitter at @imogennyc.