For years, the territory’s government piled on the benefits without paying for them. Now, it faces the prospect of stiffing retirees, or foreign creditors ... or both.
Puerto Rico’s other crisis: impoverished pensions
SAN JUAN, Puerto Rico – When Puerto Rico attempted to shore up its chronically underfunded public-employee pensions in 2013, Francisco del Castillo “knew grown men and women who wept.”
Under the reform package, retirement ages rose. So did employee contributions. Current and future participants were transferred to less-generous defined-contribution accounts, similar to 401(k) retirement savings plans. Del Castillo, then the deputy chief of the island’s largest government-employee pension system, said members of his own staff who were on the verge of retirement suddenly faced the prospect of working seven or eight more years for reduced benefits.
The law extracted “a pound of political flesh” from those, like del Castillo, who helped craft it, he said. “We wanted it to work.”
It didn’t, largely because Governor Alejandro Garcia Padilla’s government hasn’t held up its end of the bargain.
To give the politically painful fixes time to take hold, the reforms required government employers to fund the pensions in the short term through annual lump-sum payments. The central government was supposed to have made $367.6 million in such payments since 2014; so far, it has forked over just $22.7 million.
Governor Garcia Padilla’s office declined to comment for this article.
Failed fixes like the 2013 reforms help explain why Puerto Rico’s public-employee pensions today are nearly broke – a financial debacle decades in the making, and now deeply entangled with the island’s $70 billion debt crisis.
Since Puerto Rico gained self-rule in the late 1940s, improvident populist governments have lavished additional pension benefits on public employees, from holiday bonuses to loans for international travel. These measures have rarely been accompanied by moves to pay for them, and occasional efforts to fill the funding gap have fallen short.
Puerto Rican leaders have been eternal optimists, “always thinking things would eventually improve,” said del Castillo, 40 years old and now legal counsel to the Teachers Retirement System (TRS), one of two main public-employee pensions on the island. “But things continued to deteriorate, and deteriorate, and deteriorate.”
Today, TRS and the other main pension fund, the Employees Retirement System (ERS), together covering about 330,000 workers and retirees, are virtually penniless. Their combined unfunded liability totals $43.2 billion. With about $1.8 billion in assets to pay $45 billion in liabilities, the 96 percent combined shortfall is among the biggest of any U.S. state pension this century, and probably the biggest ever for pensions “of this size and scale,” said Keith Brainard, research director at the National Association of State Retirement Administrators.
And they’re only sinking further. Their combined burn rate – the difference between what they pay out and what they receive in contributions – is more than $1 billion a year, forcing them to rapidly liquidate assets. At that rate, they are forecast to run out of money in 2019, according to a 2015 report by actuarial and consulting firm Milliman, on whose recommendations the government relies.
TRS officials declined several interview requests. ERS Administrator Pedro Ortiz Cortes said pensions “kind of fell off the radar” after the 2013 reforms. The legislation was “reasonable in theory,” he said, though “the ability to comply was not taken into consideration.”
SHIFTING THE BURDEN
Absent a permanent fix, the responsibility to cover benefits will shift to the Puerto Rican government, creating a pay-as-you-go system funded mostly by taxpayers. At $1 billion a year, retirement benefits would cost the island around 11 percent of annual revenue, an unsustainable burden when combined with the 36 percent of revenue now going toward paying bondholders.
“It’s pretty clear a pay-as-you-go Puerto Rico pension system is no more sustainable than Puerto Rico’s debt.”
The upshot is that an island of 3.5 million people, where nearly half the population lives below the poverty line and the economy has been contracting for most of the past decade, is at a crossroads where neither path forward is appealing.
It can protect pensions, forcing hedge funds and other bondholders to accept draconian cuts under a debt restructuring – a scenario that could wreck Puerto Rico’s ability to borrow internationally for years.
Or, it can lessen the burden for bondholders by cutting pensions as well, sparking domestic political backlash and fueling outmigration that would further shrink an already dwindling tax base.
“I would need to go to the U.S., sell my house and start looking for a job” if pensions were cut, said Obdulia Lopez, 60, a retired social services worker from rural Juana Diaz who lives on a pension check of about $1,000 a month, after taxes.
Puerto Rico can’t fully control which path it takes. Governor Garcia Padilla’s administration on Feb. 1 unveiled a plan that would preserve pensions while reducing what’s owed to bondholders. The Obama administration also promoted a plan to protect pensioners over investors, and Puerto Rico’s top financial adviser, turnaround specialist Jim Millstein of Millstein & Co, in February said the island has taken pension reform as far as it can under current law.
But creditors with lobbying power -- including hedge funds, mutual funds and bond insurers -- want the Puerto Rican government to do more to curb spending, on pensions and other things. One source in the creditor camp called it “insane” to propose that “bondholders … effectively take all the hit.” Another said: “Puerto Rico’s people are really the ones being victimized. If I had a heart, it would be breaking for them.”
Majority Republicans in Congress are standing with bondholders. In a written response to questions from Reuters, Utah Republican Orrin Hatch, who chairs the Senate Finance Committee, said: “It’s pretty clear a pay-as-you-go Puerto Rico pension system is no more sustainable than Puerto Rico’s debt.”
In March, a group of 170 House Republicans voiced opposition to a draft bill by the House Natural Resources Committee that would allow for debt restructuring.
Garcia Padilla has warned that without a resolution of some sort, Puerto Rico stands to default on some of its $70 billion in debt as early as May, when $422 million comes due.
The government payments into the pension funds under the 2013 law were designed to avoid the very conflict now playing out. Instead, they ended up as yet another example of how solutions can create new problems in the complexities of Puerto Rico’s crisis.
“Puerto Rico’s people are really the ones being victimized. If I had a heart, it would be breaking for them.”
To reduce costs, Puerto Rico has cut its government payroll in recent years through layoffs and other measures that have led to declines in pension contributions. The payments from the government’s general revenue fund were calculated in part to offset those declines, so skipping them means the island’s payroll savings have only deepened the hole for retirees.
Maria Carattini Alvarado, a 72-year-old former teacher who spends more than half of her monthly pension on medicines for a blood condition, supplements her income by making ribboned hats that she sells for $5 a pop. “I’d go live with my son in Texas” if pensions were cut, Carattini said.
In Puerto Rico, teachers, as well as police officers, are ineligible for Social Security, so pension payments are often all they have in retirement. Like many retired teachers, Carattini gets affordable healthcare and housing through programs set up by the Associacion de Maestros, one of Puerto Rico’s teachers’ unions.
But those benefits could disappear, too, if pensions collapsed, said union President Aida Diaz. “If people can’t afford their dues, we can’t provide those services,” said Diaz, herself a pensioner.
Most pensions have a few decades to mature, building up assets in the early years before members retire. Puerto Rico’s pensions carried big unfunded liabilities nearly from the outset, inheriting them from retirement systems in place before the island became a self-governed U.S. commonwealth in 1948. From there, longer life expectancies helped deepen the gap.
So, too, did island leaders. Populist Luis Munoz Marin, Puerto Rico’s first elected governor, in 1956 instituted cultural excursion loans for pensioners. Puerto Rico was in “a stage of rapid social, economic and political development,” the 1956 law said, and should aim to enable “the largest possible number of Puerto Ricans to travel to foreign countries.”
Today, ERS and TRS participants can take out as much as $5,000 to travel if they can show that the trip will be culturally rewarding. The pensions also offer as much as $5,000 for personal loans and $100,000 for mortgage loans. Together, the two funds have more than $1 billion tied up in illiquid loan portfolios.
‘CANDY TO CHILDREN’
The largess continued under Luis Ferre, governor from 1968 to 1972, who increased benefits and instituted mandatory Christmas bonuses. Last December, creditors griped privately when Puerto Rico doled out about $120 million of the bonuses even as it missed some minor bond payments.
Christmas and medication bonuses, ad hoc cost-of-living adjustments, death benefits and other perks were expanded periodically throughout the 1980s, ’90s and 2000s. These now account for nearly $3 billion in liabilities, according to Milliman’s latest actuarial report, even after reductions under the 2013 reforms.
Rafael Hernandez Colon, president of the Puerto Rico Senate during Ferre’s administration, said his party went along with the Christmas bonuses “for political reasons” to avoid being labeled obstructionist, but did not consider it good governance. “We looked at it as giving candy to children,” Hernandez Colon said in an interview at his foundation in Ponce, a city on Puerto Rico’s southern coast.
Yet when Hernandez Colon won the governor’s seat in 1972, his administration approved perhaps the most structurally damning benefit of all. Under a 1973 amendment to existing pension law, government employees who retired at 55, with 30 years of service, were entitled to lifetime annual payouts worth 75 percent of their salary.
That percentage was based not on a worker’s career average salary, but on the average of his three highest salaries. So those who were promoted close to retirement, or for only a short time, could earn lifetime pensions disproportionate to contributions.
“People were making pensions that might not have reflected the average of what they were putting in over decades,” said Marcos Rodriguez-Ema, a banker and former government official involved in pension reform efforts in the 1990s and 2000s.
Familiar populist language peppered the 1973 legislation, vowing to “stimulate the creative vitality” of workers who had dedicated their lives to Puerto Rico, and cushion them against the “uncertainty that comes with age.”
The amendment brushed off concern about future financial strain on the pensions, saying their investments were producing revenue twice what actuaries had approved, so the “measures won’t be burdensome.”
“I feel that I was very sensitive to the pensioners and tried to comply with them in a responsible way,” Hernandez Colon, now 79, told Reuters. “Whether it was in fact responsible, you’d have to analyze it.”
“People don’t want to make hard decisions today for savings that, when it would occur, they were not going to be in office.”
The benefit structure remained in place until reforms in 1990 – during Hernandez Colon's second stint as governor – reduced benefits for future workers. Today, of ERS’s $30.2 billion total unfunded liability, about $24 billion – 80 percent – is attributable to that era, owed to people who worked, retired or were hired before the 1990 changes.
Another set of reforms in 1999, known as System 2000, eased the pensions’ long-term liabilities by moving future retirees to a defined-contribution system. But legislation to ensure adequate long-term funding for benefits, such as by increasing employer contributions, has been rare. Unlike in some states, the rate Puerto Rico contributes to its pensions is set by statute, rather than the recommendation of actuaries, and requires legislation to change. This makes pension contributions a political issue.
“People don’t want to make hard decisions today for savings that, when it would occur, they were not going to be in office,” del Castillo said.
Rodriguez-Ema helped shape what would become System 2000 as president of Puerto Rico’s Government Development Bank (GDB). He said that so long as Puerto Rico’s economy kept growing and ratings agencies weren’t concerned about pension liabilities, strengthening the pensions wasn’t a priority. “We realized we were going to have a problem, but it was in the future,” he said. “We could fund the retirement system without any problems whatsoever.”
That blithe approach came to an end by the mid-2000s, as the island’s economy showed its first signs of decline. When Anibal Acevedo Vila assumed the governor’s chair in 2005, the two pensions’ combined unfunded liability stood at around $12 billion. The new governor pushed a bill to authorize a $2 billion bond issue from the government’s books, with proceeds to go to ERS.
The bill died in Puerto Rico’s legislature, a victim of political feuding.
Acevedo Vila’s next effort to boost pension funding proved disastrous. To skirt the need for legislative approval, his administration arranged for ERS to issue its own bonds – unheard-of for a public pension – and put up employer contributions as collateral. But, Acevedo Vila said, the government “needed to assure people the pension would not collapse.”
The plan was to raise $7 billion -- the amount the administration calculated was necessary to earn enough interest to cover ERS’s annual burn rate. The pension in 2008 sold $2.9 billion in the first of multiple planned tranches underwritten by UBS and arranged by Jorge Irizarry, then president of the GDB.
But Acevedo Vila, plagued by a lengthy indictment on charges he violated campaign finance laws, lost his 2008 re-election bid. (A jury later found him not guilty.) His successor, conservative Luis Fortuno, had no interest in issuing more bonds.
Instead, in what is widely viewed today as a political maneuver, Fortuno commissioned consultants Conway MacKenzie to examine his predecessor’s handling of ERS. The firm’s 2010 report excoriated the bond deal, calling elements of it so “obviously flawed and not logical” that it “could imply a lack of understanding” of the deal by island officials.
Conway concluded that UBS was hired to place the bonds locally only after Merrill Lynch failed to place them internationally, showing a lack of appetite for the full $7 billion. The report said Alfredo Salazar, GDB’s chairman at the time, and Irizarry should have known that raising less than $7 billion would fail to generate sufficient returns to pay bondholders and cover ERS’s burn rate, only adding to the pension’s liability down the road.
In separate interviews, Irizarry and Salazar said it was never the idea to issue all the debt at once. Conway’s report “misstated many facts and omitted others,” Irizarry said.
Salazar said the bonds were issued locally so they could qualify as tax-free. “We decided,” he said in an interview, “to do whatever capacity we could get in the local market and then move on to the taxable market if we needed more.”
A Conway spokesman did not return calls seeking comment. UBS and Merrill declined to comment.
Conway’s politically convenient conclusions may have taken pressure off Fortuno to solve the pensions’ problems, but few independent observers dispute one of its major findings: The bonds increased “the complexity of … fixing [ERS’s] fundamental structural problems.”
The bonds saddled pensioners with a big new obligation without generating enough returns to stave off insolvency. Chunks of government pension contributions are now going out the door to pay bondholders who rank ahead of pensioners in the payout line.
A former Acevedo Vila administration official told Reuters that if the administration had known that only $2.9 billion would be raised, it “wouldn’t have issued the bonds at all.”
Acevedo Vila insists the bonds extended the pension’s life. “I never said I fixed the problem,” the former governor, now 54, said at his law office in San Juan’s Rio Piedras neighborhood. “But I was doing something to give the pensions more time.”
As governor, Fortuno signed a 2011 law that raised the government’s pension contributions – the first increase since the 1990 reforms – then appointed a bipartisan commission to explore more comprehensive changes.
In the end, he could not save the pensions, either. The commission never produced any draft legislation. Fortuno blames the man who eventually succeeded him as governor, Garcia Padilla.
In early 2012 – an election year – Fortuno’s commission began to coalesce around a proposal to reduce bonuses, raise retirement ages and increase employee contributions, Fortuno said during a phone interview from his Washington, D.C., law office.
Garcia Padilla, then a senator who headed the opposition party, withheld his party’s cooperation on any pension fixes, according to Fortuno and members of his administration. Garcia Padilla “was saying, ‘Luis Fortuno is the enemy of retirees. We’re not going to work with him. Vote against him,’ ” Fortuno said.
When pressed on whether he could have done more to reverse the pensions’ downward spiral, Fortuno said: “Maybe I could have done more in 2009 or 2010 to ram [pension reform] down the throats” of lawmakers by shutting down Puerto Rico’s government, “but I didn’t want to further shatter people’s faith in their economic future.”
As the crisis over pension funding was reaching fever pitch, Garcia Padilla, newly installed as governor, signed into law the kind of comprehensive pension reform that had eluded earlier generations – and which he had months earlier criticized Fortuno for trying to enact.
The April 2013 reform – the one del Castillo said caused some people to cry – imposed stricter terms on plan participants to improve ERS’s funding over the long term while requiring the government to pay into the system for a few years to cover short-term needs. The law “created a healing process” for ERS, del Castillo said, putting it on track to stabilize as legacy obligations die out.
Lawmakers tried to enact similar reforms at TRS, but Puerto Rico’s Supreme Court invalidated some key elements, putting teachers’ benefits in jeopardy in both the short and long term. Pension reform efforts generally have not addressed teachers, who today remain eligible for guaranteed, defined-benefit payouts.
Some people attribute this lack of action to the power of teacher groups. “They’re homogeneous, they’re well-organized, and they lobby hard,” said Hector Mayol, the top official at both ERS and TRS from 2009 to 2013. Pension cuts are more politically charged at TRS because beneficiaries don’t receive Social Security.
The 2013 law has hardly fixed ERS, though, largely because Puerto Rico has failed to follow its own law by withholding the bulk of payments into ERS, so-called additional uniform contributions (AUCs).
Maintaining pension benefits in the near term was part of the shared sacrifice to ensure pensioners’ long-term concessions were not made in vain. But 14 months after the 2013 reforms were passed – and on the heels of credit downgrades by S&P and Moody’s – Puerto Rico enacted Act 66, a fiscal emergency law that let the government suspend some financial obligations.
ERS is still waiting on about $345 million of the combined $367.6 million in AUCs owed by Puerto Rico's central government, according to data provided by ERS. Actuary Milliman raised the AUC for the current year, in part to offset decreases in pension contributions from layoffs and other payroll cuts, and in part to make up for previous years' missed payments.
But Ortiz Cortes, the ERS administrator, said the pension has not received any of this year's infusion from the central government, and only about $23 million from municipalities, public agencies and other employers.
That means next year's AUC will shoot even higher, and Ortiz Cortes said his staff has been told by the island’s budget officials not to expect close to a full payment then, either.
Through a spokeswoman, Budget Director Luis Cruz Batista declined to comment.
“It’s going to be a bumpy road” for pensions, Ortiz Cortes said. “Whatever goes down, it’s going to be bumpy.”
By Nick Brown
Graphics: Stephen Culp
Photo editing: Stelios Varias and Claudia Daut
Edited by John Blanton