Puerto Rico's Forgotten Creditors

by: Daniel Irvin


Most followers of Puerto Rico's financial crisis are likely aware that the Commonwealth's unfunded pension obligations are among its largest liabilities.

However, a bizarre practice by the largest pension fund has received little if any attention by the media.

The largest retirement system seems to be using contributions from defined contributions plan participants to pay current benefits rather than segregating and investing these funds on behalf of the contributors.

Allowing Puerto Rico access to Chapter 9 would do little to address this situation and could make these obligations to retirees more vulnerable.

This highlights the Kafkaesque reality of Puerto Rico's financial crisis and the need for a Federal Financial Control Board to restore budgetary balance, which Chapter 9 cannot accomplish.

Anyone following Puerto Rico's fiscal crisis is likely aware the pension systems are dangerously depleted as the government has consistently failed to make the contributions recommended by actuaries to fund future benefits. A recent article in El Vocero pointed to a change in practice under which the pension system is prepaying benefits to the general fund rather than reimbursing the general fund after payments have been made. The article implies that by receiving the money from the pension funds immediately prior to disbursing them to retirees, the government is using the "float" to make other payments including Christmas bonuses to current workers. Whether or not this is true, there is no doubt the pension system is in serious trouble. In the article, one official cites 2019 as the year the system will run out of money to pay benefits.

Despite media attention on the pension funds, they seem to have overlooked a bizarre practice by the largest pension fund, the Employees Retirement System.

In 2000, the Commonwealth instituted a conversion from a defined benefit plan to a defined contribution plan--supposedly a 401k-type plan. The new plan called "System 2000" required that all new workers beginning in 2000 would contribute to a defined contribution plan and would receive benefits based on the principal and earnings realized from the plan as opposed to any fixed schedule of benefits.

Page 159 of the Commonwealth's most recent (unaudited) financial report published on November 6, 2015 (November Report) contains the following disclosure:

"System 2000 is not a separate plan as there are no separate accounts for System 2000 Participants. Contributions received from System 2000 Participants are pooled and invested by the Employees Retirement System together with the assets corresponding to the defined benefit structure. Thus, future benefit payments under the defined benefit structure of Act 447 and Act 1 of 1990 and the defined contribution structure of System 2000, as amended by Act 3-2013, will be paid from the same pool of assets of the Employees Retirement System." [emphasis added]

What happens when (not if) there are no assets left in the plan? How would earnings on the depleted contributions by System 2000 participants' (supposedly) 401k-like accounts even be computed?

This seems analogous to a situation in which Enron had not even bothered to buy its own stock for its 401k plan but used the contributions to pay other workers' benefits to avoid funding a defined benefit plan.

Page 162 of the November Report goes on to say

"Pursuant to the Constitutional and statutory priority norms for the disbursement of public funds that apply during any fiscal year in which the resources available to the Commonwealth are insufficient to cover the appropriations approved for such year, employer contributions by the Commonwealth to the Retirement Systems fall within the third priority category, after payment of the public debt, the fulfillment of contractual obligations, eminent domain payments and certain commitments to protect the credit and good faith of the Commonwealth government." [emphasis added]

These disclosures seem to turn on their head the Governor's statements in the press that he would defend payments to retirees against a proposed Federal financial control board. The Governor has already failed to defend the Commonwealth's obligations to its retirees by refusing to bring spending in line with available resources--even after steep tax increases. The narrative that Puerto Rico has suffered enough "austerity" is only true for tax-payers. The current Administration and Legislature have refused to make significant spending cuts and, along with prior administrations, have refused to fully fund the pension contributions recommended by the system's actuaries.

The focus on debt renegotiation and Chapter 9 as a "solution" is a false hope, that has enabled the current administration to avoid making meaningful spending cuts. Indeed, Pension obligations could be at least as vulnerable as bond debt in a Federal bankruptcy court.

In contrast to Chapter 11, Chapter 9 provides Federal bankruptcy judges no real power to reform a government debtor's spending and budgeting practices. That is a one reason policymakers have so often turned to financial control boards rather than bankruptcy courts to turn around financially troubled jurisdictions including New York and the District of Columbia. The financial control board imposed by a higher level of government is a tried and true approach that has worked for many decades to achieve fiscal balance in jurisdictions with much larger and much smaller populations than Puerto Rico's.

Puerto Rico's growth in debt is a symptom not the cause of the crisis. Until the Commonwealth's budget is under control, debt renegotiation or "cram-downs" imposed by a bankruptcy judge will just enable an endless stream of horrible financial practices like the one described above.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long bonds of the Commonwealth of Puerto Rico and certain of its subdivisions.