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Puerto Rico’s largest retirement system is on a path to insolvency within a year or two, unable to make good on its benefit promises to thousands of public servants unless its finances improve quickly.

Without an infusion of new contributions, the system will become effectively insolvent and “pay as you go,” Carlos Gonzalez, president of the law firm BenefitsPuertoRico.com, told Bloomberg BNA.

A combination of factors has brought the Puerto Rico system to its current precipice, said Gonzalez, whose firm assists U.S. and international companies with employee benefits and executive compensation matters in Puerto Rico.

Unless the commonwealth’s Employees’ Retirement System receives more cash, it will run out of funds in the fiscal year that begins July 1, 2017, unable to make good on its promise of $30.2 billion in benefits to current and future retirees, according to the latest audit report by KPMG LLP. As of the fiscal year ending June 30, 2014, the system had only 0.27 percent of funds to cover those promised benefits.

“Puerto Rico was caught in a Catch-22 between the emphasis in the 1990s and early 2000s of reducing the size of state and local governments and keeping a sound and functional state pension system,” Gonzalez said. “To entice employees to retire early, the government was making the situation of the public pension system even worse.”

Unsustainable From Day One

As the audit report confirms, the island’s public pension plan has been unsustainable since its inception in 1951, Gonzalez said. Various legislative tweaks over the years have done little to reverse the tide. For example, in 1990 the benefit accrual formula was materially reduced, in 2000 new hires were placed on a defined contribution program and in 2013 employer and employee contributions were increased and future benefit accruals under the defined benefit program were frozen.

“When these reforms were enacted, the expectation was that they would add 15 to 20 years of solvency to the system. Instead, however, they added at best five to six years of solvency, but there was no impact on the underlying problem of too many people receiving too many benefits,” Gonzalez said.

Difficulties were compounded when the system’s board of trustees issued $3 billion in pension funding bonds at the beginning of 2008, Gonzalez said. Though designed to increase liquidity in the plan, the bonds instead became a financial drag on the system because the investments of the funds generated by the bonds were adversely affected by the Great Recession that took hold later on that year. And so a good chunk of the increased contributions had to go to pay the bondholders, he said.

Hands Off Accrued Benefits

“There was an emphasis in 2013, even with all the legislative changes and the freezing of the defined benefit accrual formula, on not reducing accrued benefits of retirees in pay status,” Gonzalez said.

The changes enacted by the legislature were prospective only and did not touch benefit obligations to the nearly 120,000 current retirees, surviving spouses and beneficiaries, he said.

The people who were already in pay status, most having been participants under the initial pension formula in 1951, are in their 70s, 80s, and 90s, and by and large were unaffected by these changes, Gonzalez said.

Then there is the additional cohort of about 130,000 future retirees to whom benefits will be owed, putting additional financial strain on the system, he said.

Potential Impact of Congressional Supervision
A question being mulled by many on the Island is what will happen to the local pension system and its participants if and when the federal oversight board currently under consideration in the U.S. Congress goes into effect? H.R. 5278, commonly known as “PROMESA,” would create a federal oversight board with authority to review and approve the local government’s fiscal plans, including the funding of the public pension system and the implementation of alternatives for meeting pension obligations towards retirees. Since the local pension system is likely to become insolvent within the new few years, the federal oversight board may be the one calling the shots when the system hits rock bottom. 

Gonzalez noted that it is unclear if retirees and participants will play a role or have a say in the future design, operation, and funding of the system under this federal oversight board. If Chapter 9 of the U.S. Bankruptcy Code were to apply to Puerto Rico, “an identifiable set of creditors would be invited to the table, including some public servants who are owed money under the system. But under PROMESA that aspect is up in the air,” he said.

See related story, Puerto Rico Pension Plan Faces Insolvency Next Year.

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