Puerto Rico has the population of Oklahoma and an economy smaller than Kansas. It also has more debt – $70 billion – than any U.S. state government except California and New York. Puerto Rico, ceded to the U.S. in 1898 after a war with Spain, has a special tax status that dates to 1917 and the passage by the U.S. Congress of the Jones-Shaforth Act which exempted interest payments from bonds issued by the government of Puerto Rico and its subdivisions from federal, state, and local income taxes (so called “triple tax exemption”) regardless of where the bondholder resides. This right made Puerto Rican bonds attractive to certain investors. This advantage strives from the restriction typically imposed by municipal bonds enjoying triple tax exemption where such exemptions solely apply for bondholders that reside in the state or municipal subdivision that issues them.

Consequently, Puerto Rico relied heavily on these tax breaks, as well as special breaks designed to attract job-creating investments from private companies, to drive economic development, attracting pharmaceutical, textile and electronics companies. Unfortunately, the proverbial wisdom about safe high-yield investment being too good to be true applies to investors in municipal debt just as much as it does to those who trusted Bernie Madoff with their money. And special tax breaks approved in Washington are only useful if they do not get repealed. And since these tax breaks were not particularly popular with elected officials governing actual states on the mainland who viewed them as unfair competition, as Puerto Rico became more and more successful in luring corporations to relocate from the mainland, state governments became more and more dissatisfied. The fact the island was often using incentives financed by selling bonds to residents of the states losing employers only poured salt in the wounds. Governors were not shy about communicating this dissatisfaction to voting members of Congress, which phased out the incentives from the mid-1990s to 2006, contributing to the loss of 80,000 jobs. Although Puerto Rico’s nonvoting representative engaged in herculean efforts of persuasion to save these tax breaks, his arguments were not effective.

Meanwhile, the Puerto Rican government and all of its subsidiaries, not just the pension plan, had borrowed heavily in anticipation of being able to leverage the municipal bond tax breaks as well as their commonwealth status, viewed as providing all the benefits of U.S. statehood without U.S. income taxes, to drive economic growth that would allow easy repayment of these obligations. Bloomberg news reports major debtors include:

  • Puerto Rico Sales Tax Financing Corp.: $15.2 billion
  • Known by Spanish acronym Cofina. Repaid from dedicated sales-tax revenue. Bonds come in two types: senior, with the first claim on revenue, and subordinated, which are second in line.
  • General obligation bonds: $12.6 billion
  • Debt backed by the island’s full faith and credit. Puerto Rico’s constitution says general obligations must be repaid before other expenses.
  • Puerto Rico Electric Power Authority: $8.1 billion
  • Prepa is island’s main supplier of electricity; repaid from what it charges customers. The utility was first government entity to cut a deal with creditors to reduce what it owes; that restructuring has yet to be completed.
  • Puerto Rico Highways & Transportation Authority: $4.6 billion
  • Repaid with gas-tax revenue.
  • Puerto Rico Aqueduct & Sewer Authority: $4.1 billion
  • Prasa supplies most of the island’s water; repaid from water rates charged to customers.
  • Puerto Rico Government Development Bank: $4 billion
  • GDB lends to the commonwealth and its localities.
  • Puerto Rico Public Buildings Authority: $4 billion
  • Repaid with lease revenue that public agencies pay for their office buildings.
  • Puerto Rico Pension-Obligation Bonds: $2.9 billion
  • Taxable debt sold to bolster the island’s nearly depleted pension fund; repaid from contributions commonwealth and municipalities make to retirement system.
  • Puerto Rico Infrastructure Financing Authority: $1.85 billion
  • Prifa bonds are repaid by rum taxes.
  • Puerto Rico Public Finance Corp.: $1.1 billion
  • Was used to help cover the government’s deficits; repaid with money appropriated by the legislature.
  • Puerto Rico Convention Center District Authority: $398 million
  • Oversees the convention center, as welt as other facilities; repaid from hotel-room tax receipts.

All figures as of Sept. 30, 2015 (the last time Puerto Rico disclosed these amounts), except the Government Development Bank, which is as of December 2015

It is interesting to note that, at $2.9 billion, Puerto Rico Pension Obligation Bonds represent only about 4.1 percent of the island’s bonded debt. It pales in comparison with bonds issued to support general operations and is about one third of debt issued to produce electricity.

Puerto Rico’s special tax status was not the only commonwealth benefit to prove a two edged sword. The Jones-Shaforth Act also made Puerto Rican residents U.S. citizens, primarily to allow them the privilege of being drafted to serve in the trenches during World War I. But it also means that Puerto Rico, which actually has a fairly healthy GDP per capita by Caribbean standards, is competing against mainland states to retain population. The World Bank’s 2014 World Development Report estimates Puerto Rico has the second-highest GDP per capita in the Caribbean at $18,000 Purchasing Power Parity (PPP). But what looks good in the islands pales in comparison to the mainland’s $50,610 PPP. Mississippi residents, ranking dead last in GDP per capita among the 50 states, nevertheless have almost twice ($34,784 PPP) the income available in Puerto Rico.

Residents of Mexico and Latin America migrating to the United States face a long, arduous, dangerous, illegal journey, not uncommonly ending in death; to reach a destination where they live in the shadows unprotected by most laws and subject to deportation at any time. Residents of Puerto Rico need to buy a one-way plane ticket; enjoy full citizenship rights upon arrival and cannot be sent home. The predictable migration began shortly after World War II, continued more or less steadily for 60 years and accelerated exponentially in the past 10. The population, now about 3.5 million, is shrinking and forecast to reach a 100-year low by 2050.

Puerto-RicoThere is no nation or state on the planet which views massive population loss as positive and Puerto Rico is no exception. Almost as soon as Puerto Rico gained self-governing status, the island began efforts to retain its population. Many of these centered around expanded public sector employment, better than average (for the Caribbean) public pay rates and pensions which were generous even by mainland standards. According to a recent Reuters article (“Puerto Rico’s other crisis: impoverished pensions,” April 7, 2016): 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.

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.

More recently, however, island leaders have recognized the rock of crushing government debt may be more damaging than the hard place of steady population loss and taken steps to severely limit public spending. Puerto Rico’s once generous public pension plan allowing workers to retire after age 55 with 30 years of service and 75 percent of their earning in the last three years of employment was replaced with a defined contribution plan, essentially a public sponsored 401K. Unlike similar reforms to the U.S. government’s Civil Service Retirement Plan in 1983, employees who had not yet retired were not given the option of remaining with the old plan. Puerto Rican public employment rolls had been cut sharply even before the pension plan reforms, reducing the number of employees paying into the fund.

Defined benefit pension plans tend to be simple in theory and off-the-charts complex in practice. In theory, employees and employers each contribute defined percentages of pay to a fund, which invests the receipts prudently in order to pay the pension plan participant a formula-determined benefit when they retire. A common structure might be employer and employee each contribute 3.5 percent of pay, the employee “vests” after five years, which guarantees them a pension at some point in the future, the retirement benefit is calculated at 1-2 percent per year times the number of years worked times the average of annual income during the employees last one to five years. In practice, even the simplest plans rapidly become much more complicated.

Example: The formula for members of the U.S. Congress and their staffs is 2 percent per year times the number of years worked up to 20 years plus 1 percent times the number of years worked over 20 times the average of the highest three consecutive earning years, unless the plan participant retires after age 62, in which case the 1 percent is increased to 1.1 percent. Plan participants can collect retirement at age 56 if they have 20 or more years of service but their retirement benefit, once calculated, will be reduced by 5 percent for each year they are below the age of 62, unless they are over age 60 with 20 or more years of service or have 30 years of service at any age.

And that is merely the complexity that creeps into a relatively simple pension benefit formula. The investment side can become even more complex.

In an ideal world, employers take fiduciary responsibility for their employees pensions, fully fund an account which they invest prudently, generate relatively strong returns on investments which build a principle account that can generate annual interest income sufficient to pay annual pension benefits. Back on planet Earth, employers establish a pension “plan” as a separate legal entity that becomes an unsecured creditor of the employer. They may or may not make regular cash payments to the pension plan to build the fund but can also simply give the pension plan unsecured IOUs promising future payments. The pension plan participants become unsecured creditors of the pension plan which, as noted, is an unsecured creditor of the employer, who has total discretion (at least in the public sector) to provide the pension fund with either cash deposits or IOUs.

What could possibly go wrong? More than most people can imagine. Private and public sector employers often underfund their pension plans. Pension plan managers assume rates of return on secure investments that are optimistic at best and in many cases downright delusional. Actuarial projections of pension liabilities are an educated guess even in the most informed environment. Employment patterns vary rapidly resulting in fewer workers paying into the system. Inflation- and promotion-driven wage growth over the employees’ careers is almost completely unknown. The list of potentially negative variables impacting defined benefit pension plans is essentially unlimited and largely unknowable.

To put the dilemma in perspective, consider a public or private sector employer paying pension benefits today to a 90-year-old retiree who started their career straight out of college at age 22. In 1948, the employer would have needed to start funding the pension plan and continue funding it without interruption during multiple recessions, the double digit inflation of the 1970s, a prolonged period of sharply increased demand for public services coinciding with an equally prolonged period of demands for lower taxes in the public sector, as well as sharply increased competition in the private sector which drove profit margins to the bone at the same time as stockholder activists were demanding ever greater ROI and a wide variety of interest rate fluctuations that made deferring contributions to pension funds appear much more attractive than borrowing in the financial markets. Meanwhile, the pension fund administrator would need to project the impact of all these factors on the fund’s investment returns, develop an accurate model of how inflation and promotions would impact the employees’ salaries, correctly anticipate the revolutions in modern medicine, as well as the decline in smoking which sharply increased longevity among retirees, and know in advance the enhancements to pension benefits from future collective bargaining agreements.

Also, when employers give their pension funds IOUs instead of cash, the fund needs to recoup not just the principal amount of the shortfall but also the ROI they would have earned between when the IOU was issued and when the employer resumes making cash contributions to the fund. The unfunded liability hole can be come very deep very fast.

When you consider the challenges, it is not actually all that surprising that a relatively small number of private sector plans have failed and a somewhat larger but still minority share of public sector plans are in trouble. It is instead somewhat amazing the vast majority of them have succeeded.

Meanwhile, back in the islands, thanks to a series of New Deal experiments too numerous and complex to describe here, Puerto Rico pension plans started out grossly underfunded when the island gained commonwealth status in 1948 and have become steadily less solvent.

Today, the Teachers Retirement System and Puerto Rico’s 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. 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.

All of this is history. It is done and cannot be undone. Puerto Rican government officials, their creditors (including pensioners), their employees, and the Federal government in Washington have no time machine to go back and correct the mistakes of their predecessors. Yes, the preferred tax status Puerto Rico enjoyed for more than half a century was unrealistic and sowed the seeds of disaster. It has already been repealed. Yes, investment advisors encouraged municipal bond investors to snap up “secure’ returns that a little research would have shown were actually highly risky. Most of the bonds have already been marked down in the secondary market. Yes, many Puerto Ricans gave up potential opportunities on the mainland to stay on the island to pursue what appeared to be lucrative public sector careers with generous safe retirements. Most are already beyond the age where relocation is a viable option. Yes, the U.S. Federal government used Puerto Rico as a shining example of capitalist success in the Caribbean during the Cold War only to largely walk away from its military bases on the islands and repeal almost all of the economic props that had made Puerto Rico so attractive. The bases are closed, the props are gone. The list of individuals responsible for Puerto Rico’s current crisis is too numerous to list. Most of them are dead and the remainder are largely old, out of power, or irrelevant. It is time for all the players in this financial tragedy to abandon fantasy and start dealing with reality.

The U.S. Congress is currently considering and will almost certainly enact legislation creating a Puerto Rico Financial Stability Council, subject to enactment of a law by the Legislative Assembly and the governor of Puerto Rico. The bill amends federal bankruptcy law to apply to Puerto Rico treatment as a state with respect to Adjustments of Debts of a Municipality. It is possible but highly unlikely elected officials in Puerto Rico will decline to enact the necessary legislation on their end. So Puerto Rico will get a glorified control board, which will do what?

Here are just some of the realities they must confront:

  • The full faith and credit of any jurisdiction’s taxing authority is, has and always will be, determined by potential GDP. Puerto Rico is not New York in the 70s or Washington DC in the 90s. It is relatively prosperous by third world Caribbean standards but a small resource-poor island, 1,000 miles from the mainland, somewhat off the main trade routes whose principal industries of agriculture, tourism, and rum are never going to generate the GDP necessary to consistently roll over long-term debt while providing the standard of living necessary to keep its population from fleeing to the mainland.
  • Global investors are looking closely at how current bondholders are treated. Puerto Rico cannot survive without access to global financial markets. A small haircut on bonds that have already been sharply discounted in the secondary market may not be viewed too unfavorably but any perception that bondholders are being treated as “bloodsucking” financiers undeserving of repayment will result in extremely high risk premiums.
  • Cuba and Venezuela, backed by China, are looking closely at how the U.S. federal government treats elderly pensioners in a Commonwealth only recently touted as the potential 51st state. Venezuela in particular would love to be able to graphically describe poverty among retired Puerto Rican public employees to divert their people’s attention from their own misery. Meanwhile, Cuba is gearing up to compete for Caribbean leadership in a post-Castro world and could receive no greater propaganda message than a failed U.S. state in the middle of the islands.
  • The U.S. federal government is no more legally, morally or politically responsible for the bonded debt and pension liabilities of Puerto Rico than they were responsible for the financial liabilities of Fannie Mae and Freddy Mac prior to the collapse of the housing bubble. Oh …
  • Finally, government leaders, particularly in Congress and the Department of Treasury, need to stop kidding themselves and each other about whether steps taken to resolve the Puerto Rican debt crisis will serve as an example for similar public pension-driven bankruptcies on the mainland. Of course they will! Nothing in global finance or national politics takes place in isolation. Laws, regulations, policies and procedures may or may not be worth the paper they are printed on but political and/or financial reality will always prevail. Investors in mainland bonds as well as public sector employee unions are already closely watching this drama. Expecting them to demand anything less than equal or better treatment when their turn comes around is delusional.

Mr. Sperry is writing in his personal capacity. Views presented are not official representation of government policy.