Last week, my column in Governing's Finance newsletter explained the rationale and complexities of extending the Build America Bonds program (BABs) - the federal subsidy of taxable municipal bonds used to finance infrastructure construction. There's an inside-the-Beltway discussion underway now about whether Congress might extend that program beyond its expiration this December. After decades of resisting the idea of a subsidized taxable bond option, state and local finance officers are giving this concept another look, as it has cut their borrowing costs in 2009 and 2010.
The SPIF Concept. In last week's column, I introduced the concept of "Sustainable Pension Incentive Funding" bonds. Under my proposal, Congress and the Administration could expand the BAB program's taxable bond option to include qualified pension obligation and OPEB obligation bonds, but with fiscal strings attached and a far lower subsidy rate of 15 percent -- one-half the subsidy given to infrastructure projects. I would also propose a two-year sunset with a mandatory review by the GAO.
Here's the rationale: State and local governments now face a whopping $2 trillion of unfunded liabilities for their pension and OPEB (retiree medical) plans. In some cases, a taxable "benefits bond" issue is a more cost-effective way to finance those obligations. But the BAB program has pushed additional supply onto the taxable bond market, which made benefits bonds too costly during the recent recession. A one-percent reduction in municipal retirement-finance borrowing costs would change the math dramatically. Federal support of proper state and local government pension and retirement plan financing (with proper and prudent strings attached) will mitigate future financial crises, and would actually stimulate the U.S. capital markets. In fact, an argument can be made that by reducing tax-exempt municipal bond costs, the Treasury will lose less revenue from the implicit nationwide subsidy of muni bonds. That would largely offset the cost of taxable pension bond incentives.
For those unfamiliar with the intricacies of municipal finance, the bonds sold by states and localities for infrastructure purposes are exempt from income taxes. So when the BAB program pays a subsidy for taxable infrastructure bonds, it replaces the tax subsidy that IRS already gives to municipal bondholders with a comparable subsidy to the bond issuer. Pension bonds which are used for investments receive no such tax preference under current law, so a 15 percent subsidy as I'm proposing here would break new ground, and would have to be justified on the basis of sound intergovernmental tax principles with the best interests of taxpayers at heart.
This arrangement should include both pension obligation bonds and OPEB obligation bonds -- the latter to raise the funding ratio of retiree medical benefits plans from near zero today to a more sustainable level as explained below. With a 15 percent subsidy of interest costs, the issuer's net expense for these bonds would decline below 6 percent in today's markets -- a level that makes their use a compelling strategy for bonding-out part of the employers' unfunded liabilities for these benefits.
Three Simple Rules for "SPIF" Bonds. There are several strings that must be attached to this concept, in order to justify and minimize the cost to federal taxpayers. Here are the rules I would suggest, and their rationale:
1. Sustainable funding requirement. A federal subsidy on SPIF bonds should be limited to 10 years. During that period, the recipient of subsidy must pay its annual debt service and the full actuarial normal cost in years 1-10, and then pay its complete actuarial cost in years 6-10, or else lose the subsidy. This will assure that the recipient of a federal interest-cost subsidy would ramp up its funding to proper and sustainable levels. Unlike the state of Illinois, which recently sold pension bonds to skip its actuarial contribution, this program would require sound actuarial financing or the incentive payments go back to Uncle Sam.
Likewise, employee benefits increases would be prohibited during the subsidy period, so that the federal taxpayers' subsidies do not spawn another round of retroactive benefits increases that boomerang on local taxpayers. Congress could also add a requirement that the SPIF issuer must establish a rainy-day fund as I have proposed in a separate column, to further reduce the need for any future federal bail-outs of state and local governments. That provision alone would pay for this entire program whenever the next recession occurs.
2. Investment rules. The proceeds of a SPIF bond issue should be invested in a separate trust fund as I described in my previous column on Benefits Bonds legislation. Investments should be limited to U.S. stock-exchange listed stocks and government bonds, so that taxpayers don't subsidize insurance companies or hedge fund managers making 2 percent management fees plus carried interest on taxpayer money. As I've written before, these bond proceeds should be invested predominantly in stocks, until the retirement fund achieves full actuarial funding or a looming recession forces trustees to invest in government bonds to preserve capital. Putting this money directly to work in the domestic stock market would stimulate economic activity and actually improve the condition of all pension and 401(k) plans as additional long-term investment demand for stocks strengthens the equity markets.
3. Borrowing limitations. To avoid excessive leverage and minimize market-timing risks, no more than half of a pension or OPEB plan's unfunded liabilities should be funded through such issuances. Likewise no deal should qualify if stocks are trading above 90 percent of their previous high-water mark (e.g., Dow Jones Industrials above 12,700 in this cycle). Selling benefits bonds above that level is an invitation to market losses in a subsequent recession, as history has proven.
Here's the Payback: Putting state and local government retirement plans on a solid financial footing would remove burdens on future taxpayers at all levels of government, and would be well worth the cost of a federal incentive, if structured properly. State and municipal credit quality would improve as these unfunded "soft debts" are finally funded on a sustainable basis. Higher bond ratings would reduce the interest rates on municipal bonds, ultimately reducing the implicit federal tax subsidies in the tax-exempt market. That's been the effect of the BAB program in 2009. The SPIF subsidy might thereby pay for itself at the federal level. And because of the reasonably expected long-term reduction in pension and OPEB costs, this program should reduce taxpayers' total federal-state-local tax burdens over the next 30 years. It's not foolproof, because stock markets don't always increase by more than the net borrowing costs of the issuer. But there are very few 30-year periods in which stocks have failed to earn 6 percent annually on average, and that is all that would be required for this program to succeed at today's market levels.
Risks and Disclosure: I'm employed by a firm that operates a financial advisory practice, and they've always been conservative in their approach to pension obligation bond and benefits bonds generally. These instruments are typically or more suitable during the recession and early-recovery stages of a business cycle, and don't make sense when stocks are trading at record levels or the economy has entered an expansion-growth phase following its recovery from the last recession. The Government Finance Officers Association has warned that considerable caution must be used in this method of financing. My own research has shown that over the past 13 business and stock-market cycles, the odds of success diminish sharply when pension/OPEB bonds are sold at levels above the previous stock-market cycle peak, at least in the following recessionary down-cycle. I would become increasingly skeptical of the use of leverage to fund a retirement plan's obligations beyond 2012 if the economy begins to regain its footing and the stock market rallies another 20 percent. Hence, the sunset provision and the 90-percent-of-peak rule I proposed above. Otherwise, we're all just better off waiting until the next recession -- a dismal thought indeed.
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