Bad News Bear
Investment markets can falter. When they do, pension bonds can become a very risky business.
Here they go again: Nine years after a borrow-and-invest scheme backfired and plunged Orange County into bankruptcy, officials in the California county are once more talking about borrowing to invest. This time around, however, it won't be a matter of leveraging investment funds to plow into high-risk derivatives, as in the early 1990s. The current proposal is to go to the bond market, raise money at low interest rates to pay down the pension system's unfunded liabilities--and then let pension officials invest the money to generate a profit.
This mechanism is called a pension obligation bond, and Orange County is far from alone in experimenting with one. Over the past decade, more than 60 municipalities have taken pension bonds to market-- borrowing money to pay pension contributions or build up pension assets. This year, however, localities aren't the only ones eyeing pension bonds. States are, too. "You hear a lot of talk," says Claire Cohen of Fitch, one of the three major bond-rating agencies. In September, there was some action as well: Even though California's plan to issue a $2 billion pension bond was put on hold by state courts, Illinois issued a $10 billion pension obligation bond, Oregon won voter approval to float $2 billion and Wisconsin decided to go to the market before the end of the year with a variation on the idea.
The recent involvement of states almost certainly reflects hard times, with many into their third fiscal year of unrelenting budget stress. "Many states have used up a lot of the arrows in their quiver," says Parry Young of Standard & Poor's. "They don't have too many options left. So every little bit, every resource is being looked to."
That doesn't necessarily mean the bonds are a good idea. The size of some of the issues--when New Jersey broke ground with its $2.8 billion pension obligation bond in 1997, it dominated the market--and the investment assumptions behind some of them add to the sense that pension obligation bonds can be a risky business.
Take Philadelphia. The city issued a $1.3 billion bond in 1998, but investment returns have not been able to match the 6.9 percent interest rate the city owes its bondholders. Moreover, with the drop in pension fund investment returns and the subsequent rise in its unfunded liabilities, the city has had to increase its current pension contributions--and continue to pay bondholders. "Over the last three years, we did not meet the earnings assumptions that were built into the bond issuance, and so we're paying twice," says Janice Davis, the city's finance director, who did not hold the post when the bonds were issued. "Because there were negative returns, we've lost some, if not all, of the value we gained by issuing the bonds."
New Jersey, too, has experienced the down side. Its pension obligation bond was issued when the stock market was soaring, the economy was healthy, inflation was under control and interest rates had fallen into the low 8 percent range--a rate that was very tempting at the time. Governor Christine Todd Whitman went to the legislature and argued that the state should seize the moment to put its pension plan on a sounder footing. Lawmakers agreed, but in the past few years, the pension fund has been unable to earn enough on investments to cover interest rates on the bond--and the bonds are uncallable, which means they can't be refinanced at lower interest rates. "At the time they did it, it certainly wasn't unreasonable," says S&P's Young. Today, however, it's a drain on the treasury.
It's not hard to figure out why states or localities want to put these bonds in play right now. They're a short-term fix for a budget crunch--a quick cash infusion that can lower current pension contribution payments by borrowing money at a lower interest rate than the actuarial rate (usually between 8 and 8.5 percent) that determines the amount of money a jurisdiction owes its pension fund. "With interest rates so low, a pension obligation bond is a mechanism to help defer obligations to a better economic time," says Monique Moyer, San Francisco's finance director who also chairs the debt committee for the Government Finance Officers Association. "It's pretty cheap relative to liability accruing at 8.25 percent."
In addition, with investment assets falling (thanks to stock market declines), the borrowed money can boost the amount in the fund and, in so doing, reduce the unfunded liability factor, which in turn helps lower annual contributions. The borrowed money can then be invested so that it makes more money--hopefully more than the interest rate on borrowing it. It's a form of arbitrage, and with interest rates low, pension obligation bonds--POBs as they're known in the market--would seem a safe bet.
For some states and localities, they're better than the alternative. State law may demand that a jurisdiction keep its pension system's unfunded liabilities above a specified minimum. If those liabilities fall below that level, the jurisdiction may have to make up for the shortfall by markedly increasing its annual contribution to the fund. That's what's happened in Minneapolis. With the drop in the stock market, funding in one of its closed plans (its members are only those hired before 1980) plummeted from 92 to 68 percent. Under state law, the city had to eliminate that liability by 2010.
"If we didn't make a cash contribution," says Patrick Born, the city's finance director, "we would have to levy a property tax in whatever amount necessary to fund that contribution. It would have doubled the growth in our property tax." To avoid that nasty alternative, the city is issuing bonds annually in the amount of the excess contribution, spreading the cost over 25 years instead of seven.
It's a conservative approach that doesn't depend on a positive arbitrage or market movements. "That's not a risk we bear," Born says. "We're just meeting a contribution commitment state law imposes."
If a state or locality is not already under the unfunded-liability gun, it could be soon. There is a whopper of a potential pressure out there. The Governmental Accounting Standards Board has put out a proposal that calls for post-employment benefits, such as retiree health care, to be treated similar to pensions from an accounting standpoint. Translation: Benefits that are now paid out of current budgetary resources would be considered unfunded liabilities that would have to be amortized. According to Joseph Mason, a director of Fitch and author of a report on public pension and other post- employment benefits, the GASB proposal "could cause annual contributions to explode."
Clearly pension bonds can be a useful management tool in smoothing out the ups and downs of pension liabilities. But how they're structured and the way a jurisdiction uses them--and how reliant they are on arbitrage--are some of the points that make credit analysts sharpen their rating pencils.
WHAT'S NOT TO LIKE
Pension bonds are often a sign of fiscal distress and an attempt to solve a budget shortfall with a one-time fix. More specifically, using bonds to pay current and subsequent-year pension contributions is considered by all three of the major credit rating agencies to be a type of deficit financing. "The pension bond in and of itself is not a negative," says Robin Prunty, an analyst with S&P. "We don't look favorably on borrowing to pay current contributions."
There are other budgetary implications. The bonding of pension payments takes some flexibility out of an operating budget. It turns a soft cost--pension payments can sometimes be deferred or restructured when necessary--into a hard and fixed debt-service payment. "Now it is etched in stone," says Philadelphia's Davis, "and you have a contract with someone other than retirees."
Credit analysts also keep a sharp eye on whether the bond leaves a jurisdiction dependent on high investment returns. "If they don't make their investment returns, they're going to have to pay not only debt service on the bonds but increased contributions for new unfunded liabilities," says S&P's Young. "That would then weaken them further."
Young also says he doesn't like to see a jurisdiction structure the bond so that it "takes the budget relief upfront. Spreading the savings evenly over the maturity of the bond is a more conservative way to do it."
VARIATIONS ON A THEME
Under the Tax Reform Act of 1986, states and localities were precluded from issuing tax-exempt bonds to make money on arbitrage. Pension obligation bonds fall under that ruling and are, therefore, issued as taxable bonds. When Illinois issued its $10 billion POB in September, it went so far as to get itself the equivalent of a corporate bond rating from Moody's Investors Service in order to make the debt more attractive to international investors.
Illinois' bond was a twofer: $2 billion was earmarked to pay current contributions to its pension system--giving the state budget relief. The rest was a cash infusion to boost assets, which had dipped to low ratios of liability funding. Historically, Illinois has had a very poorly funded pension program, so this was an attempt to right past wrongs. But it also puts the state at risk if investments don't do well.
Wisconsin's bond hews to a much more conservative line. The state is financing only accrued prior-service liabilities--not current contributions or asset enhancements. These accrued liabilities represent 1.2 percent of the state's current payments to the pension fund. By breaking off the prior-service piece and, in essence, refinancing it at a lower rate than the actuarial rate, it will lower its overall annual contribution payments. In essence, says Frank Hoadley, Wisconsin's capital finance director, the state will be refunding a payment that had been calculated at 8 percent with a bond in the range of 5 percent. Some states issuing pension obligation bonds "are looking to a bond issue to correct serious funding problems," Hoadley says. "We're starting from a 90 percent-funded position. The bond is only for the prior service--it has nothing to do with current service. That's a major distinction."
Pension bonds in general look like a very attractive alternative to budget-stressed states and localities. After all, interest rates are very low. Nevertheless, "in your exuberance to do it," warns Philadelphia's Davis, "you have to weigh the impact of what you'll do if you have two or three years of bad earnings." In these times, that's not something to be taken lightly.