Pension Cost Problems

Cities and States Are Making Risky Bets To Cover Pension Costs, BY STEVEN MALANGA, 05/08/2015 07:00 PM ET

For years state and local governments have borrowed money to bolster their underfunded pension systems, even though the practice is controversial and played a role in municipal bankruptcies in Detroit and Stockton, Calif. Undeterred, cities and states that face growing retirement costs are looking to issue new rounds of pension bonds and hoping they can parlay the borrowed money into big gains in the stock market. If these governments bet wrong, taxpayers could pay a steep price. Kansas' legislature earlier this year approved a $1 billion package of pension obligation bonds, while Pennsylvania Gov. Tom Wolf has proposed $3 billion in debt to augment the State's steeply underfunded pension funds. Legislators in Kentucky have been debating a proposal by the state's teacher retirement system, with $14 billion in unfunded liabilities, to borrow $3.3 billion. And Colorado's House passed a measure earlier this month backed by the state treasurer to authorize a whopping $10 billion in pension bonds, although the legislation has yet to win approval in the Colorado Senate. Meanwhile, Michigan municipalities are using borrowed money to finance hundreds of millions of dollars of retiree health care promises. All of this comes even though the wisdom of such borrowings has been hotly debated for years. Pension bonds got their start in the mid-1980s when local governments like Oakland, Calif., floated tax-free debt at low interest rates and invested the money in higher-paying securities like corporate bonds. The federal government, however, objected to the practice, which critics described as tax arbitrage at the expense of the U.S. Treasury. In 1986, Washington banned local governments from issuing tax-free debt to raise funds for investment. Pension bonds disappeared, but reemerged during the stock market boom of the mid-1990s, when governments started to float taxable debt (at higher interest rates than tax-free bonds) and then plowed those proceeds into surging market. That strategy paid off when market gains exceeded the interest payments governments made on the borrowing. But when stock returns sputtered at the end of the decade, many bonds became losers for governments. The sharp decline in equities in 2008 further buffeted pension systems relying on borrowed money. Stockton sought to boost its sagging pension funds by borrowing $125 million in 2007. When the stock market crashed the following year, Stockton lost about 30% of the borrowed money on top of the $400 million its pension system already owed. The city sought federal bankruptcy protection in 2012 and agreed to repay pension bond creditors 55 cents on the dollar. Similarly Detroit, struggling to make up a $1.7 billion shortfall in contributions to its retirement funds, issued $1.44 billion in pension bonds in 2005. That debt played a role in the decision by the city's emergency financial manager, Kevyn Orr, to place Detroit into bankruptcy in 2013.Orr subsequently argued that the bonds were illegal because Detroit officials circumvented state debt limits to borrow the money. The city paid backers of the pension bonds just 13 cents on the dollar when Detroit exited bankruptcy last year. Politicians often acquire enthusiasm for pension bonds when stocks are soaring, but then invest the borrowed money near the market's peak — with costly results. In 1998, New Jersey floated $2.7 billion in pension bonds and then projected robust investment returns. But so far the borrowed money has earned about $3 billion less than original estimates. Meanwhile, Jersey has already paid nearly $3 billion in interest on the bonds and owes another $7 billion. Kansas officials have justified their proposed $1 billion pension offering on the grounds that the state can average 8% annual returns on the money. But critics point out that equity markets are near all-time highs, and investment experts are warning of much smaller gains in the foreseeable future. A recent study by the benefits consulting firm Cheiron estimated that government pension funds have only a 40% chance of averaging 7.5% annual returns over the next 20 years. States and cities also typically issue these bonds in lieu of reforms to cut the cost of unsustainable pensions. In 2003, Illinois floated $10 billion in pension debt, but then did nothing to slow down the rise in unfunded liabilities. As new debt piled up, Illinois increased taxes by $7 billion in 2011 to raise cash for its pension system. Now Illinois is faced with both steep pension debt and $1.4 billion a year in interest payments on its pension bonds.Gov. Wolf has of Pennsylvania floated a speculative plan to bolster the state's pension system. He wants to remodel state-owned liquor stores to generate additional revenues, which would be dedicated to paying off the billions in proposed pension bonds. But Wolf has offered no substantial reforms to pensions to stem the continued rise of debt. Meanwhile, Michigan municipalities face billions of dollars in promises to provide health care for retirees. So the state legislature has passed legislation allowing municipalities to float bonds to create a pot of money to be invested to pay for retiree health care. So far, according to the Detroit News, 10 municipalities have borrowed $711 million and another, Macomb County, has announced a $267 million offering. But if anything, relying on investments with borrowed money to fund future health care obligations is even riskier than pension debt. The Government Finance Officers Association has repeatedly warned municipalities to be cautious about the practice because health care costs are inherently volatile and may rise rapidly over time, outpacing the investment returns on the borrowed money.Still, the lure of using debt to fund long-term obligations appeals to officials. Michigan State Sen. Jack Brandenburg even described the cash that municipalities raise through health care bonds as "cheap money" and "a hell of a temptation. "If the past is any guide, however, it's a temptation that taxpayers should ask their elected officials to avoid.• Malanga is senior fellow at the Manhattan Institute.

 

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