The new new thing in pensions

Ever since we can remember (in our case, that’s 2012), the City has been struggling to find ways to ensure that it will be able to pay its retired employees the pensions it promised them.

The problem is simple:  As of June 30, 2020, the total present value of the City’s pension liabilities was $822,015,367.  As of that date, however, the market value of the assets available to pay those pensions came to only $525,247,514 – a shortfall (aka “unfunded accrued liability” or “UAL”) of $296,767,853.

Over the years, the City has convened task forces and adopted budgetary policies to tackle this issue.  (Our favorite suggestion, endorsed by the then-heads of the police and firefighters’ unions, was for the City to sell Alameda Point and use the proceeds to pay their members’ pensions.)  This Tuesday, Council will hear the latest idea devised by staff and its consultants.  It’s called “Pension Obligation Bonds.”

The gist of the idea is that the City would issue bonds carrying an interest rate lower than the rate CalPERS is now charging the City on its UAL.  The City would deposit the proceeds with CalPERS to pay off the current amount of the debt.  Then, instead of having to make an annual contribution to CalPERS to amortize (i.e., pay down) the UAL, it would make annual payments to bondholders to service the bonds.

Here’s a chart prepared by the City of San Jose finance department depicting the cash flow:

Basically, the strategy amounts to substituting one debt (the bonds) for another (the UAL).  And since the interest rate paid on the bonds would be lower than the interest rate charged on the UAL, the City would end up saving money.

Here’s a chart prepared by the City of Chula Vista finance department to illustrate the point:

The projected savings for Alameda are nothing to sneeze at.  According to the staff report, by employing this strategy, “the City could anticipate, based on current market conditions, aggregate savings of approximately $131.5 million in total UAL savings, with a net present value savings of $94.9 million. . . .”

Such a deal! (as they might say in the Yiddish theater).

Maybe so.

Or maybe not.

At first glance, the concept seems the same as the one involved in deciding to refinance a car loan.  Suppose you took out a loan from the auto dealer at a 10 percent interest rate to buy the car.  But now your credit union is offering car loans at 5 percent interest.  You’d surely jump at the chance to borrow from the credit union and pay off the dealer.

But issuing POBs to pay off the UAL is not quite so simple and straightforward as refinancing a car loan.

For one thing, the swap of continuing liability to bondholders for the accrued liability to pensioners will not get rid of the City’s obligation to make annual payments to CalPERS entirely.  The “employer contribution” the City makes every year consists of two parts, one of which (called the “normal cost”) is based on the cost of pension benefits earned in the current year, and the other of which (amortization of the UAL) is based on the costs of benefits earned in prior years.  For example, the City’s total employer contribution for the safety plan in fiscal year 2021-22 is projected to be $5,538,713 for “normal cost” and $12,963,710 for amortization of the UAL.

Issuing POBs affects only the latter component.  The “normal cost” remains due and payable regardless of the status of the UAL.  So even if the City managed to pay off the entire current balance of its unfunded liabilities, and thereby wiped out the need for any future amortization, it still would owe CalPERS $5.5 million for the safety plan’s “normal cost” (plus $3.2 million for the “normal cost” of the miscellaneous plan).

Second, paying off the current amount of the UAL with the proceeds of a bond issue does not mean that the City will have eliminated any unfunded pension liability once and for all and that its pensions plans are now “fully funded” – i.e., that the available assets are, and always will be, sufficient to cover future costs.

The reason is that the UAL is a moving target.  It is based on assumptions, but assumptions can change – and they can turn out to be wrong.  As the president of the Government Finance Officers Association noted in a recent article, “After [pension obligation] bonds are sold, a government still faces the potential for unfunded liabilities in the future caused by lower‑than‑expected investment returns, changes in benefit levels, shifts in employee demographics, or other factors that were not fully anticipated or expected when the bonds were issued.”

This is what she’s talking about:

In determining the UAL, CalPERS makes demographic assumptions about such things as mortality rates, retirement rates, employment termination rates, and disability rates of plan participants.  If, say, pensioners turn out to live longer than they were expected to, the total pension liability will be higher than it otherwise would have been.

Equally significantly, in determining the UAL, CalPERS makes assumptions about the rate of return it will be able to earn on its investment of the plan assets.  At present, the assumed rate is 7 percent.  If CalPERS actually earns less than it anticipated, the total assets available to pay pensions will be less than they otherwise would have been.

What this means is that, even after the issuance of POBs, the UAL may not go away forever.  Instead, new unfunded liabilities may arise that would require the City to resume making amortization payments to CalPERS (in addition to paying CalPERS to cover the normal cost and paying the bondholders to cover debt service on the bonds).  Imagine a homeowner who cleans out her gutters at the end of autumn – only to see them cluttered up again as leaves fall during the winter.

The risk of underperformance by CalPERS is not just a theoretical issue.  “Given current conditions in the economy and the investment markets, we believe that the risk of future CalPERS underperformance is very real,” one money manager wrote in 2018.  And the data backs him up:  As the chart below, taken from the CalPERS valuation reports, shows, investment returns have varied dramatically from year to year:

What about the long-term picture?

Essentially, POBs are a gamble – a bet that, over the life of the bonds, the amount earned on the proceeds (as invested by CalPERS together with the plans’ other assets) will exceed the amount paid to the bondholders.

It’s too soon to tell whether the gamble would turn out to be a good one for Alameda, since, as the City of San Jose finance department recently noted, “The full effect of issuing pension obligation bonds can only fully be tallied at final maturity of the bonds when actual investment performance of the retirement plan can be measured.”

What track record does exist about the long-term profitability of POBs is generally favorable.  According to the estimable Roger Davis, the successor to George Herrington as the state’s preeminent bond lawyer,

One study of POBs in 2004 concluded that 84% were profitable to their issuers. Another 7% were at breakeven, leaving only 9% that have lost money.  Even measured as of the least favorable time in the stock market, late 2002, only 34% were money losers, most of which were less than four years old and most of which are now at breakeven or profitable.  Virtually all POBs are expected to be profitable over their term.

Likewise, a study by the Center for Retirement Research at Boston College found that, as of February 2014, the majority of POBs had produced positive returns as a result of the large market gains that followed the 2008 financial crisis.  “Only those bonds issued at the end of the market run‑up of the 1990s, and those issued right before the crash in 2007, have produced a negative return,” the report stated.  “[A]ll others are in the black.”

Nevertheless, one can find at least a handful of POB detractors.  For example, the Government Finance Officers Association issued an “advisory” in 2015 warning state and local governments not to issue POBs to refinance pension debt.  The primary reason was that “the invested POB proceeds might fail to earn more than the interest rate owed over the term of the bonds, leading to increased overall liabilities for the government.”  (The Association’s president reiterated that position in June 2020.)

Despite the GFOA’s negative view, POBs have become something of a fad in the municipal finance world:  the California Debt & Investment Advisory Commission reported that local governments in the state issued $4.2 billion in POBs in 2020, compared to $705 million in 2019.  (According to CDIAC, the total volume between 1985 and 2020 was $30 billion.)  The investment bankers will tell you the reason for the surge is that the bond and equity markets now are aligned perfectly for POBs, with interest rates low and stock prices booming.  And they might be right.  What they won’t tell you – because they can’t – is that those conditions will continue into the indefinite future.

At Tuesday’s meeting, staff will ask Council to adopt a resolution authorizing the issuance of one or more series of bonds for the purpose of refinancing the UAL as well as the filing of a so-called “validation action” confirming the legality of the bonds.  The supporting staff report was written by the City’s consultant, an outfit called Urban Futures, Inc., which also prepared a 52‑page presentation that, frankly, only an M.B.A. could follow.  We note, without intending to cast any aspersions, that UFI already is charging the City $80,000 for its consulting services, and it undoubtedly will earn a hefty fee for structuring the deal if Council approves moving forward.

Fortunately, City Manager Eric Levitt has prior experience with POBs, having worked on a potential issue during his former job at the City of Simi Valley.  In our conversations, Mr. Levitt acknowledged some of the risks we’ve highlighted, primarily the ones arising from potential underperformance by CalPERS.  Due to those concerns, Mr. Levitt said, he would recommend against refinancing the entire current amount of the UAL through the issuance of POBs.  In addition, he would urge that, if the City did issue bonds, it take steps to mitigate the effects of any future underperformance, such as by establishing a “sinking fund” into which it would deposit half of the annual “savings” resulting from the lowered borrowing costs made possible by the POBs.

Alamedans are also fortunate that the City Treasurer, Kevin Kennedy, is a Registered Investment Adviser and Certified Financial Planner who has worked in the financial services industry since 1988.  We know there are some politicians and “activists” – particularly those beholden to the firefighters’ union – who would restrict Mr. Kennedy to the duties of a treasurer specified by the City Charter.  But we think it would be a shame if everyone on Council took this narrow-minded view and thereby deprived themselves of expert advice.  (In fact, Mr. Kennedy told us, he already has had one conversation with Mr. Levitt about POBs.)  And we would like to hear what City Auditor Kevin Kearney, a C.P.A., has to say, too.

Which leaves the scary part:   the Council itself.  It’s possible, we suppose, that Councilman John Knox White counts municipal finance as one of his many areas of expertise, and thus would regard himself as qualified to evaluate the merits of a POB strategy.  But we don’t think any of his colleagues can make the same claim.

In any event, several of our Council members tend to vote, regardless of the merits, in the way they think will please their political base.  But pensions do not arouse people’s passions.  Nor is reducing pension liability high on the “progressive” agenda.  (As far as we know, neither Bernie Sanders nor A.O.C. has taken any position on pension obligation bonds.)

This gives Mr. Levitt an unusually large sway over the ultimate decision.  Those Council members inclined to defer to him are likely to go along with his recommendations.  Those who are wont to distrust work by City staff are not.

Sources:

Staff report & presentation: 2021-10-19 staff report re POBs; 2021-10-19 Presentation

Articles: Wulff, Hansen, White Paper on POBs; Center for Retirement Research, POBs — Financial Crisis Exposes Risk (2010); Center for Retirement Research, Update on POBs; Orrick, Intro to POBs; GFOA, POBs; GFAO, POBS — Yes or No (1-20)

City/county presentations: City of San Jose, Overview of POBs; City of Chula Vista, POBs; CSAC, POBS – When do they make sense