Paying pension debt with bonds
An $8 million pension bond was approved last week by voters in Piedmont, a small well-to-do city completely surrounded by deep-in-debt Oakland, originator of the pension bond that has figured in the Stockton, San Bernardino and Detroit bankruptcies.
The bond approved by 83 percent of the voters in the Oakland hills city of about 10,600, known for a high school bird-calling contest featured on late night TV shows, is one of the least risky types of borrowing to pay pension debt.
A CalPERS “side fund” loan costing 7.5 percent a year in interest will be paid off with money presumably borrowed at a much lower interest rate, saving the city an estimated $600,000 to $700,000 over the next nine years.
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When the giant system put small plans with less than 100 active members into large “risk pools” in 2003 to avoid massive rate swings, more than 1,500 side funds were created to separate their widely varying “unfunded liabilities” and allow an equal start.
The California Public Employees Retirement System created a business opportunity for bond salesmen by treating the side funds as loans, with an annual interest rate based on the pension fund investment earnings forecast, now 7.5 percent a year.
“Pension obligation bonds had their start with the famous City of Oakland pension bond financing in 1985, which Orrick helped to invent and for which it served as bond counsel,” said the website of the Orrick, Herrington and Sutcliffe law firm.
The Oakland bond issue and “copy-cat” issues elsewhere were driven by “arbitrage,” Orrick said. Money borrowed at low tax-exempt bond rates was invested to get a higher return, until a federal tax reform in 1986 barred issuing tax-exempt bonds for that purpose.
A decade later Oakland issued a taxable $417 million pension bond, part of the current wave of pension obligation bonds. The bond money is used to make employer contributions to pension funds, easing the strain on government budgets.
Pension funds expect to get what critics say is an overly optimistic return on their stocks and other investments, often 7.5 percent or higher. So the borrower paying a lower interest rate on bonds used for annual payments to the pension fund can come out ahead.
But it’s a gamble, and Oakland lost.
The 1997 Oakland bond money was for the Police and Fire Retirement System, closed to new members in 1976 due to a huge shortfall. Property tax diverted to the closed fund did not cover unusual pensions that grow with the pay of active police and firefighters.
After putting the bond money into the closed system, Oakland gave itself a 15-year “holiday” with no contributions. Like most pension funds, the closed system’s investments fell well below their target during the last decade.
An Oakland city auditor report in 2010 said: “The amount still owed by the city is approximately $250 million dollars higher than the scenario where the POBs were not issued in 1997 and the same payments were made to the pension fund instead.”
By 2012 hard-pressed Oakland, which had laid off police and made other cuts, needed to put $38.5 million into the depleted closed system. So the city issued a $212 million pension bond and gave itself a four-year contribution holiday.
Since taxable pension obligation bonds began in 1993, said the four-year-old Oakland auditor’s report, there have been more than 350 pension bond issues, roughly 100 of them in California for $11 billion.
The state treasurer’s office was still putting the pension bond total at $11 billion last fall, said a Center for Investigative Reporting analysis, which found pension bond gambles not panning out so far for Richmond, Pasadena and Merced, San Bernardino and San Diego counties.
A study by Alicia Munnell and others at the Center for Retirement Research at Boston College in 2010 was based on $53 billion worth of taxable pension bonds issued by 236 government agencies since 1986.
Most of the pension bonds issued since 1992 were in the red after the financial crisis, the study found. The issuers of pension obligation bonds often are fiscally stressed and in a poor position to handle investment risk.
“Nevertheless, it appears that POBs have the potential to be useful tools in the hands of the right government at the right time,” the study concluded. “Issuing a POB may allow well-heeled governments to gamble on the spread between interest rates and asset returns or to avoid raising taxes during a recession.”
In California, one of the attractions of a pension bond is that large debt, providing temporary budget relief, can be taken on without voter approval as required by the state constitution.
The Orrick website refers to a “judicially created exception” to the state constitutional debt limit, called “obligations imposed by law,” that allows general obligation pension bonds to be issued without a vote.
A Piedmont advisory commission said some cities use a “validation” process under the court ruling to issue bonds without voter approval. But the commission said the process apparently is not allowed by the Piedmont city charter.
When the state struggled to balance its budget in 2004, former Gov. Arnold Schwarzenegger proposed issuing a $949 million pension bond to make part of the annual state payment to CalPERS.
His initial bond proposal, picked up from the administration of former Gov. Gray Davis, was scaled back to $500 million. Ruling in a Howard Jarvis taxpayers suit, the courts blocked the pension bonds, saying a vote of the people is needed.
As the Boston study noted, the timing of a pension bond can be crucial. Stockton issued a $125 million pension bond in 2007 and put the money in the CalPERS investment fund.
A Stockton bankruptcy document said the bond money lost about a third of its value as the market dropped and then crashed in the fall of 2008. This fiscal year the city has a $30 million CalPERS payment and an additional $8 million pension bond payment.
Detroit borrowed $1.4 billion for its pension fund in 2005, a complex variable-rate plan backed by “interest-rate swaps” to hedge risk. Asuit filed by the bankrupt city to erase the debt reportedly contends the plan violated the state debt limit.
Bankrupt San Bernardino, said to owe CalPERS $17 million for payments skipped last fiscal year, stopped annual payments of $3.3 million on a $50 billion pension obligation bond issued in 2005.
“The POB is also issued as a capital appreciation bond,” consultant Michael Bush told the San Bernardino city council last April, “which means the debt service goes up over time, and over the next I think 15 to 20 years actually doubles on an annual basis.”
Last week, San Bernardino elected a new mayor, Carey Davis, endorsed by outgoing Mayor Patrick Morris, a backer of San Jose Mayor Chuck Reed’s proposed pension reform initiative.
“After Tuesday night, six of seven council members are now on record as saying they want to explore reducing San Bernardino’s pensions, along with Davis, the new mayor, and a new city attorney, Gary Saenz,” Reuters reported.
San Bernardino prepared an outline or “term sheet” of its debt-cutting plan for closed-door mediation with creditors that began last November. As directed by a federal bankruptcy judge, details have not been made public.
Ed’s Note: Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Calpensions.com.
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