The Truth about Pension Bonds

Some of you may recall that during the campaign, I advocated the use of pension bonds as one of the tools that could be used to help solve our pension crisis. At the time Turner chided me that, "Bill, you know that you cannot solve debt with more debt." Now, of course, he is singing a different tune.

 Pension bonds are a tool that can be used to help solve the problem. But like any tool they can be used the right way or they can be used the wrong way. What Turner is being proposing is definitely the wrong way.

What follows is a primer on pension bonds. If you are interested in learning more about them than you ever thought you would want to know, please continue reading. If not, you may want to skip to the next item in your inbox.

A Brief History of Pension Bonds

Some enterprising investment bankers began promoting the use of pension obligation bonds ("POBs) about 20 years ago, as public pensions began to see their unfunded liabilities grow. POBs gave governmental entities a way to make up some of the shortfall without having to raise taxes or reduce expenses, thus avoiding any fiscal pain, at least in the short run. Also, investment bankers pitched that the governmental entities would actually earn a profit by issuing the bonds at lower interest rates than the pension plans would earn when they invested the money (this is referred to as an "arbitrage" -more on that in a minute.) Of course, pension managers loved the idea, as it would give them more money to invest and, hopefully, close their funding gap.

The problem the investment bankers and pension managers had in Texas is that we generally require taxpayer approval of bonds that are secured by property taxes, which POBs are. So, in 2003, SB1696 (now Texas Local Govt. Code Chp. 107) was introduced to allow certain cities in Texas to issue any amount of POBs up to the amount of their unfunded pension liabilities, without taxpayer approval. There is scant legislative history on the bill. In the committee hearing in the Senate only an investment banker from Morgan Stanley and a representative of the Houston Police Officers' Union testified, not surprisingly, in favor of the bill. It does not appear there were any witnesses in the House committee meeting nor was there any debate on the floor of either house.

After passage, the bill was sent to then Governor Rick Perry and he did something highly unusual. He refused to sign the bill, but also declined to veto it, thus allowing it to become law without signature. Even more unusual, he issued a "non-veto" statement on the bill which said, in part, " . . . these bonds [i.e. POBs] are a proven tool for addressing short-term funding needs. I am concerned, however, that some cities may not use this tool properly or effectively." His words have turned out to be prophetic.

Since 2003, three Texas cites, Houston Dallas and El Paso, have issued $1.2 billion in POBs. Houston accounts for about half that total. In all three instances, those cities' pension problems have gotten much worse since the POBs were issued. Their most recent audits found Houston and El Paso to be technically insolvent, i.e., their liabilities exceed their assets. Dallas will almost certainly join those ranks when its audit for this fiscal year is issued. 

A June, 2014 study by the Center for Retirement research at Boston College found that since 1985 about 500 governmental entities had issued about $98 billion in POBs. In nearly every case, the entities that have issued POBs have seen their pension problems get worse. So clearly POBs have not proved to be a panacea for pension headaches.

Do Issuers Earn an Arbitrage on POBs?

 As I mentioned, one of the principal rationales advanced by POBs advocates is that issuers earn an arbitrage, i.e., a profit from issuing bonds at a lower rate than its pension plans will earn when they invest the bond proceeds. Frequently you will hear some advocates for pension bonds claim that issuers can earn as much as a 400 basis point (4%) spread.

But the actual results for those governmental entities who have issued bonds are considerably more modest. The 2014 study by the Center for Retirement Research at Boston College that I mentioned, calculated the spread on over 5,000 POB issuances from 1985-2012. The study found that those issuers earned an average spread of 150 basis points (1.5%) as of early 2014. Investment returns since then have been fairly mixed, so these results are still probably pretty close.

One factor that is frequently overlooked in projecting the results from POBs is that they are not exempt from federal income taxes like the typical municipal bonds. The IRS has ruled that POBs are "arbitrage bonds" and, therefore, do not qualify for tax exempt status. As a result, the interest rate on POBs is typically about 100-150 basis points higher than the interest rate of the typical municipal bond.

Today's rate on high quality municipal bonds is about 4%. So, POBs issued today are likely to be issued in the 5-5.5% range. Turner has conceded that a 7% return for the pension funds is about the best we can hope for. If that is the case, the City will realize a 150-200 basis point (1.5-2%) arbitrage, which would be consistent with the Boston College study.

But that is certainly not guaranteed, as Houston's experience demonstrates. The City issued most of its POBs from 2005-2008. The interest rates on those bonds ranged from 5.5-6.3%. Our pension plans' most recent audits reported that their 10-year average rates of return ranged from 5.4-6.6%. So, at best the City has about broken even on the POBs it has issued.

If the City issues more POBs, it will probably realize some positive arbitrage, but to assume anything more than 100-150 basis points would be foolhardy.

POBs as a Bridge to Defined Contribution Plans

 As those of you who have followed my missives on this issue know, I strongly believe that there is no pathway to real pension reform that does not phase out the existing defined benefit system. The real potential benefit for POBs is their use as a bridge from the current defined benefit system to a defined contribution system. This could be accomplished in a number of ways.

First, everyone needs to understand how dire the financial condition of our pension plans really is. The plan for the City's non-uniformed employees (HMEPS) is in, by far, the worse shape. Its audit for June 30, 2016, which was just released, shows that it has less than half the funds it needs to pay for the benefits its members are expecting to be paid. It would take an infusion of $2.6 billion to fully the plan according to the audit, and that is still using the absurd assumption of an 8% rate of return. If a 7% assumption is used, the plan has barely 40% of the assets it needs and it would require a $3.2 billion infusion to fully fund.

The police pension plan is only in slightly better shape. According to its June 30, 2016 audit, that plan now has only 62% of the assets it needs to pay the benefits its members are expecting. Fully funding the plan would require a $2.5 billion infusion. Again, this is at the 8% assumption. Lowering the rate to 7% would drop the funding ratio to 55% and the shortage would be nearly $3.3 billion.

The condition of the police plan may be even more serious than the audit indicates. It has been the most aggressive in investing in "alternative" assets, i.e., private equity, hedge funds and direct real estate investments. Currently, about half of its investments are in these risky asset categories. The Dallas joint police-fire plan recently wrote off $1.2 billion of these kinds of assets, precipitating a run on the system.

The fire fighters' system is in better shape, although its condition has significantly deteriorated in the last couple of years as it, too, has badly missed its investment return goals. As of June 30, 2016, the fire fighter plan had about 80% of the assets it needs to pay its planned benefits and would require about a $900 million infusion.   But the fire fighter plan uses an even more absurd 8.5% investment assumption, which, by the way is the highest in the U.S. If a 7% rate is used, the plan's funding ratio drops to 60% and the shortage is $1.6 billion.

My point to this review of the plans' financial condition is that they are desperate for the cash infusion the issuance of POBs would provide. Under Turner's plan, the municipal plan would get $250 million from the POBs and the police plan would get $750 million. The fire fighter plan gets none of the POBs proceeds, which explains why the municipal and police plans are more supportive of Turner's plan than is the fire fighter plan.

Turner's plan basically is a deal to trade the issuance of the POBs and the infusion of this cash for some reduction in benefits. There is nothing wrong with that approach, except that the first condition that should be on table for the issuance of any POBs is a transition to defined contribution plans.

The second condition should be that the employees shoulder, at least some of the responsibility for the investment performance of the plans. The employees of each plan elect a majority of the pension plan boards, who, in turn control the plans' investment policy,  Under the current plan, taxpayers underwrite the performance of the plans. but have no input into how the pension funds are invested. If the plans make poor investment decisions, taxpayers have unlimited exposure to make up the losses.  If the police are going to let their plan invest half their assets in alternative investments, they should bear some of that risk.

Turner's plan purports to share this risk with his so-called corridor. But it is becoming increasingly clear that the barely intelligible mechanism will be utterly unenforceable and unworkable. [Note: More on this point once the secret drafts of the bills are released to us mere taxpayers.]

Finally, POBs proceeds should be used to finance an option for employees to withdraw their pension savings from the existing system. Any accelerated withdrawal would and should necessarily involve a reasonable discount. But employees, many of whom are fed up with the uncertainty, complexity and questionable investments and governance of their plans, should have the right to opt out.

Conclusion

Pension bonds can be a useful tool in solving our pension crisis. The analogy I like to use that if a person has a lot of credit card debt and a large equity in their home, there is nothing wrong with borrowing against that equity to pay off the credit card debt, IF THEY CUT UP THE CREDIT CARDS!! But not if the person borrows against their home equity to make the minimum payments and keep charging. That is what Turner's plan does.  It borrows a billion dollars to facilitate the continuation of the same broken defined benefit system that got us into this mess in the first place.

This is why voter approval of any new pension bonds is so important. We need a check on our City leaders using pension bonds to just kick the can down the road again. If the City uses pension bonds to facilitate a transition to defined contribution plans, shift some of the responsibility for investment returns from taxpayers to our employees (who control the investments) and provide an option for employees to withdraw from the current system, I will be the first to advocate the passage of a pension bond referendum.  Until then, taxpayers should sit on their hands and say, "No more."

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