Pension bonds may be worth the risk

Since the fall of 1993, over $5 billion in bonds has been sold in California to finance municipal pensions. Bond proceeds are deposited with the issuer’s retirement system to pay off some or all unfunded pension liability. Thus, debt service on the bonds replaces amortization of unfunded liabilities through payments to the system.

Lowering pension costs is the motivation for these financings. Typically, unfunded liability is amortized at a rate set by actuaries based on a projection of future earnings on the system’s assets. Rates of between 8 percent and 8.5 percent have been common in recent years.

But since taxable rates have been at historic lows, some officials have figured that if they can sell bonds at, say, 6 percent, then the cost of amortizing bonded debt will be substantially below the traditional cost of amortizing the same obligation.

Pension bonds work through risk arbitrage. Funds are borrowed at the interest rates of a relatively low-risk municipal obligation for reinvestment in the pension system. Pension portfolios usually outperform municipal bonds, as they are heavily weighted toward corporate securities, including a significant position in equities. A major stock market correction, therefore, could set a pension bond program back many years.

While a handful of pension bonds have been issued in other states, most of the activity has been in California, where laws require municipalities to amortize any unfunded pension liabilities over a stated period of time. Therefore, such payments are already a relatively fixed part of a city or county’s budget. In addition, low interest rates coincided with a period of significant fiscal stress during California’s severe recession, and refinancing pension liabilities became one tool for budgetary relief.

The specific motivation for issuing pension bonds plays a key part in how they are rated, and how such debt can effect an issuer’s other ratings. If used to generate one-shot budget relief, pension bonds may be evidence of severe fiscal stress and often trigger rating downgrades. But to the extent that savings are spread out over the life of the program, pension bond financings typically have no impact on the issuer’s credit ratings.

Key considerations for issuers interested in pension bond financing include:

* Legal authority. This may prove the greatest obstacle in many states. California has a long tradition of innovative financing, a product of strict constitutional restrictions on “debt” and a history of court decisions that have created numerous exceptions to the debt limitation, such as an “obligation imposed by law.”

But in most other states that encourage debt to be in the form of general obligations, pension bonds may not be an option or would require voter approval. Because debt laws vary by state, local bond counsel can best address this question;

* Nature of the retirement system. Again, practice and law vary. For example, many localities participate in statewide systems, and the ability of a single participant to fund-up its obligations is subject to the rules of the system; and

* Tolerance for risk. Since the play with pension bonds is risk arbitrage, the issuer must recognize potential downsides for accelerating its investment in the retirement system’s portfolio. Of primary importance is the investment strategy for any bond proceeds and the plan to manage short-term market risk.

Pension bonds are not a sure-fire way to reduce operating costs. Rather, they are a calculated risk based on reasonable assumptions, whose benefits are only clearly known at their term’s end. But when prudently structured, they may play a viable role in managing long-term liabilities.