Bankers are urg­ing gov­ern­ments to bor­row-and-bet away their pen­sion prob­lems


If there were ever a time not to bet the moon on the stock and bond mar­kets, it’s now, with U.S. stocks at near­record highs and in­ter­est rates on qual­ity bonds at near­record lows. But Wall Street is urg­ing state and lo­cal gov­ern­ments to do just that — and they’re lis­ten­ing. ¶ De­spite the risks, gov­ern­ments are lin­ing up to is­sue bil­lions of dol­lars in new debt to re­plen­ish their de­pleted pen­sion funds and, as a bonus, take some pres­sure off strapped bud­gets. In some cases, the bor­row­ing makes their bal­ance sheets look vastly bet­ter. Bankers, who make fat fees for rais­ing the money, are en­cour­ag­ing this bor­row and bet trend. Their sales pitch is that bor­row­ing at to­day’s low in­ter­est rates all but guar­an­tees a profit for the gov­ern­ments be­cause they can in­vest the pro­ceeds in their pen­sion funds and for decades earn re­turns higher than the 5 per­cent or so in in­ter­est they will pay on the bonds. ¶ But there’s a catch: If the tim­ing is wrong, these pen­sion obli­ga­tion bonds could clob­ber the fi­nances of the gov­ern­ment is­suers. Pen­sion funds and ben­e­fi­cia­ries will be bet­ter off be­cause pen­sions will be more soundly fi­nanced. But taxpayers — present and fu­ture — might be con­sid­er­ably worse off. They will be run­ning huge risks and could get stuck with a mas­sive tab.

“It’s sold as a magic bean,” said Todd Ely, a pro­fes­sor at the Univer­sity of Colorado at Den­ver who has stud­ied pen­sion bonds. “But when it goes bad, it’s not free. Then it isn’t re­ally magic. If it could be counted on to work as of­ten as it’s sup­posed to, then ev­ery­one would be do­ing it.”

Plenty of tak­ers are bel­ly­ing up to the bor­row­ing bar. Gov­ern­ments sold $670 mil­lion worth of pen­sion bonds through the first half of this year, more than dou­ble the $300 mil­lion raised for all of last year, ac­cord­ing to deal-track­ers at Thom­son Reuters.

That to­tal would more than dou­ble if Kansas com­pletes a pend­ing $1 bil­lion deal, which would be its big­gest bond is­sue. A $3 bil­lion sale is un­der con­sid­er­a­tion in Penn­syl­va­nia, that state’s largest as well. Law­mak­ers re­cently re­jected record multi­bil­lion-dol­lar deals in Ken­tucky and Colorado, but those pro­pos­als are ex­pected to resur­face. And newp ro­pos­als are be­ing pitched to other gov­ern­ments.

Pen­sion bonds have waxed and waned since the 1980s, but the cur­rent boom is dif­fer­ent. An ex­am­i­na­tion by The Washington Post and ProPublica found that it’s be­ing driven not only by the prospect of in­vest­ment prof­its but also by a new ac­count­ing quirk that has largely es­caped public no­tice while mor­ph­ing into a ma­jor mar­ket­ing tool for Wall Street banks.

The quirk stems from a rule change that was meant to force gov­ern­ments to more clearly dis­close the health of their pen­sion funds. But a side ef­fect is to al­low gov­ern­ments with ex­tremely un­der­funded pen­sions to slash re­ported short­falls by $2 or more for each $1 bor­rowed.

Here’s how: If a pen­sion plan is so poorly funded that it is pro­jected to run out of cash, the newrules re­quire it to make less op­ti­mistic pro­jec­tions about fu­ture re­turns. That in­creases the re­ported pen­sion short­fall. But if gov­ern­ments in­fuse a big slug of bor­rowed money into the fund, they can re­sume us­ing op­ti­mistic pro­jec­tions, and the short­fall shrinks.

It’s like get­ting a new credit card, bor­row­ing on it to pay off part of an ex­ist­ing loan, then hav­ing the to­tal amount owed mag­i­cally shrink by more than what is bor­rowed. Sounds im­pos­si­ble — but it’s true.

The im­pact can be dra­matic. In March, the town of Ham­den, Conn., re­duced its un­funded pen­sion amount by about $320 mil­lion with a $125 mil­lion pen­sion bond and prom­ises of fu­ture pay­ments, ac­cord­ing to an es­ti­mate by ProPublica and The Post. The Ken­tucky Teach­ers’ Re­tire­ment Sys­tem said it es­ti­mates that a $3.3 bil­lion bond is­sue plus pay­ment prom­ises could carve $9.5 bil­lion off its un­funded li­a­bil­ity.

Those fig­ures don’t re­flect the decades of debt and risk placed on taxpayers.

The rule change, from the Gov­ern­men­tal Ac­count­ing Stan­dards Board, has been in the mak­ing since 2006, but is only now start­ing to take ef­fect — and to be no­ticed. So GASB is fast be­com­ing a rec­og­nized acro­nym in state cap­i­tals.

“GASB is cer­tainly a huge con­cern,” said Beau Barnes, deputy ex­ec­u­tive sec­re­tary of the Ken­tucky Sys­tem. Un­til this year the term was un­fa­mil­iar to state leg­is­la­tors, he said, “but in 2015 when you say ‘GASB,’ most of them have an idea that it’s go­ing to be bad.”

It’s not clear whether any­one in­volved in the long rule­mak­ing process re­al­ized that the change would en­cour­age gov­ern­ments to sell bonds to im­prove their bal­ance sheets.

We asked GASB Chair­man David Vaudt about this but couldn’t get a clear an­swer. His re­sponse was, “We fol­low our due process, and the in­put that we con­sider is from our stake­hold­ers: the pre­par­ers, au­di­tors and users” of gov­ern­men­tal fi­nan­cial state­ments.

The ques­tion of whether gov- ern­ments will come out ahead in the real world— as op­posed to the ac­count­ing world— with pen­sion bonds is far from clear. In large part, it de­pends on gov­ern­ments’ will­ing­ness to make sub­stan­tial pay­ments to their pen­sion funds af­ter the bonds are sold.

A re­view by Pro Publica and The Post of the 20 largest pen­sion bonds is­sued since 1996 found that in three-fourths of the deals, gov­ern­ments did not make their full re­quired con­tri­bu­tion in the years af­ter the bonds were sold. Those bonds ac­count for nearly two-thirds of the pen­sion debt is­sued since 1996, ac­cord­ing to Thom­son Reuters. In more than half the deals, some pro­ceeds even went on to make an­nual pen­sion con­tri­bu­tions — bor­row­ing from the fu­ture to pay to­day’s ex­penses. Be­cause of the un­der­fund­ing, most of the pen­sion funds now are worse off than be­fore the bonds were is­sued.

In all five re­cent or pro­posed bond sales ex­am­ined — by Ken­tucky, Kansas, Penn­syl­va­nia, Colorado and the town of Ham­den, Conn.— the is­suers and po­ten­tial is­suers said they were plan­ning to make less than full pay­ments for many years.

“These bonds are per­ni­cious,” said Alicia Mun­nell, di­rec­tor of the Cen­ter for Re­tire­ment Re­search at Bos­ton Col­lege. “They dis­cour­age pen­sion fund­ing. They shift costs for­ward to fu­ture gen­er­a­tions.”

‘Dark road with thorns’

Mun­nell said that soundly fund­ing pen­sions is a much more im­por­tant fac­tor in the over­all suc­cess of a bond is­sue than out­earn­ing in­ter­est costs— which is largely a roll of the dice.

A 2010 study by Mun­nell’s group of all the pen­sion bonds is­sued since 1986 showed that, in most cases, the in­ter­est paid on the bonds ex­ceeded the re­turn on pen­sion fund as­sets. Re­turns had been hurt by the 2007-2009 mar­ket crash. But a 2014 up­date, five years into the cur­rent bull­mar­ket, showed the re­verse, with most is­suers ahead.

Given this mixed history, Wall Street sales­peo­ple point to the bonds’ other ben­e­fits. Bonds of­fer “im­me­di­ate bud­get re­lief,” as Citi group put it in sales pitches to Colorado and Penn­syl­va­nia, whereas fund­ing pen­sions “con­trib­utes to bud­get stress.”

In a pitch book to Ken­tucky, in­vest­ment bank Ray­mond James as­serted that the bonds would “ma­te­ri­ally re­duce the re­ported li­a­bil­ity” that the teach­ers’ re­tire­ment sys­tem would have to dis­close un­der the new GASB rule. Bank of Amer­ica Mer­rill Lynch made the same point in a pitch book to Penn­syl­va­nia. Both banks de­clined com­ment, as did oth­ers we con­tacted.

There’s big money at stake not only for the prospec­tive bor­row­ers, but for Wall Street as well. The pend­ing $1 bil­lion Kansas is­sue is ex­pected to gen­er­ate more than $3 mil­lion in fees for bankers, while pro­vid­ing bud­get re­lief for Gov. Sam Brown­back (R) and law mak­ers.

You can see why peo­ple whose time hori­zons don’t ex­tend past the next elec­tion might like pen­sion bonds: Re­duc­ing the re­quired an­nual pen­sion pay­ments leaves more money for schools, roads and other needs.

Ham­den’s ex­pe­ri­ence shows how this can play out. In 2014, af­ter years of un­der­fund­ing, the small New Haven sub­urb’s pen­sion fund was about to run out of money. The town faced the prospect of hav­ing to pay pen­sions di­rectly out of its $211 mil­lion op­er­at­ing bud­get. The tab was pro­jected to grow to more than $60 mil­lion an­nu­ally, said Mayor Curt Leng, an amount Ham­den sim­ply couldn’t af­ford with­out a “gi­gan­tic tax in­crease.”

Ham­den also would have had to show a huge in­crease in its un­funded pen­sion li­a­bil­ity un­der the newrules.

Con­necti­cut law re­quires is­suers of pen­sion bonds to make the full re­quired an­nual pen­sion pay­ments af­ter the bonds are is­sued— a safe­guard to make sure politi­cians can’t dig the hole deeper later on. The law would have com­pelled Ham­den to put in $29.5 mil­lion this year.

“We would have had to lay off half our po­lice force and three­quar­ters of our fire depart­ment to make it hap­pen,” said Scott Jack­son, who was Ham­den’s mayor when the bonds were is­sued.

So Ham­den — pop­u­la­tion 61,000 — got the state leg­is­la­ture to pass a law giv­ing “any mu­nic­i­pal­ity in New Haven County with a pop­u­la­tion of less than 65,000” an ex­emp­tion from the full-pay­ment re­quire­ment.

Af­ter the bond sale — which dou­bled the town’s out­stand­ing debt — Ham­den’s pen­sion fund went from al­most broke to a still low 40 per­cent funded. This year, it put in roughly half its nor­mal re­quired con­tri­bu­tion. The town doesn’t have to make full pay­ments un­til 2019.

Even if Ham­den ul­ti­mately makes the pay­ments and earns its pro­jected 7 per­cent an­nual re­turn, the pen­sion won’t be fully funded un­til 2044. If things go badly, its fund­ing level will linger at 40 per­cent.

Jack­son said he doesn’t think Ham­den had much choice: “If you’re star­ing at a dark road and a dark road with thorns in it,” he said, “take the dark road.”

Known un­knowns

Is­su­ing bonds to fund pen­sions orig­i­nated in the 1980s, when state and lo­cal gov­ern­ments re­al­ized they could use their tax-ex­empt sta­tus to bor­row at low cost and get guar­an­teed higher re­turns.

In 1984 and 1985, the first two gov­ern­ments to use the strat­egy— a school dis­trict in Ore­gon and the city of Oak­land, Calif. — sold low­in­ter­est tax-ex­empt bonds and bought an­nu­ity con­tracts that paid their pen­sion funds fixed amounts of money each year.

Be­cause the an­nu­ity in­come ex­ceeded in­ter­est costs, the strat­egy was a sure­fire win­ner. “You knew what the an­nu­ities were go­ing to pay,” said Bob Muszar, pres­i­dent of the Re­tired Oak­land Po­lice Of­fi­cers As­so­ci­a­tion, who has stud­ied the city’s pen­sion bonds. “You don’t know what the stock mar­ket is go­ing to pay.”

Congress quickly de­cided that it didn’t want lo­cal gov­ern­ments us­ing their tax-ex­empt sta­tus to mint free money, and closed the loop­hole in 1986 by mak­ing in­ter­est on pen­sion bonds tax­able. Gov­ern­ments could still bor­row to fund pen­sions— but they had to take on se­ri­ous risk.

Bankers then changed their sales pitch from “bor­row to buy an­nu­ities” to “bor­row to make a profit in the mar­ket.” Re­turns would be nice enough for the is­suer to come out ahead, the new pitch went.

Gov­ern­ments can bor­row cheaply these days— but the risks of in­vest­ing pen­sion bond pro­ceeds are un­usu­ally high.

Stock prices have more than tripled from their 2009 lows and are el­e­vated by his­tor­i­cal stan­dards. At the same time, in­ter­est rates on high-qual­ity bonds — the kind pen­sion funds in­vest in — are at very low lev­els. When in­ter­est rates rise, as is widely ex­pected to hap­pen, bond­hold­ers — in­clud­ing pen­sion funds— will get whacked.

Should the U.S. stock­mar­ket fall 20 or 25 per­cent soon af­ter bond pro­ceeds are in­vested, it will put is­suers into such a deep hole that they­may never come close to mak­ing the re­turns they bet on. In the past 16 years, the mar­ket has twice fallen by more than 50 per­cent.

Given to­day’s mar­kets and gov­ern­ments’ his­to­ries of cut­ting pen­sion con­tri­bu­tions af­ter selling bonds, the Gov­ern­ment Fi­nance Of­fi­cers As­so­ci­a­tion, Mun­nell’s re­tire­ment re­search cen­ter and many credit an­a­lysts say they now con­sider pen­sion bonds a ter­ri­ble idea. Pre­vi­ously, they were mildly neg­a­tive. Now, they’re wildly neg­a­tive.

“I think that right now is prob­a­bly as sketchy a time as any to get into pen­sion bonds,” said Dustin McDon­ald, who leads fed­eral li­ai­son ef­forts at the fi­nance of­fi­cers as­so­ci­a­tion. “You’re gam­bling with tax­payer dol­lars that inthe end the in­vest­ments you’re mak­ing are go­ing to pan out for you. . . . I just think it’s des­per­a­tion that makes you make the de­ci­sion.”

The as­so­ci­a­tion pre­vi­ously had cau­tioned against these bonds, say­ing they were risky. But in Jan­uary, it of­fi­cially rec­om­mended against us­ing them.

Eric At­wa­ter, the ac­tu­ary who ad­vised Ham­den on its deal, said pen­sion bonds aren’t the prob­lem. “It’s the po­ten­tial im­pact on fu­ture be­hav­ior af­ter it’s done that can cause prob­lems,” he said, point­ing to so-called pen­sion fund­ing “hol­i­days.”

The big­gest pen­sion bond in history— Illi­nois’ $10 bil­lion is­sue in 2003 — shows how pen­sion funds can de­te­ri­o­rate even when the mar­kets are with you.

Illi­nois has earned more by in- vest­ing bond pro­ceeds than it has paid out in in­ter­est. But af­ter that is­sue, the state cut back reg­u­lar con­tri­bu­tions and de­layed re­forms. It later dou­bled down by selling another $7.1 bil­lion in pen­sion bonds to pay for its an­nual con­tri­bu­tions.

It’s no ac­ci­dent that Illi­nois now has the worst state credit rat­ing in the na­tion. Its pen­sion funds are more than $100 bil­lion un­der­wa­ter, putting huge pres­sure on its bud­get.

One big pen­sion fund seems to have done it right. Wis­con­sin was soundly funded, though not fully, when it sold $850 mil­lion of pen­sion bonds in 2003. The state con­tin­ued to make the full re­quired pay­ments to its pen­sion, and a 2014 Pew Char­i­ta­ble Trusts study said it was the best-funded state plan in the na­tion.

Bet­ting on liq­uid as­sets

Ner­vous­ness about mak­ing huge, long-term bets has stymied some pen­sion bond pro­pos­als — at least for now.

In Fe­bru­ary, Colorado Trea­surer Walker Sta­ple­ton steered law­mak­ers away from au­tho­riz­ing a pen­sion bond sale. Sta­ple­ton sent them a chart of the Stan­dard & Poor’s 500-stock in­dex show­ing the two afore­men­tioned 50 per­cent drops. Given the run-up in prices, he said, stocks were poised for a fall.

In an in­ter­view, Sta­ple­ton, a Repub­li­can, said he op­posed let­ting Colorado’s public pen­sion sys­tem make the state “preg­nant” with a li­a­bil­ity that could have tripled the state’s debt. By mak­ing the pen­sion fund look health­ier, he said, it would also greatly re­duce pres­sure to re­form ben­e­fits and bring the sys­tem into longterm sta­bil­ity.

Greg Smith, ex­ec­u­tive di­rec­tor of Colorado’s Public Em­ploy­ees’ Re­tire­ment As­so­ci­a­tion, said as much dur­ing an April meet­ing about the deal. ProPublica and The Post ob­tained an au­dio file of the ses­sion through an open-re­quest.

“We are a fo­cus for the next leg­isla­tive ses­sion in terms of po­ten­tial fo­cus on our ben­e­fit struc­ture,” Smith said, as he re­minded board mem­bers that “our du­ties go ex­clu­sively to our mem­bers and ben­e­fi­cia­ries” while the state bears the risk of any bond deal.

Asked about his re­marks, Smith said that the pen­sion bonds are meant to ad­dress the “fail­ure to fund past prom­ises,” not to im­pede re­forms.

Once leg­is­la­tors re­al­ized the bond is­sue could be as large as $12 bil­lion, sup­port quickly dis­ap­peared. “For us, the word ‘ bil­lion’ is a very large num­ber,” said state Sen. Chris Hol­bert (R), who voted against the bond pro­posal in com­mit­tee.

Oneof the ma­jor prob­lems with pen­sion bonds, for taxpayers, is that they trans­form a rel­a­tively soft obli­ga­tion into a hard one. Many gov­ern­ments have made deals to trim pen­sion obli­ga­tions, es­pe­cially cost-of-liv­ing ad­just­ments. But you can’t trim back bond obli­ga­tions with­out painful and messy restruc­tur­ing.

In Penn­syl­va­nia, the Repub­li­can-con­trolled leg­is­la­ture would rather trim ben­e­fits than in­cur a hard obli­ga­tion by sup­port­ing Demo­cratic Gov. Tom Wolf’s pro­posal to sell $3 bil­lion in pen­sion bonds.

Wolf wants to pay for the bonds with $185 mil­lion a year in pro­jected prof­its from ex­pand­ing sales at state-owned liquor stores. On Thurs­day, he ve­toed a Repub­li­can pack­age that, among other things, would have con­verted fu­ture pen­sions into a less-gen­er­ous 401(k)-style plan.

The al­ter­na­tive? Drink­ing up to help fund pen­sions, and hop­ing not to get a hang­over from pour­ing bil­lions in liq­uid as­sets down the drain. ProPublica is an in­de­pen­dent, non-profit news­room that pro­duces in­ves­tiga­tive jour­nal­ism in the public in­ter­est.


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