Borrowing to Backfill Public Pensions Makes a Comeback

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Public Finance Update - Nov. 15, 2022

Welcome back to another edition of Route Fifty’s Public Finance Update! I’m Liz Farmer and this week I’m writing about an oldie but a goodie: pension obligation bonds (POBs). These bonds, which are also issued in the municipal market as “certificates of participation,” are taxable debt issued by governments looking to shore up their pension plans. Proceeds from the sale are typically used to pay off part or all of a pension’s unfunded liability, making future bills much more manageable. The debt comes at a higher interest rate than non-taxable general obligation bonds, but governments who issue POBs generally view the added stability they get for their retirement plans as worth the extra financing cost.

Still, POBs are a gamble and they fell largely out of favor after the Great Recession. Timing is everything and governments always face the risk of putting a bunch of borrowed money into their pension plan only to see it lose value in the event of a downturn. That happened to a number of places after the 2008 financial crisis and contributed to Stockton, California’s bankruptcy. In these worst-case scenarios, governments are now saddled with 30 years of debt payments and a pension plan that’s not much better off.

But last year, debt for pensions made a big comeback. More than 110 governments issued bonds to pay off pension liabilities, totaling nearly $13 billion in new debt, according to data compiled by Municipal Market Analytics. It’s more than double the issuance compared with recent years and the highest total since 2003, according to Bloomberg.

Roughly one-third of issuances came from California, where localities have seen rising pension costs for years following adjustments that the state’s biggest pension agency made to its investment return assumptions. The top issuers were Orange County, Santa Ana, Huntington Beach and Chula Vista, which combined for more than $1.6 billion in pension bonds.

More than a dozen Arizona localities issued the bonds last year, with Tucson alone accounting for $658 million intended to reduce its public safety pension’s $1.5 billion unfunded liability. Tempe and Pima also had large bond sales of $300 million or more.

In many cases, the amount issued was equal or close to the government’s unfunded pension liability and intended to bring their plans to 100% funded. Then, between January and October of this year, the S&P 500 Index lost one-quarter of its value. It’s gained since then, but is still down about 15% for the year. Pension plans across the county posted investment losses for fiscal 2021, meaning that bond proceeds poured into the funds last year also lost value.

“If you’re looking at it broadly, they took all their money, put it into the roulette wheel and lost,” said S&P Global Ratings analyst Todd Kanaster. “Now in order to meet their expectations, they have a steeper hill to climb.”

A New Strategy For Pension Bonds

Still, governments have gotten savvier about pension bonds since the Great Recession, Kanaster said. Many of them have protected themselves in some way from suffering big losses on their bond proceeds by investing a certain amount of them in less volatile (but lower return) assets, or have taken other mitigation measures. 

“I’m seeing more and more focus on risk mitigation,” Kanaster said. That’s why, he added, he’s not necessarily worried about the surge of pension bonds last year, “but we’re definitely watching.”

Some, like Tucson, established a separate trust to manage and invest the bond proceeds. The city would make smaller, more manageable pension payments from its general fund, and earnings from the trust would be used to make up the difference. Joyce Garland, Tucson’s chief financial officer, said that plan hasn’t quite worked out yet because the trust initially lost value and the city ended up dipping into the principle to make its pension payment. But as of last week, she said the trust had gained back nearly all its losses.

Others are using a pension stabilization fund—like a rainy day fund, but only for pension funding—to buffer against market losses. The city of Orange, California, established a stabilization fund as part of a larger pension policy that included approving its $286 million bond sale. The policy calls for at least half of budget surplus money or one-time revenue to be deposited into the fund, in addition to regular payments.

West Hartford, Connecticut, which issued more than $324 million in pension obligation bonds to combat rapidly rising pension bills, also established a reserve fund and set aside about $30 million. The city also had a strategy to minimize the risk of early losses in the market: instead of investing all its bond proceeds right away officials plan to spread out investments over a couple years.

In the Meantime, More Stability

While the surge in issuance did coincide with a record-breaking stock market, officials were more attracted to historically low interest rates and the chance to stabilize their rising pension payments rather than trying to capitalize on 2021’s bull market. 

The Government Finance Officers Association still cautions against issuing POBs, but the protections in place for many of these bond sales are a sign governments are not taking these risks lightly. Several finance officials interviewed by Route Fifty said they spent at least a year discussing the risks and stress testing hundreds of scenarios before deciding to move forward.

A review of bonds sold last year show many governments are paying rates between 2% and 3% on their debt. Tucson snagged an interest rate of 1.6%, a rate Garland said she’s never seen for taxable debt. And in the meantime, the city’s pension payments from its general fund become more predictable, freeing up more money for services.

“I’ve been doing this for over 30 years and in my career I never would have thought I’d issue POBs,” she said. “But when you can do it at less than 2%, you have to think about it.”