Connecticut is gearing up for a $2 billion pension obligation bond issue this spring to help fund the state’s severely underfunded Teachers’ Retirement Fund.
The deal would be the fourth-largest POB issue ever sold in the U.S. and the state is taking steps to make sure it doesn’t backslide on meeting its annual pension costs as some other municipal governments have done after issuing pension bonds.
Connecticut wants to close on the deal by June 30 and potential investors said the municipal market should be receptive to the taxable bonds despite the spillover of concerns from the meltdown in the subprime mortgage sector.
Treasurer Denise L. Nappier’s office said it likely will not use insurance, as the debt will be a general obligation of the state.
Fitch Ratings and Standard & Poor’s give Connecticut’s GO debt AA ratings, while Moody’s Investors Service assigns it a Aa3 rating. Finance officials have not yet decided if they will seek a global scale rating in order to better market the taxable debt overseas.
“There is a demand for that structure, for the GO debt of a state,” said Morgan Keegan & Co. managing director Ben Landers, a sell-side trader who has been doing taxable munis for 20 years. “I feel pretty comfortable the market could digest that easily, and it wouldn’t need insurance.”
“Due to the lack of Connecticut issuance and the demand that is consistently out there, I think it will do well,” said Belle Haven Investments LP president Matt Dalton. “It’s a great time for the state to be issuing, with the short-term rates as low as they are right now.”Dalton noted that given the uncertainty with bond insurance lately, investors will be interested in Connecticut’s POB sale. He said that his firm would likely be interested in buying the debt.
Still, there are other investors who are a bit more reserved about the deal because it is a POB.
Sage Advisory Services president and chief investment officer Robert G. Smith said that while he thought there might be an appetite for POBs, he was fundamentally opposed to them. While he buys GO and revenue bonds of all kinds, he does not and will not buy POBs.
“It supports incorrect public policy. I do not support the notion of pension obligation bonds,” Smith said. “It’s the municipal gamble for pension solvency.”
Smith said that issuing debt to pay for pension fund promises is “stealing growth and prosperity for the future to pay for the past without addressing the issue of mitigation … Maybe there is a problem here with promising too much. Why are we compounding this now with borrowed money?”
While the success of the deal in the market remains to be seen, whether or not Connecticut will improve the TRF’s funded ratio is another question.
Currently, the TRF is about 60% funded. Bear, Stearns & Co. — which has led POB transactions for Illinois, Oregon, and Puerto Rico, and will be lead book-runner for Connecticut’s deal — prepared an analysis estimating that the funded ratio in Connecticut’s TRF would immediately rise to about 70% after the bonds are issued. The actuarial accrued liability should be fully funded at the end of 25 years due to making 100% of the actuarial required contributions, or ARC, each year.
Lawmakers last year passed and Gov. M. Jodi Rell signed into law legislation that Nappier and Rep. James A. Amann introduced to issue up to $2 billion of bonds for the TRF and also requires the state to make actuarially required payments into the fund each year.
For about a decade — between 1997 and 2006 — Connecticut had not made its full ARC to the TRF. But since 2006, Rell has fully funded the TRF, and under this legislation, fully funding the TRF is required. Still, in 2006 and 2007, Connecticut used surplus budget funds to pay part of the fund’s ARC. Rell has incorporated into Connecticut’s 2008 and 2009 budget funds to pay the TRF’s ARC, but again, some of the payments will come from forecasted revenue surpluses.
“While they have at least made the payments, I think they still have to arrive at a structural budget balance,” said Moody’s Nicole Johnson. She noted that Connecticut’s use of one-time resources to balance its budget has decreased in the last couple of years, which is a positive. However, the TRF “is one area where they have used surplus one-time money to fund an ongoing cost.”
Connecticut Rep. Shawn T. Johnston, who voted against the legislation, is skeptical that Connecticut will really be able to pay its ARC every year for the next 25 years. While Connecticut paid the full amount of $412 million for fiscal 2007, by 2020 ARC payments more than double to $1 billion. By 2031, the ARC rises to nearly $2 billion.
Other states and cities have issued POBs and not seen their pension funding levels improve.
“It’s a bet that the interest you’ll be paying will be sufficiently less than the money you can earn on your investments, and some governments have lost that bet,” said independent consultant Katherine Barrett about POBs. Barrett co-authored with Richard Greene a December 2007 Pew Charitable Trusts’ Center on the States report, Promises with a Price, which looked at pension costs in the United States.
Barrett said that Philadelphia is “a really good example of how, with all good intentions, a city took out a pension obligation bond and did terribly.”
Philadelphia issued $1.3 billion of POBs in 1999, and “their pension is funded no better now than when they did that,” Barrett said. Philadelphia’s pension obligations are only 52% funded, which is one of the lowest levels in the country. The city’s unfunded pension liability stands at $3.9 billion.
New Jersey is another example of POBs gone bad. It issued $2.8 billion of POBs in 1997 in the second largest POB sale in the U.S., according to Thomson Financial. While the state’s pensions were 102% funded that year, and even 111% funded in 2000, New Jersey is now down to being only 79% funded and still paying off debt from the issuance.
The largest POB issuance of all time in the U.S. came from Illinois — $10 billion in June 2003. The Pew pension report shows that in 2002, Illinois’ pensions were 54% funded. The funding level dipped to 49% in 2003, rose to 64% in 2004, and was 60% funded in both 2005 and 2006. In its fiscal 2006 and 2007 budgets, the state decided to scale back on the payment amount owed to the pension funds by about $1 billion, a move that Chicago-based think tank the Center for Tax and Budget Accountability claimed eroded gains made by the state’s $10 billion POB issuance in 2003.
“Pension obligation bonds have to be accompanied by responsible financial behavior, so if you borrow the money to help put your pension system in a better position, you really need to make sure that you’re continuing to keep up with your other funding obligations,” Barrett said. “Illinois, for a long time, hasn’t met its obligation for its annual requirement contributions.”
Barrett said that Connecticut’s commitment to fully fund its ARC to the TRF for the life of the 25-year bonds is “a promising part of that legislation.”
Barrett also noted that Oregon’s pension system is in good shape, and it also issued POBs. In the third largest POB sale ever, Oregon issued $2.08 billion of POBs in October 2003. The state’s pension system is now funded at 110%, while it was at 91% in 2002.
While the U.S.’s overall pension funds are about 85% covered, Connecticut falls way below the average. The Pew report shows that Connecticut’s pensions — for teachers, state, and judicial — are 56% funded overall, which is just behind West Virginia’s 55%, the lowest percentage for a state pension system in the country. West Virginia in 2005 said no to a $5.5 billion POB issuance when voters opposed the proposed deal. Still, without the use of POBs, the state has made a notable jump in funding its pension system from 49% funded in 2005 up to 55% funded in 2006.
“We came away from the report with the sense that in terms of pensions, on the whole, the states were doing pretty well, but you really have to look at the individual states,” Barrett said. “Connecticut really has some of the more major pension issues in the country.”
All three rating agencies noted that Connecticut’s pension fund was weak. Issuing debt could be a positive step for Connecticut, they said, though not without reservation.
“For some issuers it works very well because it forces discipline,” said Standard & Poor’s Robin Prunty. “It can work very effectively to improve the funded ratio, but there are risks involved.”
Prunty noted that if the cost of borrowing is more than what you’re earning on the investments, then “there could be increased contributions in addition to the fixed cost of debt service.”
Additionally, Prunty said that once governments improved the funded ratio, sometimes they have a tendency to enhance benefits. While Prunty didn’t think that would be the case for Connecticut, she said that Standard & Poor’s would keep an eye on that.
“There are advantages and disadvantages to issuing pension obligation bonds for a pension liability,” said Fitch director Douglas Offerman. “On the one hand, it’s increasing the funding level of a pension fund which has the potential over time to enable a state to sort of reduce its annual required contribution because investment returns are that much higher. However, it’s also taking a liability that is somewhat flexible and turning it into something that is a lot more fixed.”
“It would add to the state’s already high debt levels, but it would hopefully improve the funding levels of their pension system,” Moody’s Johnson said.
Over the next three decades, states have promised at least $2.73 trillion for pension, health care, and other retirement benefits for public employees, according to the Pew report.
All in all, states face about $731 billion in unfunded bills coming due, and it’s difficult to know exactly where the money will come from to pay this. And while states have saved enough to cover about 85% of their long-term pension costs, the Pew report notes that only 3% of the funds needed for promised retiree health care and other non-pension benefits has been saved.
