DALLAS -- Royal Oak, Mich., is awaiting state approval for a general obligation-backed deal to help the city pay off its legacy retirement obligations.
The city, which hatched the plan more than a year ago, sees the bonds as a means to deal with pension obligations and other post-employment retiree healthcare benefits that are a drain on its balance sheet, but critics warn that the funding tool shouldn't be seen as a cure-all as it has long-term risks.
"The allure of lower annual fixed costs, which is the promise of POBs, is attractive to places like Royal Oak that are seeing more and more of their budgets devoted to pensions and retiree health care costs," said Tom Schuette, co-head of Investment Research & Strategy at Gurtin Municipal Bond Management.
Royal Oak expects to save approximately $10.69 million annually through 2040 by paying down its liabilities to the retirement programs with the bonds.
The city is planning a $126 million taxable financing. The bonds include a limited tax general obligation series for $106 million for the purpose of defraying all or part of the costs of the unfunded accrued health care liability of the Royal Oak health care fund and the costs of issuing the bonds.
A second series for $20.6 million of limited tax general obligation bonds is for the purpose of defraying all or part of the costs of Royal Oak's unfunded pension liability in its defined benefit plan and costs of issuance.
The city's limited tax obligation bonds are rated AA by Fitch Ratings and AA-plus by S&P Global Ratings. Moody's rates the bonds A1.
JPMorgan is the underwriter.
Hutchinson, Shockey, Erley & Co. is advising the city and Dickinson Wright Plc is bond counsel.
The city had anticipated coming to market later this week but the issue is still awaiting final approval by the state Treasury office as required under state law. The city's finance director. Julie Rudd, doesn't anticipate a problem with approval but "if it comes in later than expected then we will probably have to back up the pricing as well."
Royal Oak leaders approved the bond issue for up to $165 million last September.
As of November 30, 2015 the retiree healthcare actuarial valuation report valued the unfunded accrued liability at $107.97 million and the general employees' pension UAL as of June 30 2015 was $21.5 million.
The city is not issuing bonds for the entire retiree healthcare and pension UAL, as cash from its state construction code fund, which holds $1.1 million for pensions and $2.5 million for retiree healthcare, will be moved to the retirement system trusts after the bond proceeds are received, fully funding the UAL for both. Approximately $20.4 million for pension UAL and $105.5 million for retiree healthcare UAL will be bonded.
According to Fitch, the city's carrying costs for pension, OPEB, and debt service were a high 28% of fiscal 2016 governmental fund expenditures, largely driven by retiree benefits.
With the new bond issuance, combined carrying costs are projected to decline to approximately 24% because debt service on the new issuance will be less than the cost to pay down the unfunded liabilities of the pension and OPEB plans.
"As the bond structure seeks to maximize cash flow savings relative to current assumptions, the investment returns on the bond proceeds must exceed the cost of borrowing for this issue over time in order to result in savings," said Fitch.
Rudd said that the assumed rate of return is 7.75%, but the city has provided a sensitivity analysis in the event the average investment rate of return is 100 basis points (1%) or 200 basis points (2%) lower than the actuarial assumed rate of 7.75%. The sensitivity analysis also includes the results should the bonds be sold at a true interest cost of 50 basis points greater than current true interest cost and 50 basis points lower than the current true interest cost.
"Actions taken by the governing body, investment board, retirees, and the timing of the markets, among other things, all play a key role in dictating whether or not these bonds are deemed successful in reducing costs," said Michigan Treasury spokesman Ron Leix. "It is possible that after issuing bonds a municipality may have higher costs than had they not issued the bonds in the first place."
In Michigan, local government pension and OPEB bonds are permitted under 2012 revisions to the state's Municipal Finance Act, which added a section to allow pension and OPEB bonding by governments that have closed their defined-benefit plans. The legislation has since been extended twice and now expires in December 2018.
"Treasury has since received 22 applications to borrow: 16 for pension bonds and 6 for OPEB bonds," according to Leix. Only municipalities rated AA or above can issue bonds.
In 2007, Oakland County became the first Michigan governmental unit to fully fund the traditional retiree health care benefit obligations incurred before adoption of the Health Care Savings Account Program.
The County first issued certificates of participation and established a source that fully funded its existing retiree health care obligation for current and future retirees. In September 2013 Oakland County used a private placement to refinance the 2007 COPs, reducing annual interest payment rates to 3.62% from 6.23%, a net savings of approximately $171 million.
The risk is if there are significant losses if the market where fund assets are invested takes a downturn. John Axe of Axe & Ecklund, one of the architects of Michigan POB legislation, said in a presentation on the Royal Oak bonds that "if you have done your investment well and you spread it out properly you will still be OK. Over a long period of time the averages indicate that there will be enough money to fully retire bonds."
Anthony Minghine, COO and Associate Executive Director of Michigan Municipal League, said that POBs are a necessary tool for communities in Michigan but so far have been used on a fairly limited basis, "which shows the state is being prudent on its application," he said. "I don't think it's a panacea, one-size-fits-all tool."
The Government Finance Officers Association discourages the use of POBs citing concerns over interest rates and whether the play on arbitrage will work.
"Many organizations, including the GFOA, have advised obligors against relying on POBs as a cure-all given that they are a bet on investment returns and therefore carry considerable risk," said Schuette.
Another concern is that rating agencies may also not view the proposed issuance of POBs as credit positive, particularly if the issuance is not part of a more comprehensive plan to address pension funding shortfalls.
"We tend to view POBs as at best a neutral credit factor, and more often a drag on credit quality – especially if they are being used as a substitute for consistent, ongoing full annual contributions," said Schuette.
However, Royal Oak and the other Michigan local governments have slightly different circumstances given that they are using POBs to fund closed retirement plans – which "may make them at least slightly more useful," Schuette said. "It's pretty situation specific and you have to have the right fact set," Minghine said.
Minghine says the city's pension problem is ultimately symptomatic of a larger issue: Michigan's broken municipal finance system. Cities and villages have lost over $7.5 billion in revenue sharing funds from the state since 2002, and in many case this has been a substantial share of their annual revenues.
Michigan legislators are working on a 12-bill retiree healthcare reform package that was first introduced by House Republicans during the December lame duck session. The legislation was aimed, supporters said, at reining in unfunded liabilities in communities that have extended more benefits to employees than they can afford.
The bills sought to impose restrictions on local governments with retiree health costs funding levels that are below, or fall below, 80%.
New employees hired after April 30, 2017 would have been excluded from retiree health care coverage. Instead, a local unit of government would have been permitted to contribute up to 2% of an employee's pay to a tax-deferred Health Savings Account that could be used at retirement.
Royal Oak is an affluent suburb in southeastern Oakland County 10 miles north of downtown Detroit. The city recorded its fourth consecutive operating surplus in fiscal 2015 bringing available fund balance across major operating funds to $25.2 million, or a 49.5% of revenue, according to Moody's. The city adopted a 2016 budget with the planned use of approximately $1.8 million of general fund reserves.
The city has shown signs of a slow recovery in its tax base following the 2007-09 recession and a long-term negative population trend.
