Pennsylvania Gov. Tom Wolf stirred a hornet's nest in the capital markets when he included $3 billion in pension obligation bonds as part of his proposed $30 billion budget for fiscal 2016.
The proposed borrowing, to help the commonwealth deal with a roughly $50 billion unfunded pension liability that prompted the three major bond rating agencies to downgrade it last year, triggered a visceral reaction to an otherwise intricate Wolf spending plan that calls for an overhaul of sales, income and property taxes and a levy on Marcellus Shale natural gas drilling.
Wolf's pension bond plan would refinance $3 billion of Pennsylvania's current unfunded liability with all proceeds reinvested into the Public Schools Employee Retirement System, one of the state's two major pension funds along with the State Employees' Retirement System.
According to Wolf, a Democrat who took office in January, new profits from "enhanced profits generated by our wine and spirits system," as he described it, would pay for the refinancing beginning in fiscal 2018. This initiative, he said, would initially fund direct payments to PSERS to reduce local school district employer payments during 2016-17.
The future of Pennsylvania's state-run liquor system itself is in question. The Republican-controlled legislature recently voted to break up and sell the system, though it may not have enough votes to override a Wolf veto.
Pension bonds have become a hot-button issue in public finance.
"I'm no fan of pension bonds," said Alan Schankel, a managing director at Janney Capital Markets in Philadelphia.
Despite warnings from major public finance figures such as Schankel, James Spiotto and Richard Ravitch, an admonishment from the Government Finance Officers Association and vivid examples of deals gone sour - notably in bankrupt Detroit, where bondholders took a big haircut - some issuers see pension borrowing, especially amid low taxable interest rates, as a means to ease cash pressure on governments and possibly offer cost savings, on the theory that returns from money invested in the pension funds will exceed debt-service costs on the bonds.
The Tax Reform Act of 1986 ended the tax exemption for pension obligation bonds, one year after Oakland, Calif., broke ground with a $222 million offering. These bonds resurfaced in the early 1990s with issuers seeing an arbitrage opportunity given the performance of the stock market at the time.
Kentucky and Kansas lawmakers are now weighing bills to issue $3.3 billion and $1 billion, respectively, in pension obligation bonds.
"Is it a growing market? It appears to be, but $3 billion as proposed is a large amount to sell, particularly for the kind of shape Pennsylvania is in and especially where pension bondholders have been treated so poorly," said William Rhodes, the head of public finance at Philadelphia firm Ballard Spahr LLP.
"They got hammered in Detroit and got hammered in San Bernardino," he said. "Pennsylvania's a state credit, I realize, but people got their fingers burned in the pension obligation game. This may be the lesson in the recent bankruptcy cases."
Pennsylvania was the second worst state -- behind New Jersey -- at underfunding its pension fund requirements between fiscal 2001 and 2013, according to a report the National Association of State Retirement Administrators released Wednesday. It paid on average just 41.2% of its actuarially required contributions. Pennsylvania has not fully funded its ARC since fiscal 2005.
Last year, Moody's Investors Service downgraded Pennsylvania to Aa3, while Fitch Ratings and Standard & Poor's lowered the commonwealth to AA-minus. All three cited unfunded pension liability.
That Pennsylvania still contributes amounts below levels recommended by pension actuaries under a "collared" rate arrangement linked to a 2010 pension-related law should continue to raise red flags with bond rating agencies, said Richard Dreyfuss, a Hummelstown, Pa., actuary and adjunct fellow with the Manhattan Institute for Policy Research.
"It is most telling that the proposed Wolf budget for fiscal 2015-16 involves a $3 billion POB just to meet the collared rates," said Dreyfuss, who oversaw compensation packages while a Hershey Foods executive. "This strategy will be of significant interest to the credit rating agencies, which were anticipating compliant pension funding practices sooner rather than later."
To borrow the $3 billion, Pennsylvania would have to tweak the 2010 law, known commonly as Act 120, which prohibits pension bonds. "We'd have to suspend parts of Act 120 to do that," Wolf said while campaigning last year.
"The bond Pennsylvania is considering is $3 billion. This looks like a drop in the bucket given the size of their overall liability," said Jean-Pierre Aubry, assistant director of state and local research at the Center for Retirement Research at Boston College. "It appears that this is not being done to fill a hole and move forward, but as a stop-gap move to make a payment obligation and buy some time until they can come up with a realistic solution.
"This is a textbook case of an issuer doing it for the wrong reasons."
Pennsylvania is no stranger to pension bonds, according to a Boston College report by Aubry, Alicia Munnell and Mark Cafarelli.
Culling data from Bloomberg and Thomson Reuters, the trio listed Pennsylvania as the fifth largest source of pension bonds, with issuers there selling about $6 billion. According to Rhodes, the time to issue pension bonds is after the market has bottomed out.
"It's essentially an arbitrage play," he said. You don't want to jump into the market before a major tradeoff. You have to time your market entry.
"The capital can be vital and if you time it right they make sense, but only if you combine it with meaningful pension reform. In Pennsylvania, pension reform could be part and parcel of a pension obligation bond, and they should include the municipalities."
State Auditor General Eugene DePasquale said in January that 562 municipalities administer pension plans that are "distressed" and underfunded by at least $7.7 billion. Also, said DePasquale, total underfunding of distressed local plans increased by $1 billion in two years. His 13-point proposal includes consolidating local government plans into a statewide system plan segregated by different classes of employees, such as police officers, firefighters and nonunion employees.
Spiotto, a managing director at Chapman Strategic Advisors LLC, said pension bonds should only be the final fix. "I don't recommend using them as a Band-Aid, but as the last piece in the reform if you know you can make the payments and have a stable and affordable plan.
"If you do them for anything other than that, you're subject to the volatility of the defined benefit program, including an economic downturns and COLAs [cost-of-living adjustments] that are not realistic."
A Government Finance Officers Association advisory in January argued against pension bonds. "POBs are complex instruments that carry considerable risk," the association said, noting that proceeds could fall well short of the interest rate owed over the term of the bonds.
Pitfalls could include complications from guaranteed investment contracts, swaps or derivatives, "which must be intensively scrutinized as these embedded products can introduce counterparty risk, credit risk and interest rate risk."
Fitch director Eric Kim said the agency would examine a pension bond offering carefully. "We wouldn't downgrade on pension borrowing in and of itself," he said in an interview. "We'd have to evaluate and see how they are utilized. There are different ways to do these kinds of borrowing."
Ravitch, long a critic of pension bonds, cited what he called budget gimmickry while he was New York lieutenant governor.
Working on the fiscal 2011 budget, he noticed an item called "pension smoothing," Albany budget officials showed him a bill that enabled the state and participating cities to make their actuarially required contributions to the pension funds not in cash, but with 10-year promissory notes. That way, the state would not have to enter $600 million on the expenditure side of the budget.
"They were calling it $600 million in savings. I was astounded," said Ravitch. "I said, 'Let's end this Orwellian double-talk. This is borrowing.' "
According to Spiotto, issuers are cutting back on other basic needs, notably infrastructure, amid the pension funding crisis. "I think we are missing the boat on economic stimulus. That's extremely important," he said. "It shows we have a false sense of 'spending wisely.' "
Spiotto cited data from the American Society of Civil Engineers, which estimated recently that it will take a $3.6 trillion investment from all government levels over five years to bring U.S. infrastructure into a state of good repair. That estimate was $2.2 trillion in 2009.
"It proves that these delays are expensive."