WASHINGTON — Pension funding bonds are more likely to hurt rather than help the credit of the state or local government issuing them, according to a report from Moody’s Investors Service.
The ability to borrow at historically low interest rates, combined with the rise of unfunded pension liabilities, can provide a strong incentive for issuers to sell pension funding bonds. Issuers can also hope to realize a savings if the return on bond proceeds exceeds the borrowing rate.
But in its report, issued Tuesday, Moody’s indicates such deficit-borrowing decisions are credit-neutral at best. The decision to utilize taxable pension funding bonds, wrote Moody’s analysts Marcia Van Wagner and Timothy Blake, introduces new risks that could be greater than failing to make the required contributions to the pension system and can reflect poorly on the overall debt management of the issuer.
“If pension bonds merely shifted an issuer’s long-term obligations from one similar form to another, in this case from an unfunded pension liability to bonded debt, they would tend to have a neutral credit impact,” the report states. “However, issuance of pension bonds changes the nature of the liability and typically creates additional risks.”
A missed payment on a pension obligation is generally not viewed as a default, while failure to pay bond investors is.. Woonsocket, R.I., which was downgraded by Moody’s “largely because outstanding debt stemming from pension bonds issued in 2002 has led to payments of nearly 17% of its operating revenues for debt service,” the report said.
Replacing pension liability with bond debt also limits the financial flexibility of the issuer, since pension payments can be lowered in some cases and help reduce the risk of default on other debt, Moody’s said. Additionally, states and localities take a long-term risk by banking on savings through investing the bond proceeds, as that money might never materialize.
The report cites several examples of pension obligation bond issuance that yielded less than stellar results. The Village of Rosemont, Ill. issued $35 million of pension bonds for its public safety plan in 2007, but has since negated any benefit from the sale by failing to make its required annual contributions, the Moody’s report explains. The state of Illinois has also infused sizable chunks of the $17.2 billion of pension funding bonds it has issued since 2003 into its two main pension plans, but both remain badly underfunded anyway.
In September, Fort Lauderdale, Fla., issued $340 million at an interest rate of 4.168%, and hopes to realize $84 million in present value savings over 20 years from the investment return on the bond proceeds. There is no guarantee that the investment will perform that well, however.
“When pension fund asset returns meet or exceed the assumed rate of return, a pension bond can generate long-term budgetary savings,” according to the report. “However, if assets under perform, annual costs increase relative to the no pension bond case.”
On top of the risks illustrated by those examples, Van Wagner and Blake conclude that issuing pension bonds can reflect poorly on the quality of the debt management at large. The borrowing could indicate the inability or unwillingness to achieve meaningful pension reforms which Moody’s would view positively. However, the report concludes that pension funding bonds could be part of a broader structural reform “aimed at restoring a balance between the pension’s actuarial liabilities and asset values and achieving affordability.”