Piper Jaffray & Co. issued a report last week warning of the potential investment risks in Puerto Rico if it does not address its pension fund challenges.

Puerto Rico’s retirement fund has the lowest funding level  in the country at 9.8%, according to the report. The island’s employee retirement system, which has 247,010 active participants and retirees, had an unfunded obligation of $17 billion and a funding level of only 9.8% as of June 30, 2009.

The fund will run out of gross assets in fiscal 2019. Beginning in fiscal 2015, it will have negative net assets, according to an actuarial report compiled by Conway MacKenzie Inc., though pension bond proceeds will still be available in the fund at that time, said Carlos Garcia, president of the Government Development Bank for Puerto Rico. The GDB is the commonwealth’s fiscal adviser. Under the previous administration, Puerto Rico sold $2.9 billion of taxable pension bonds in the local market.

“There are total assets available all the way to 2019,” Garcia said. “The gross assets include all the investments and cash that was raised through the pension obligation bonds. The actuarial report assumes that you repay that on 2014, and that in 2014 you run out of all the rest of the assets. But the only assets left out are the pension obligation bond-related assets and since you have to pay that debt, they net it out.”

Piper Jaffray believes the condition of the retirement fund should be a concern for investors as the commonwealth has already implemented changes to tackle structural deficits.

Gov. Luis Fortuño and his administration slashed Puerto Rico’s structural deficit to $1 billion in fiscal 2011 from $3 billion in fiscal 2009. They did it by cutting the government payroll 17%, reducing spending, increasing the sales tax, and implementing a property tax.

Puerto Rico has fewer remaining options now.

“No other state in the country has the trifecta of an accumulated general fund deficit, after they already reduced head count by 17%, a weak lagging economy with 16% unemployment, and an extremely levered debt position,” said Yaffa Rattner, managing director at Piper Jaffray and author of the report. “Exacting further change will be a challenge.”

Puerto Rico bonds benefit from a triple tax exemption.

The commonwealth has an A3 rating with a negative outlook from Moody’s Investors Service and a BBB-minus rating with a stable outlook from Standard & Poor’s.

It has $9 billion of outstanding general obligation debt.

While Puerto Rico tends to offer more yield to its investors due to its credit ratings and historical budget imbalances, Piper Jaffray questions whether higher yields compensate the difficulties and uncertainties of implementing unpopular pension reforms.

“The bottom line is — investors beware — an attractive price and yield may not warrant the risk if the current pension issues remain unresolved,” the report reads.

Garcia stressed that the pension challenges are not an immediate credit threat as the system will have the cash it needs until fiscal 2019.

Puerto Rico’s secretary of labor is working on legislation to help repair the pension fund. Officials anticipate presenting the legislature with a comprehensive pension reform initiative in early 2011. Potential changes include increases in employer and employee contributions, raising the retirement age to 65, and capping pension benefits.

The GDB president said the Fortuño administration has a track record of implementing unpopular but necessary fiscal measures, such as increasing certain taxes while at the same time reducing government services and laying off thousands of employees.

“We continue to move forward with our holistic and comprehensive plan that will address this pension issue,” Garcia said. “As we have addressed other challenges that have been questioned by others and we have continued to deliver results for the past 22 months.”

“We’re confident that we have the time,” he added. “We know what needs to get done and that a consensus legislation will be obtained to address the pension challenge on a timely basis.”

Puerto Rico’s yearly pension payments are greater than its annual employer and employee contributions. In fiscal 2010, the estimated benefit payment was $1.18 billion and the estimated member and employer contribution was $753 million, leaving a difference of $428 million.

“With Puerto Rico’s pension fund, you have more money being spent than being contributed,” Rattner said. “Most other governments — when you look at their unfunded liability and their annual contribution — will have more money going in than what is annually expended, but the contributions will not be necessarily sufficient to cover the future associated expenses for those employees.”

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