Should local Illinois governments consider pension obligation bonds for public safety funds?
As local Illinois governments search for fixes to pension burdens straining their fiscal health, the Illinois Public Pension Fund Association is counseling leaders to weigh whether pension obligation borrowing will help.
The IPPFA, which represents local suburban and downstate government public safety funds, said it neither endorses nor opposes the use of POBs — which carry a deep stigma among many in the municipal market — but is encouraging local government leaders and fund managers to explore the option. It lays out the benefits and risks in a newly published “informational bulletin.”
“Pension obligation bonds are not a risky financing bet,” IPPFA President James McNamee said in a statement. “These bonds are a well thought-out technique in which the possibility exists to substantially lower the taxes needed to meet pension obligations.”
The technique can work if the investment return in the local pension fund over several decades exceeds the interest rate that must be paid on the bonds and if the arbitrage play works over the long-term local residents and businesses would pay less in taxes to retire the municipality's unfunded pension liability, the group says.
In addition to the borrower risks on arbitrage, POBs were tarnished by the poor recoveries seen in the bankruptcies of Detroit and the California cities of Stockton and San Bernardino. Some see, and worry, over a potential resurgence of interest as bankers pitch them with local governments searching for fixes as they struggle with deep tax losses by the COVID-19 pandemic economic shutdown and could see higher pension costs if investment returns suffer.
The bulletin acknowledges POBs don’t offer a solution for all. “The Center for Retirement Research at Boston College found that the best chance for success is when bonds are issued by financially sound and well run governments who understand the risk and have a pension reform or financing strategy,” McNamee said in the statement. “Bonds issued by fiscally stressed cities seeking budgetary relief are riskier.”
Pension burdens weigh heavily on local government ratings and have driven dozens of downgrades in recent years. The collective unfunded pension tab for local downstate and suburban Illinois public safety funds grew by $1 billion to $11 billion and the collective funded ratio is around 55% based on 2017 results. The numbers don't include Chicago's police and firefighter funds.
The fund said its goal with the paper was to disseminate the information through seminars in cooperation with the Illinois Government Finance Officers Association, the Illinois City Managers Association and the Illinois Municipal Treasurers Association. Members of the IPPFA, which describes itself as a not-for-profit organization founded to educate public pension fund trustees, manages more than $18 billion in pension assets.
The organization said it had planned on releasing the report in March along with a schedule of meetings with finance and city manager groups. “When the pandemic hit all of the meetings had to be cancelled. We put the project on hold but then got some inquiries from local pension funds, so we released the bulletin this week but kept the meetings on hold until 2021,” said Dan Ryan, project coordinator at the association.
Association officials see the market’s low interest environment and depressed stock market prices as a potential opportunity but acknowledge the risk associated with a volatile market that fluctuates with news on the pandemic and economy. “The volatility in the investment markets experienced in 2020 certainly makes one cautious. But at the same time, borrowing rates are at an extremely low level,” it says.
The report outline rating agency views which take into consideration the overall fiscal plan in assessing whether POB borrowing is a negative, neutral, or positive.
The Government Finance Officers Association recommends governments avoid POB issuance given the reliance on earning a higher return on the investment of bond proceeds than the interest rate paid on the bonds. “Failing to achieve the targeted rate of return burdens the issuer with both the debt service requirements of the taxable bonds and the unfunded pension liabilities that remain unmet because the investment portfolio did not perform as anticipated," the GFOA warns.
“In recent years, local jurisdictions across the country have faced increased financial stress as a result of their reliance on POBs, demonstrating the significant risks associated with these instruments for both small and large governments,” the GFOA says.
The GFOA said that POBs are complex instruments that can add risk to a government’s debt portfolio depending on the inclusion of guaranteed investment contracts, swaps, or derivatives. Because most pension bonds sell using a taxable structure that typically carry “make-whole” calls over 10-year municipal calls, a government’s flexibility is limited on refunding and POBs potentially limits the availability of borrowing for capital.
“Rating agencies may 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,” the GFOA says.
The IPPA tries to address GFOA concerns with counterpoints on how local governments can offset them.
“Municipalities can work with their bond advisors and attorneys to avoid a risky structure” and to “be sure that their overall debt capacity is properly used” while maturities and amortization can be limited and rating agency concerns addressed in structuring.
The state's options on reforms are limited. Illinois' constitution restricts the state from taking any action that impairs or diminishes promised benefits, and the state's high court has affirmed that position. Gov. J.B. Pritzker opposes seeking a constitutional amendment that could ease the restriction.
Pritzker won legislative approval last year for a consolidation of the assets of the more than 650 funds into just two funds, one covering police and the other firefighters. Funding decisions such as POB borrowing are still made by the local fund.
Prtizker pushed the consolidation as a means to generate between $850 million to $2.5 billion in additional investment returns over the first five years and $3.6 billion to $12.7 billion through the 20-year scheduled ramp up to a 90% funded mandate in 2040 by pooling assets. About $160 million of savings are expected by trimming administrative costs.
Unfunded liabilities rose to $11 billion in 2017 from $9.9 billion a year earlier, with the police and firefighters outside of Chicago now funded at a collective ratio of 55.47%, down from 57.58% in 2016. Police funds account for $6.3 billion and firefighters for $4.7 billion of unfunded liabilities, according to the 2019 report published last summer by the non-partisan Commission on Government Forecasting and Accountability.
Local governments have faced more pressure to make their full actuarial contributions since 2018 when state Comptroller Susana Mendoza began enforcing an intercept mechanism. State law allows the local funds to requests a diversion of tax funds that flow through the state to the local government if they short actuarial payments. A handful of funds have filed claims over the last two years.
Under a 2011 law, local governments have shifted from a statutorily based payment to an actuarially based contribution level that puts their public safety funds on a path to a 90% funded ratio by 2040. Local governments outside of Chicago contribute to just one fund — the Illinois Municipal Retirement Fund — for its general employees. It has a healthy funded ratio and actuarial contributions have long been required.
Some local governments have turned to pension borrowing including the Chicago suburb of Berwyn, the Orland Fire District, Round Lake Park, Bedford Park, Winnebago County, Rantoul, Granite City and Milan have used POBs, but it’s not been widespread.
POB skepticism runs deep in the marketplace with some outright opposed given the arbitrage gamble and others taking the position that such borrowing can help if carefully managed meeting several musts including using proceeds solely to pay down liabilities and not cover current contributions or to re-amortize future contributions. Illinois used more than $2 billion of its $10 billion 2003 general obligation-backed POB issue to cover near-term contributions.
“POBs enable governments to gamble with taxpayer money based on the theory that they can generate returns in excess of borrowing costs. Any consideration of POBs as a way to address today’s funding problems should be weighed against the potential costs/risk that it thrusts onto future taxpayers to make up the difference if investment returns lag assumptions while also servicing the debt,” said Lisa Washburn, a managing director at Municipal Market Analytics.
“It also seems like a particularly dicey time to think about executing such an arbitrage transaction, given where stock prices are and the economic uncertainty related to the pandemic,” Washburn said.
Local governments must tread cautiously because of the pitfalls, but POBs can offer help if scrutinized properly and structured with the borrowers, investor and taxpayers in mind as governments struggle under the pandemic’s weight, said Richard Ciccarone, president of Merritt Research Services.
“It's not a panacea and it’s not a free ride but it can provide some relief if you do it right,” Ciccarone said. Local governments must be able to accommodate the higher bonded debt burden that drives up fixed costs and there’s the arbitrage gamble. “Timing also remains the big uncertainty.”
To accommodate lenders burned by past bankruptcies, the bond structure must offer strong security provisions such as a statutory lien and a dedicated tax or revenue stream. While Illinois local governments can’t file for bankruptcy, investor worries extend to distressed situations so a strong security is needed to entice them at the most affordable rate that allows the arbitrage play to work, Ciccarone said.
Transparency and a sound long-term plan are needed to protect taxpayers and a realistic assessment of a fund’s health that looks at its actuarial assumptions is also needed. “It can’t just be a paint job, there has to be structural improvement,” Ciccarone said.