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Providence and Pension Obligation Bonds
Providence, RI voters recently approved a plan to issue debt to improve its ailing pension system, but is trading one liability for another a good idea?
Pension Obligation Bonds (POBs) are a complex transaction. As the Government Finance Officers Association (GFOA) puts it,
The use of POBs rests on the assumption that the bond proceeds, when invested with pension assets in higher-yielding asset classes, will be able to achieve a rate of return that is greater than the interest rate owed over the term of the bonds.
Over the course of 2020 and 2021, low borrowing costs contributed to a surge in POB issuance. In a report last year, S&P Global Ratings noted that from January 1, 2021 to September 15, 2021, they rated 64 new POB issuances totaling about $6.3 billion, up 113% from $3.0 billion issued in calendar year 2020.
Often derided by the public finance community, yet POBs clearly found a new footing these past two years. A far divergence from a low point a decade ago in which one article referred to borrowers as “being reckless by mortgaging their employee pension funds and opening their finances to additional risk.”
This past week Providence, RI has been in the news for attaining voter approval of its POB ballot measure. The question before voters was whether the city should issue up to $515 million of general obligation bonds towards its unfunded pension liability (less than the $850 million originally considered).
Ultimately approved, voters seemed apathetic on the question. The measure was rejected by 1,519 — quite low for a city with a population of almost 180,000 — until you find out that only 4% of eligible voters participated.
The city’s ability to issue these bonds also requires state approval. A law [House Bill No. 7499 SUB B] has been moving through the Rhode Island General Assembly and Senate likely to attain state approval. However, one provision in the law limits the "true interest cost" not to exceed 4.9% per year, a condition largely dependent on market conditions.
This week we look at the Providence pension system and the broader issues of POBs.
The Trouble with a High Discount Rate, Low Assets Levels, and Cash Flow
According to the City’s promotional material, “Why we must act now to invest in Providence’s future” (April-May 2022), there were two main reasons for the bonds (aside from “bankruptcy is not an option”):
“Currently, the pension system is just 23.94% funded, even after making 100% of the City’s pension payments for ten years.”
“Currently pension costs consume 14.4% of the City’s General Fund revenues. By 2035, it will become 21.4%.”
The city claims the increase of its pension contributions was outpacing revenue growth, threatening to consume more budgetary resources and crowd out spending in other key service areas. However, …
It is important to note that making 100% of required payments isn’t enough if those contribution requirements are based on poor assumptions. For most of the past decade the plan assumed their rate of return on investments was over 8% (high by comparative standards); it was only dropped below that recently, in 2019, to 7%.
Even with an 8% discount rate in 2018, the system was only 27% funded. In reality, with plan funding that low at a high discount rate, the pension plan’s cash flow position is not strong. At those levels they are more likely to be in a position of needing to liquidate long-term investments, losing out on their potential returns, in order to meet benefit payments.
The State of Kentucky underwent similar cashflow issues and needed to increase plan assets. Instead of issuing bonds, the state recognized a more accurate picture of their two poorly funded pension plans and lowered their assumed rate of return to 5.25%. The state made difficult decisions to meet substantially increased levels of contributions demanded by the lower discount rate.
For context, the City of Providence pension plan pays over $100 million a year in benefit payments, has about $360 million in assets, and contributes about enough annually to meet those payments — the math doesn’t look great and seems to barely meet a level of cash inflows matching outflows in any given year depending on investment returns. Timing of when those contributions are received and benefits are paid may further complicate cash flow.
POBs May Limit Future Debt Capacity
Under Rhode Island state law, a municipality cannot increase its aggregate indebtedness to an amount greater than 3% of taxable property. According to Providence’s 2021 financial statements, $42.2 million of current debt is subject to the limit, leaving about $407.5 million of additional debt capacity. If the POB debt is issued, it will place the city well above its debt limit. There are ways to exempt debt and the city already has $4.6 million of debt incurred outside this limit.
In 2013, Portsmouth, VA sold POBs that added over $168 million to its pension plans. The debt, however, was not exempt from the state’s municipal debt limit of 10% of taxable assessed value. From 2012 to 2013, the city’s debt subject to the limit increased from 43 to 89 percent, giving it a slim amount of bonding capacity for future capital projects.
Studies Generally Show POBs are a Bad Idea and Depend on Timing
“For States and Localities, Borrowing and Issuing Pension Obligation Bonds Increased as a Response to COVID-19,” Pew Charitable Trusts, May 2021
“Issuing debt to close budget gaps and pay down unfunded pension liabilities can alleviate short-term budget pressures but also presents long-term risks.”
“When POB proceeds are invested is particularly important. For example, the risk of incurring long-term losses is greatest when stock market valuations are near their peak.”
“POLICY BRIEF: Pension Obligation Bonds are a Bad Idea,” University of Minnesota, September 2020
“Under current governance, POBs only resolve funding challenges over the short term.”
“Under our [the authors’] assumptions both taxpayer and beneficiary economic welfare is adversely affected by POBs. Hence, unless bond issuance is accompanied by structural changes in governance, they are a bad idea.”
“An Update on Pension Obligation Bonds,” Center for Retirement Research, July 2014
“POBs had a negative average real return from 1992-2009, but show a small gain when the time period is extended to 2014.”
“POBs could be a useful tool for fiscally sound governments or as part of a broader pension reform package for fiscally stressed governments.”
“But results to date suggest that, instead, POBs tend to be issued by governments under financial pressure who have little control over the timing.”
Any opinions expressed herein are those of the author and the author alone.