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Pension Bonds Are a Short-Term Strategy That Carry Long-Term Risk

As cities and states look for new ways to meet pension obligations, bonds offer an opportunity to bridge those gaps. We canvassed experts in pension reform to discuss what some might say is a risky approach to meeting funding goals.

New Jersey has been underfunding its pension plans since 1996. As of last year, the plans had only 59 percent of the assets on hand needed to match projected liabilities, which was one of the worst ratios in the country. Collectively, state pensions are underfunded by more than $1 trillion — money that federal law makes clear they’ll have to come up with eventually.

However, New Jersey has started making up for lost ground: In September, New Jersey took its biggest step toward solvency when it devoted a record $4.7 billion to its pensions. Where did the money come from? To make up for its budget shortfalls, the state took advantage of a $4.5 billion loan from a new federal program helping states with serious cash flow problems. This wasn’t the first time Garden State lawmakers shifted money around to make its pension funds more flush. In 2017, proceeds from the state lottery were transferred over to pensions. That allowed the state to budget fewer of its operating dollars, but has left the pension on the hook when lottery revenues are down. This year, they slumped 11.6 percent.

Making good on pension promises is a perennial problem for state and local lawmakers. Like people failing to save for retirement, states have sometimes failed to make scheduled annual contributions to pension funds, which rely heavily on earning investment income over time to meet future obligations. Over the past couple of decades, moreover, interest rates have remained low, meaning there’s less money to be made from certain classes of stable investments. The stock market enjoyed a bullish run for a decade following the Great Recession, but returns have been volatile this year due to the impact of the pandemic on the global economy. At this point, making ongoing contributions to pensions are going to be particularly challenging, because states, cities, and counties face collective budget shortfalls reaching into the hundreds of millions of dollars.

'Political and Social Pressure'

Pensions have long been an important benefit that has encouraged talented people to become public-sector workers and stay on the job for the long haul. Despite the continued need, it’s politically difficult to increase or even maintain funding for these benefits at the expense public safety or education programs. “There’s a lot of political and social pressure against increasing taxes to deal with local and state pension issues,” says Leonard Gilroy, Vice President of the Reason Foundation’s Pension Integrity Project.

Given historically low interest rates and the political infeasibility of raising taxes, some policymakers have turned to pension obligation bonds. These bonds allow states and localities to borrow large sums of money. If they can achieve market returns larger than the rate they pay to bondholders, they can fill immediate funding holes and come out ahead in the long run. “They can borrow cheaply,” says Kurt Winkelmann, Senior Fellow at the University of Minnesota's Heller-Hurwicz Economics Institute. “It solves a short-term accounting problem and it shores up the balances.”

In June, Flagstaff, Ariz., issued a form of bond-like debt known as certificates of participation to pay down its police and fire pension liability, using city-owned buildings as collateral and agreeing to make lease payments on them to investors. Entities ranging from the state of Illinois to a county-owned nursing home in Michigan are exploring the idea of issuing pension obligation bonds.

A major infusion of cash is always welcome, but perhaps now more than ever, when overall budget pictures are looking dire. Still, Gilroy and other pension experts caution that pension obligation bonds represent a risky strategy. Winkelmann recently coauthored a paper arguing that such bonds shift risks over the long haul onto taxpayers. In essence, the bonds are no different than an individual borrowing money to buy a stock she’s convinced will continue to go up. That doesn’t always work out. There’s no guarantee that returns on investment will run ahead of borrowing costs, or even remain positive.

'An Investment Gamble'

In the case of pension obligation bonds, fund managers are betting not only on positive returns, but coming out ahead for as long as 30 years. Kansas, for example, issued $1 billion worth of pension obligation bonds in 2015. Its returns have outpaced its borrowing costs, but those costs will stay constant for another quarter-century to come. Other jurisdictions haven’t been so lucky. Pension obligation bonds contributed to the bankruptcies of Stockton, Calif., and Detroit, along with the insolvency of Puerto Rico’s public employee pension system. Sometimes, in order to cover bond debts, jurisdictions pursue potentially rewarding but riskier investment strategies. “It’s an investment gamble and therefore a risk,” says Greg Mennis, who directs work on public sector retirement systems for the Pew Charitable Trusts.

Issuing bonds now, when the economy and the stock market are both still shaky, could be dangerous. Despite gains following last winter’s historic dip, market returns overall this year are likely to fall far short of the seven to eight percent growth many pension plans counted on. Gilroy argues that pension managers tend to be too optimistic in general about how well their funds will perform over the long term. “It’s another bad year for pensions,” Gilroy says. “It could have been an abysmal year, but it’s shaping up to be a bad year with a lot of uncertainty ahead.”

Bonds can help fill gaps, but work best if they’re part of an overall strategy aimed at shoring up a pension system. If a jurisdiction issues bonds but fails to fix its underlying funding problems, it’s a bit like bailing water out of a leaky boat but not plugging the actual leak. The city of Houston issued $1 billion worth of pension obligation bonds in 2017, but those were part of a comprehensive reform package — codified by state law — that included benefit cuts and a strict schedule requiring the city to make further payments.

Regardless of a pension system’s design, a state or locality should put risk management policies in place, Mennis says. They can’t ignore the basics, such as running stress tests and following sound actuarial standards. Well-managed states such including South Dakota, Tennessee, and Wisconsin have predictable rules and “shock absorbers” written into their plans that automatically lower benefits or raise contributions in response to market shocks.

In 2017, Pennsylvania passed a pension reform law that called for reductions in fees and benefits when investments fall short of expectations. “Pennsylvania has taken a lot of medicine over the past decade, but it’s starting to turn the corner,” Mennis says. “It’s no longer included in the conversations about the worst-funded plans with New Jersey and Illinois.”

What the best-managed states have in common is that they make 100 percent of their scheduled contributions, rather than shaving them off when budgets are bad. Even if a state can take some heat off its pension problems by issuing bonds, it will only get back into trouble if it uses the improved picture as an excuse not to keep paying. “Unless states keep making contributions in the future, they just go back to the same problems they had in the past,” says Winkelmann.