For better or worse, public employee pension systems might be tempted to use bonds to fill big holes punched in their investment portfolios by the stock market crash.
If required pension contributions soar as expected, bonds would be a way for recession-hit local governments to get the money without cutting services or raising taxes.
Pension bonds have another attraction — if interest paid on the bonds is less than the bond money earns in the investment portfolio, the pension system makes a profit.
A successful bond strategy helped the Fresno city retirement system remain fully funded in recent years while employer and employees made no contributions.
“The city has had sort of a holiday — and the employees as well,“ said Kathleen Riley, assistant administrator of the City of Fresno Retirement Systems. “It worked out very well for us.“
Fresno claimed to have the two highest funded public employee pensions in the state before the crash, one at 148 percent and the other 130 percent. Riley said the contribution holiday may continue, even after the crash.
On the other hand, a failed bond strategy is causing the San Diego County Employees Retirement Association to pay an additional $500,000 a month interest on its pension bonds.
The market for the auction-rate bonds issued by the San Diego County system began to fail last fall, causing interest rates to rise. The good news for the county: Its rates are capped at 6.8 percent.
A dismal bond market is giving pause to any retirement system thinking about issuing pension bonds at this point.
“I haven’t heard of any big movement afoot to issue pension obligation bonds,” said Rich Goss, administrator of the California Association of Public Retirement Systems, which includes 40 of the largest systems.
“The state’s credit rating has been downgraded,” he said. “It’s a tough market out there.”
Bob Palmer, executive director of the 20-member State Association of County Retirement Systems, which operate under a 1937 law, said the “illiquidity of the markets” and low demand for pension bonds is mentioned by county treasurers.
But Palmer said he has been suggesting that because both the interest rates on bonds and the stock market are low, retirement systems might think about preparing the paper work for a pension bond to keep their options open.
“If the market does turn around, there could be a real opportunity out there,“ he said.
One of the pioneers of pension bonds, the Sonoma County Employees Retirement Association, has had success with a $97 million bond at 6.75 percent interest in 1993 and a $200 million bond at 4.8 percent interest in 2003.
Until the market crash last fall, the earnings on the bond money were well above the interest payments, said Rod Dole, the Sonoma County auditor-controller-treasurer-tax collector.
In addition to being a man with “four hats” in his lengthy job title, Dole is a trustee of the county retirement system. He said the system is thinking about issuing a $300 million pension bond.
“If the interest rates would favor the bonds, we probably would be in the midst of of a pension obligation bond right now,” he said.
Dole said three things are needed for a successful pension bond: a high unfunded liability in the retirement system, low interest rates on the pension bonds, and a low stock market with room to grow.
“If those three are aligned, then pension obligation bonds are very favorable,” he said.
The Sonoma County retirement system pension bond in 1993 is the first taxable pension bond issued in California, according to the web site of a law firm that has been involved in 30 pension bond issues, Orrick, Herrington and Sutcliffe.
“Pension obligation bonds had their start with the famous City of Oakland pension bond financing in 1985,” says the Orrick web site. Other retirement systems quickly issued their own tax-exempt bonds before a federal law change in 1986 made them difficult.
Money from the sale of the tax-exempt bonds could be invested in higher yielding U.S. Treasury bonds, giving the retirement system risk-free earnings that some call “arbitrage.”
Defenders of taxable pension bonds say they are not “arbitrage“ because there is no guarantee that the investment of the bond money will earn more than the interest payments.
Another hurdle for a pension bond is obtaining a court ruling that the bonds are valid without a vote of the people. Orrick says the pension bonds are exempted from a vote because the funding of pensions is an “obligation imposed by law.”
During a budget crunch in 2003, the state of California attempted to make its annual payment to the California Public Employees Retirement System with a $2 billion pension bond.
In a suit filed by the Pacific Legal Foundation, a court blocked the state pension bond because it had not been approved by a vote of the people. The state appealed, but the lower court ruling was upheld.
Pension bonds issued by the counties that contract with CalPERS for retirement services face a complication. Funding of trial courts has shifted from counties to the state, but not completely.
Solano County is pushing a bill, SB 752 by Sen. Pat Wiggins, D-Santa Rosa, that would exempt the county from a requirement that it participate jointly in CalPERS with the trial court, allowing the assets of the county and trial court to be separated.
“What we are looking to do is lay the groundwork going forward in the event that other counties do issue pension obligation bonds,” said Paul Yoder, a lobbyist for Solano County.
There are negotiations between the county, the Judicial Council, CalPERS, organized labor and perhaps others — all apparently within the larger context of taking another step in the separation of counties and trial courts.
And finally, a broad criticism of pension bonds in general is that they make pension funds look financially healthy, increasing pressure from employee unions to provide more retirement benefits.
At a joint hearing of Santa Barbara County supervisors and retirement trustees last month, Bill Hallmark of Mercer consulting gave a hypothetical example of a $1 billion pension bond added to a $1 billion investment portfolio.
He said earning 16 percent on a $2 billion investment could yield a net return after the bond payment of $270 million or 27 percent; earning 8 percent could yield an 11 percent return, and earning zero percent would be a 5 percent loss.
“Entities that have done them (pension bonds) at the right time have been rewarded handsomely,” Hallmark said. “Entities that have done them at the wrong time have had to pay for years. I’m not here to say this is the right or the wrong time. I don’t know.”
Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at http://calpensions.com/ Posted 7 May 09