The big casino: paying pension debt with bonds

An $8 million pension bond was approved last week by voters in Piedmont, a small well-to-do city completely surrounded by deep-in-debt Oakland, originator of the pension bond that has figured in the Stockton, San Bernardino and Detroit bankruptcies.

The bond approved by 83 percent of the voters in the Oakland hills city of about 10,600, known for a high school bird-calling contest featured on late night TV shows, is one of the least risky types of borrowing to pay pension debt.

A CalPERS “side fund” loan costing 7.5 percent a year in interest will be paid off with money presumably borrowed at a much lower interest rate, saving the city an estimated $600,000 to $700,000 over the next nine years.

When the giant system put small plans with less than 100 active members into large “risk pools” in 2003 to avoid massive rate swings, more than 1,500 side funds were created to separate their widely varying “unfunded liabilities” and allow an equal start.

The California Public Employees Retirement System created a business opportunity for bond salesmen by treating the side funds as loans, with an annual interest rate based on the pension fund investment earnings forecast, now 7.5 percent a year.

Piedmont City Hall (Patch photo)

Piedmont City Hall (Patch photo)


“Pension obligation bonds had their start with the famous City of Oakland pension bond financing in 1985, which Orrick helped to invent and for which it served as bond counsel,” said the website of the Orrick, Herrington and Sutcliffe law firm.

The Oakland bond issue and “copy-cat” issues elsewhere were driven by “arbitrage,” Orrick said. Money borrowed at low tax-exempt bond rates was invested to get a higher return, until a federal tax reform in 1986 barred issuing tax-exempt bonds for that purpose.

A decade later Oakland issued a taxable $417 million pension bond, part of the current wave of pension obligation bonds. The bond money is used to make employer contributions to pension funds, easing the strain on government budgets.

Pension funds expect to get what critics say is an overly optimistic return on their stocks and other investments, often 7.5 percent or higher. So the borrower paying a lower interest rate on bonds used for annual payments to the pension fund can come out ahead.

But it’s a gamble, and Oakland lost.

The 1997 Oakland bond money was for the Police and Fire Retirement System, closed to new members in 1976 due to a huge shortfall. Property tax diverted to the closed fund did not cover unusual pensions that grow with the pay of active police and firefighters.

After putting the bond money into the closed system, Oakland gave itself a 15-year “holiday” with no contributions. Like most pension funds, the closed system’s investments fell well below their target during the last decade.

An Oakland city auditor report in 2010 said: “The amount still owed by the city is approximately $250 million dollars higher than the scenario where the POBs were not issued in 1997 and the same payments were made to the pension fund instead.”

By 2012 hard-pressed Oakland, which had laid off police and made other cuts, needed to put $38.5 million into the depleted closed system. So the city issued a $212 million pension bond and gave itself a four-year contribution holiday.

Since taxable pension obligation bonds began in 1993, said the four-year-old Oakland auditor’s report, there have been more than 350 pension bond issues, roughly 100 of them in California for $11 billion.

The state treasurer’s office was still putting the pension bond total at $11 billion last fall, said a Center for Investigative Reporting analysis, which found pension bond gambles not panning out so far for Richmond, Pasadena and Merced, San Bernardino and San Diego counties.

A study by Alicia Munnell and others at the Center for Retirement Research at Boston College in 2010 was based on $53 billion worth of taxable pension bonds issued by 236 government agencies since 1986.

Most of the pension bonds issued since 1992 were in the red after the financial crisis, the study found. The issuers of pension obligation bonds often are fiscally stressed and in a poor position to handle investment risk.

“Nevertheless, it appears that POBs have the potential to be useful tools in the hands of the right government at the right time,” the study concluded. “Issuing a POB may allow well-heeled governments to gamble on the spread between interest rates and asset returns or to avoid raising taxes during a recession.”

In California, one of the attractions of a pension bond is that large debt, providing temporary budget relief, can be taken on without voter approval as required by the state constitution.

The Orrick website refers to a “judicially created exception” to the state constitutional debt limit, called “obligations imposed by law,” that allows general obligation pension bonds to be issued without a vote.

A Piedmont advisory commission said some cities use a “validation” process under the court ruling to issue bonds without voter approval. But the commission said the process apparently is not allowed by the Piedmont city charter.

When the state struggled to balance its budget in 2004, former Gov. Arnold Schwarzenegger proposed issuing a $949 million pension bond to make part of the annual state payment to CalPERS.

His initial bond proposal, picked up from the administration of former Gov. Gray Davis, was scaled back to $500 million. Ruling in a Howard Jarvis taxpayers suit, the courts blocked the pension bonds, saying a vote of the people is needed.

As the Boston study noted, the timing of a pension bond can be crucial. Stockton issued a $125 million pension bond in 2007 and put the money in the CalPERS investment fund.

A Stockton bankruptcy document said the bond money lost about a third of its value as the market dropped and then crashed in the fall of 2008. This fiscal year the city has a $30 million CalPERS payment and an additional $8 million pension bond payment.

Detroit borrowed $1.4 billion for its pension fund in 2005, a complex variable-rate plan backed by “interest-rate swaps” to hedge risk. A suit filed by the bankrupt city to erase the debt reportedly contends the plan violated the state debt limit.

Bankrupt San Bernardino, said to owe CalPERS $17 million for payments skipped last fiscal year, stopped annual payments of $3.3 million on a $50 billion pension obligation bond issued in 2005.

“The POB is also issued as a capital appreciation bond,” consultant Michael Bush told the San Bernardino city council last April, “which means the debt service goes up over time, and over the next I think 15 to 20 years actually doubles on an annual basis.”

Last week, San Bernardino elected a new mayor, Carey Davis, endorsed by outgoing Mayor Patrick Morris, a backer of San Jose Mayor Chuck Reed’s proposed pension reform initiative.

“After Tuesday night, six of seven council members are now on record as saying they want to explore reducing San Bernardino’s pensions, along with Davis, the new mayor, and a new city attorney, Gary Saenz,” Reuters reported.

San Bernardino prepared an outline or “term sheet” of its debt-cutting plan for closed-door mediation with creditors that began last November. As directed by a federal bankruptcy judge, details have not been made public.

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Calpensions.com. Posted 10 Feb 14

15 Responses to “The big casino: paying pension debt with bonds”

  1. John Moore Says:

    Pacific Grove issued 19 million in POB in 2006 to pay off its side-fund.. There was no required payment for three years, freeing up a million dollars a year for a 30% per year raise for police, but increasing the size of the POB to about 22 million dollars. About one-third of the POB money was lost in the market by CaLPERS. PG now has a new deficit of about 48 million dollars(a termination cost of 120 million) and still pays 1.7 million a year on the POB(Thru 2029). A residential charter city, its revenues last year were only 16 million dollars. It had 234 employees, it now has about 70, many part time. It has raised taxes and fees dramatically, but services are bare bones at a higher cost. PG is in a CaLPERS pool, so it is not alone, except that cities that issued POB before the crash are in deeper DOO Doo than Public Agencies that did not

  2. buck novak Says:

    I expect this all to end in a violent uprising when this game of financial musical chairs comes to its conclusion in total default. It will be the young who will be leading the charge. They will be the ones left holding the bag expected to pay these pension bonds. That is also when new parties will appear and the old corrupt order replaced.

  3. Berryessa Chillin' Says:

    It amazes me when cities don’t learn from others’ mistakes. Are there not politicians in Piedmont who can’t see what has happened to Oakland?

  4. acm_acm Says:

    If this is such a good idea, then why doesn’t every state, county and municipality tap every last line of credit they have and float as many bonds as they can and invest the money? You don’t even need a pension plan to do it.

    Here’s a hint: It’s NOT a good idea.

  5. Captain Says:

    acm_acm Says: “If this is such a good idea, then why doesn’t every state, county and municipality tap every last line of credit they have and float as many bonds as they can and invest the money?”

    Pension Obligation Bonds are illegal in most states.

  6. Captain Says:

    Berryessa Chillin’ Says: “It amazes me when cities don’t learn from others’ mistakes. Are there not politicians in Piedmont who can’t see what has happened to Oakland?”

    Berryessa Chillin’, your comment assumes Council Members, City Managers, City Attorneys, and City Finance Directors, even city employees are acting independently – or even in the taxpayers best interest. Some are but many are NOT. The bias is built into our local governments. In the case of everyone on the city payroll responsible for protecting taxpayers while managing their tax dollars, it is to their benefit to float these “Casino Bonds” because it insures funding of their own pensions and compensation, while transferring the entire burden to taxpayers left holding the bag (and taxpayers are getting nothing in return for funding these bonds that pump millions/billions into the employee pension plans). You’d think taxpayers deserve some sort of fiscal/pension reform for all these dollars, but we‘re not getting it. And, as John Moore points out in the first comment, it also frees up funds for raises (money which really doesn’t exist absent deferring debt even further into the future), which also increases the unfunded pension liability – thereby perpetuating the original problem.

    All of this is being done with CalPERS blessing. And it is being done because both CalPERS and the Public Employee Unions believe that taxpayers are on the hook for every calculated decision they make. I consider the Pension Obligation Bonds nothing more than a CalPERS and Public Employee Union:

    - hedge against their bet that TaxPayers are obligated to fund these pensions, no matter what, is proven wrong.

    - a way to free up more General Fund money to pay wage increases while hiding the magnitude of the problem, creating even more unfunded pension debt.

    My biggest issue with Pension Obligation Bonds is that they’re a short-term fix with long-term risk, while completely ignoring the root cause of the problem (the biggest risk of all); they create more issues than they resolve. That’s exactly why Oakland is in so much trouble. They wiped away the blood (Red Ink) by placing a Band-Aid on a gaping wound and calling it a solution/fix/balanced budget. Oakland never addressed their cost/spending problem. Oakland is Bankrupt – they just haven’t acknowledged it yet. Is Piedmont doing the same? If they aren’t addressing the underlying issues that created their problems then maybe they haven’t learned anything from Oakland.

    Hopefully someone from Piedmont can chime in.

  7. Captain Says:

    John Moore, I’m a huge fan of yours. And that goes back to circa 2008 and the day of the pig. I look forward to the remainder of your seven part series.

  8. Bille Says:

    So the voters are deciding that it is better to save money by getting a better interest rate than PERS offers. Let me repeat, the voters are deciding that it is better to save money by getting a better interest rate than PERS offers. Somehow, this has to be bad news. NO it is not bad news. It is smart fiscal management in difficult times.

    I am glad to see you referenced Alicia Munnell. However, while cherry-picking notes for your propaganda piece, you didn’t mention that right there on the Center for Retirement Research website there is a real news worthy report:

    “Are city fiscal Woes Widespread?”
    “Are pensions the cause?”

    The findings:

    “About 13 percent of the cities and towns in our local sample has been cited in the press as having financial problems, which is not
    surprising in the wake of the 2008 financial crisis and the Great recession. Second, fiscal mismanagement and economic issues are more important than pensions in explaining why cities are identified as being in financial trouble.” What? Fiscal Mismanagement? But Oakland has a sports arena? And they built Jack London Square? I don’t get it. Must be pensions…it must be it must be…more facts please!

    http://crr.bc.edu/wp-content/uploads/2013/12/slp_36.pdf

    In fact, in the summary of the City of Oakland Retirement System you provided, you left out one minor but important historical fact, important because it helps explain why that system was closed and new employees went into PERS. Alicia cites this reason in the report I linked above; Proposition 13.

    “In the wake of Proposition 13, two things have happened. First, many new initiatives introduced a tax cut or an expanded service without compensating financing, so much of the budget was allocated before the legislature even had a chance to negotiate. Second, the requirement for a super majority for any revenue increase made it more difficult for policymakers to raise taxes.3 The state, in effect, lost control of its finances.”

    http://crr.bc.edu/briefs/are-city-fiscal-woes-widespread-are-pensions-the-cause/

    Her conclusion:

    “The question is whether cities across the country are about to topple like dominoes. And whether pensions are the problem. The answer appears to be “no” on both fronts.”

    Next time, Wall Street and the Banksters will just have to try harder.

  9. Berryessa Chillin' Says:

    Bille, “The question is whether cities across the country are about to topple like dominoes. And whether pensions are the problem. The answer appears to be “no” on both fronts.”

    I don’t know much about municipalities in other states. I’m concerned about this state. And it is clear that the #1 and #3 cities in California, LA and San Jose, are in serious trouble due to outsized pension obligations. City #2 (San Diego) has also had its struggles. Numerous counties have large unfunded pension liabilities. For this Calpensions blog with its focus on CALIFORNIA, a forthright discussion of the pension problem in this state and possible solutions is in order.

  10. Captain Says:

    Bille Says: “So the voters are deciding that it is better to save money by getting a better interest rate than PERS offers. Let me repeat, the voters are deciding that it is better to save money by getting a better interest rate than PERS offers. Somehow, this has to be bad news. NO it is not bad news. It is smart fiscal management in difficult times.”

    Billie, did you read about Oakland’s POB’s? I guess not. If Piedmont were to sell bonds with a reduced interest rate in order to pay-off debt, financing the bonds over the same duration (or remaing years) as the current debt, then I would still not agree with you.

    The unions won’t agree to anything unless they get something in return. Why shouldn’t the taxpayers get something in return for the millions they would be contributing, in the way of Pension Obligation Bonds, to the employees pension fund. Surely providing additional funding to the employee’s pension plan provides some value to the employees: CaLPERS will show a better funding ratio, employees get millions more that is locked in to their plan, and the unions can tell the uninformed public they’ve made progress by reducing their unfunded liability.

    Unfortunately what Piedmont is probably doing is financing X amount of debt over 2X the amount of years they’re currently paying. That may free-up some money the unions will bargain for in the way of increased compensation but that only perpetuates the problem.

    What happens to the cost saving spread of the interest rate if CalPERS lowers their projected rate of return to something close to what private sector pension plans use? The savings go poof (!) and the problem becomes even larger. What happens if CalPERS continues to under perform both their expectations and their peers? When talking about extending payment terms there are no savings absent extreme fiscal discipline, but there are extreme risks as evidenced by what’s happened in Oakland.

    I’m not sure how this additional funding impacts the new Jerry Brown pension reform rules but I’m guessing it will negatively impact (for taxpayers) the calculations related to employers being able to require employee’s to contribute 50% of the normal cost for their pension plans (up to a max of 13.4% – I think). Maybe someone can comment on the issue because I haven’t seen it addressed?

    As long as the taxpayers are back-stopping every failed CalPERS policy & investment strategy, I see little upside in selling Pension Obligation Bonds, which are illegal in most states, unless significant employee contract concessions are part of the deal and the years/duration of the restructuring remains the same. Otherwise, let the employees live with the same fiscal uncertainty the taxpayers are facing.

  11. SeeSaw Says:

    I don’t understand about bonds–but as for your remark, “let the employees live with the same fiscal uncertainty the taxpayers are facing”: I don’t think you need to be informed, so its a little disgusting that you don’t even recognize public employees as members of the human race. Public employees are taxpayers and pay the same tax bills that you pay!

  12. toothbrushes Says:

    John Moore, Thanks for explaining the PGrove parking meters downtown nailing tourists. Next time I will park on a side street.

  13. Bille Says:

    The study cited here is “Number 9 2010″. In other words, only performance between the years 1992 and 2009 was studied. This study has not been updated in 3 years? Good thing nothing has changed. The results? Mixed. POBs issued in a recession or long enough before the one in 2007/08 are performing. Those that were not “timed well” are not. DOH! Buy low, sell high! Why can’t anyone get this right?

    As for how they work? Well, as my insurance agent explained to me at my kitchen table a few weeks ago, if I put X $ into a policy I can have a cash value and accumulate it over time earning Y % fixed rate. How do they do that I asked? They invest my money and expect to earn Z % and after taking fees etc. return to me Y %. Fortunately, my insurance company doe not have to use NPL to account for my policy the minute I signed up.

    I love the quote Ed uses, “most bonds issued since 1992 were in the red after the financial crisis”. It would be just as accurate to say most people who entered employment after 1992 were on unemployment after the financial crisis. Most homes purchased after 1992 were in foreclosure. I could go on and on and but isn’t pandering illegal in most states?

  14. Captain Says:

    Bille Says:
    “February 13, 2014 at 4:04 am
    The study cited here is “Number 9 2010″. In other words, only performance between the years 1992 and 2009 was studied. This study has not been updated in 3 years? Good thing nothing has changed. The results? Mixed. POBs issued in a recession or long enough before the one in 2007/08 are performing. Those that were not “timed well” are not. DOH! Buy low, sell high! Why can’t anyone get this right?

    As for how they work? Well, as my insurance agent explained to me at my kitchen table a few weeks ago, if I put X $ into a policy I can have a cash value and accumulate it over time earning Y % fixed rate. How do they do that I asked? They invest my money and expect to earn Z % and after taking fees etc. return to me Y %. Fortunately, my insurance company doe not have to use NPL to account for my policy the minute I signed up.

    I love the quote Ed uses, “most bonds issued since 1992 were in the red after the financial crisis”. It would be just as accurate to say most people who entered employment after 1992 were on unemployment after the financial crisis. Most homes purchased after 1992 were in foreclosure. I could go on and on and but isn’t pandering illegal in most states?”

    - Billie, you’re a boob.

  15. Bille Says:

    Hey Captain,

    When you aren’t smart enough to post a rebuttal, start name-calling. Glad to see you continue to keep your comments thoughtful, respectful, and intelligent. You make Ed, Marsha, David, John, all so proud.

    Ps…you quote me well. Thanks!

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