As the California Public Employees’ Retirement System (CalPERS) adopts more realistic actuarial assumptions and addresses unfunded liabilities, it is raising employer contribution rates for its 3,900 local government pension plans. Some local agencies in California, like the city councils in Chowchilla and the Ridgecrest, are considering pension obligation bonds (POB) to meet the rising bills. But recent stock market volatility reinforces our argument that POB issuance is a risky strategy.
In October, the S&P 500 dropped 7 percent and, as of this writing, is down for the fiscal year that began July 1. If stocks continue fluctuating like this, CalPERS and other large pension systems may log 2019 returns below assumed rates, resulting in fresh actuarial losses and more unfunded liabilities.
A bear market, like the one seen in 2008, could produce even steeper actuarial losses. But for POB issuers, an already bad situation would be even worse: their newly invested bond proceeds would shrink. The value of their investment may never recover to the point at which it equals the principal and interest payments to bondholders, leaving the local agency in worse shape than before.
So, correctly timing a POB issuance is both crucial and difficult. Ironically, the best times to issue POBs are also the most politically difficult. Issuing a POB in 2009 would have probably worked out well for just about any government. But in the aftermath of a market crash, POB advocates in any given community would have been hard-pressed to gain support.
The worst time to issue a POB is near a market top, but, of course, it is impossible to know ahead of time that the market is peaking. That said, we can say with confidence that a market that has been rising for nine years is more likely to peak than one that has just crashed.
So, today’s environment of rich valuations is not the best of times for POB issuance. Indeed, issuers could be in for a repeat of the fiasco that befell Puerto Rico, which issued POBs at the beginning of the 2008 crash— a move that contributed to the commonwealth’s bankruptcy and the transition of its Employee Retirement System to a pay-as-you-go basis (i.e., one with a funded ratio near zero). With that in mind, let’s look at three recent pension bond issuance cases in California.
Located in the affluent eastern suburbs of Los Angeles, La Verne is a pension obligation bond veteran, having previously issued a series in 2006, which have now been redeemed. In July, the city once again issued $54 million in POBs maturing between 2019 and 2044.
Coupon rates on the bonds ranged from 2.7 percent for the 2019 maturity to 4.32 percent for debt maturing in 2044. According to the State Treasurer’s Debt Watch database, the True Interest Cost (TIC) for the issue is 4.22 percent. The TIC is much higher than the simple average of the highest and lowest coupons for a couple of reasons. First, the bond issue is heavily weighted to later maturity dates: more than half the bonds mature in 2038 or 2044 and pay coupons above the TIC. Second, the TIC applies to bond proceeds net of issuance costs. For the La Verne POB, costs of issuance totaled $500,000 or almost one percent of the bond’s face value.
Municipal bonds are often recommended as a financing alternative because their coupon payments are exempt from federal income tax, and often exempt from state income tax as well. As a result, municipal issuers should be able to pay lower interest rates than otherwise since investors will compare their after-tax return to those provided by other options. But this benefit does not apply to pension obligation bonds. POBs are taxable, just like corporate bonds, and thus do not provide tax-related interest savings to the governments that issue them.
That aside, it is still noteworthy that La Verne obtained a TIC of 4.22 percent, well below CalPERS assumed rate of return of 7 percent. The city benefited from a low interest rate environment and a strong S&P bond rating of AA+, just one notch below the top AAA level.
In its ratings announcement, S&P cited La Verne’s solid economic base and a strong reserve position for the relatively high rating. This begs the question of whether the city could have made accelerated CalPERS contributions or established a Section 115 trust for additional pension funding. In either case, the city would have used existing resources to cover pension obligations that it has already incurred rather than shifting the bill to taxpayers in 2038 and 2044.
Chowchilla, a small Central Valley city, paid over $900,000 to CalPERS in its 2016-17 fiscal year. According to CalPERS , annual contributions are projected to reach almost $1.8 million by fiscal 2024-25—almost doubling from recent levels.
In August, the city council approved a pension obligation bond issue, but the bonds have not been issued as of this writing. Chowchilla’s financial advisor estimated that the city would enjoy net savings of $145,000 per year from the issuance. The estimate was based on an interest rate of 4.5 percent for the bonds.
Whether Chowchilla can issue at that rate remains to be seen. Thirty-year Treasury bonds have risen about 0.35 percent since the summer. Also, Chowchilla is rated lower than La Verne and Tulare County. S&P rated Chowchilla single-A when it sold lease revenue bonds last year. The bond issue itself was rated AA because it was insured by Assured Guaranty. Chowchilla could also buy insurance for its pension obligation bonds, but the insurance premium is a cost of issuance that would raise the city’s True Interest Cost. The projected savings of $145,000 is less than one percent of annual municipal revenue, leading one to wonder whether the risk of a pension obligation bond issue is really worth it for Chowchilla.
Tulare County, located in California’s Central Valley, operates its own pension system, which, like CalPERS, struggles with underfunding. In its 2017 actuarial valuation report, the system’s actuary found that the system was only 74 percent funded on a market value basis and recommended increasing employer contributions from $38 million in fiscal year 2017-18 to $52 million in 2018-19.
The county responded by issuing $251 million in pension obligation bonds in June. S&P took a somewhat dimmer view of Tulare’s POBs, rating them AA-, or two notches below those of La Verne. Moody’s, also asked to rate the issue, was even more pessimistic, assigning an A1 rating to the issue (equivalent to A+ on the S&P scale, one notch below AA-). Moody’s rating on Tulare’s POB was also two notches lower than the rating it assigns to the county’s general obligation bonds noting:
The two notch distinction between the A1 pension obligation bonds (POBs) rating and the county’s Aa2 Issuer rating reflects the strong legal features of California general obligation bonds that are not shared by unsecured debt such as POBs.
Despite the lower ratings, Tulare enjoyed funding costs similar to La Verne’s. The True Interest Cost reported by the State Treasurer was 4.2 percent. Tulare’s bonds mature earlier and its cost of issuance as a percentage of the bond issue was lower than La Verne’s. These factors appear to have offset the financing cost impact of the lower rating.
The only other pension obligation bonds listed in the state treasurer’s system for 2018 are from Herald Fire District and Orange County. The Herald Fire Protection District borrowed $470,000 from a local bank to retire its CalPERS obligation and exit the system. Although the district’s debt took the form of a bank loan rather than a bond, it still had to be reported to the state treasurer.
The Orange County POBs are short-term in nature and appear to be more of a cash management tool: by making pension fund contributions early, the county can achieve contribution rate savings that exceed the cost of the bonds.
In 2017, the cities of Brawley, Inglewood, Monrovia and Riverside collectively reported over $200 million of POB issuance to the State Treasurer.
Admittedly, La Verne and Tulare County have sold their pension obligation bonds at a relatively low cost and have a reasonable chance to achieve cost savings from these issues. If, however, we experience a repeat of 2008 market conditions in the coming months, their moves will seem ill-advised in retrospect. Chowchilla and any others thinking of making the leap ought to take the recent choppy market as a warning sign.