Pension bonds creeping back into the conversation

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With a global pandemic exacerbating Chicago’s pre-existing financial crisis, talk among some aldermen and policy wonks is turning to a risky financing tactic with a checkered history in Illinois: a pension obligation bond. Mayor Lori Lightfoot hasn’t rejected the idea.

Proponents say a pension obligation bond, or POB, would ease fiscal pressure as the city confronts a $1.2 billion budget gap, $31 billion in unfunded pension liabilities and a projected $756 million increase in required annual pension contributions over the next six years. Critics warn that POBs have worsened fiscal problems for other cities and raise the specter of former Illinois Gov. Rod Blagojevich’s ill-fated POB, which failed to solve the state’s pension problems.

Freshman Ald. Matt Martin, 47th, argues that City Council deliberations over the mayor’s upcoming budget should include hearings on a POB. Now "is the time when we need to talk about structural solutions so we’re not just lurching from budget to budget, year after year in quasi-crisis" about how the city will make its pension contributions in the coming years.

POBs work like this: A government borrows money from bond investors and hands the proceeds to its pension funds to invest. From there, it’s an arbitrage play: Officials hope the pension funds’ investment returns exceed the interest due on the bond debt.

Former Mayor Rahm Emanuel pitched a $10 billion POB in summer 2018. If all went well, it might have cut the pension funds’ liability to $18 billion from $28 billion. That rise in the funded ratio would, at least early on, have reduced the city’s required pension contributions and allowed the pension funds to make bigger and longer-term investments. To appease ratings agencies and attract investors, the debt would have been backed by dedicated revenues from water and sewer taxes and the city’s share of income and personal property replacement taxes from the state.

Emanuel made his proposal while he was still considering running for a third term. By December, he was on his way out, but he urged his successor to take up a POB, arguing the window of opportunity was closing and it could save $200 million in the 2020 budget without creating additional debt. He then left it for Lightfoot and the council to consider.

Conditions for a POB may be even better now. The City Council’s Office of Financial Analysis said in a February report that interest rates were even lower than when Emanuel pitched it, and "if there will ever be an appropriate time for Chicago to issue POBs, this would appear to be it."

In an analysis of more than 4,500 POBs issued by governments between 1992 and 2014, Boston College’s Center for Retirement Research—still a POB skeptic—found that pension bonds earned an average 1.5 percent return for governments.

BIG SAVINGS?

According to the Center for Tax & Budget Accountability, a properly structured POB could save the city billions over the coming decades. Rather than one big issuance, the Chicago-based fiscal think tank suggests four or five smaller POBs to reduce market risk.

The CTBA also warns against repeating the mistakes that undermined Blagojevich’s infamous $10 billion POB in 2003. Rather than depositing all the bond proceeds with state pension funds to invest, Blagojevich diverted nearly $3 billion to plug gaps in Illinois’ operating budget.

"That’s precisely the kind of terrible POB design that takes away from the value of something like this," says Drazzel Feliu, research director at the CTBA.

But Blago’s bonds did generate arbitrage gains: The latest report from the state’s Commission on Government Forecasting & Accountability found returns through the 2019 fiscal year on the 2003 POBs ranged from 7.05 to 7.76 percent, exceeding the true interest cost of 5.05 percent.

But even with interest rates generally at historically low levels, the city’s poor financial outlook has boosted its borrowing costs. Chicago now pays interest rates ranging from 6.75 to 7.25 percent in taxable bond markets. With city pension fund investments yielding about 6.57 percent annually in recent years, the potential return on a POB might not be very great. Proponents argue the city could get lower interest rates around 5 or 6 percent.

But the results of any POB depend heavily on timing and the direction of stock markets over the course of the financing.

"If the assessment date is the end of 2007—the peak of the stock market—the picture looks fairly positive," the Boston College analysis found. "If assessed in the middle of 2009—right after the market crash—most POBs appear to be a net drain on government revenues. And, as of February 2014, the majority of POBs have produced positive returns due to the large market gains that followed the crisis. Only those bonds issued at the end of the market run-up of the 1990s, and those issued right before the crash in 2007, have produced a negative return; all others are in the black."

Chicago is not as financially well positioned as other cities to withstand market downturns. Poorly timed POBs exacerbated financial troubles in Puerto Rico, Detroit and Stockton, Calif. And ` Chicago were to issue a POB just before a long stock market slide, it could lose money on the deal for years, warns city Chief Financial Officer Jennie Bennett.

PART OF A PLAN

While a POB can reshape the curve the city is climbing—helping to reamortize the city’s liabilities and lower the contribution ramp—Chicago could only sell the idea to ratings agencies if it’s part of an overall pension reform plan and does not include "scoop and toss" debt refinancing practices that previous mayors resorted to, Bennett says.

"We want to see ways that we can convince rating agencies that it’s not just about borrowing, it’s not just about moving out debt, but it’s a lot about how it is that you’ve reformed and restructured your liabilities and changed it in a way that’s more efficient for city government overall," she says.

Matt Fabian, a partner at Municipal Market Analytics who leads the firm’s market and credit research, says Chicago would be better off with short-term borrowing. The market swings over the 20- or 30-year term of a POB are unknowable, he says. It might work out, or could put the city in a deeper fiscal hole: "You can send your 10-year-old to take your Ford F-150 to go pick up soda and lunch and come back. He comes back fine. Was that a good idea?"

via Crain’s Chicago Business https://ift.tt/1mywUHL

October 18, 2020 at 08:57AM

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