States Borrow to Cover Pension Fund Shortfalls

By Michelle Kaske 

May 10, 2012 - BLOOMBERG BUSINESS WEEK

Debt-burdened U.S. states and municipalities were grappling with about $900 billion in long-term unfunded pension liabilities as of 2011, according to a Boston College analysis of 126 plans. The solution for some local governments from California to Florida: Take on more debt.

State financial authorities are betting the pension assets they now manage will get better returns as the U.S. economy recovers and stock and bond markets improve. If so, states can take advantage of today’s ultralow borrowing costs to strengthen their retirement plans now—and pay off the debt later when pension funds generate returns robust enough to more than cover their annual payouts. Local governments sold $4.96 billion of pension bonds in 2011, the most since 2008, according to data compiled by Bloomberg. In California, Pasadena issued pension bonds in March. Oakland, Calif., and Fort Lauderdale are among issuers considering a bond sale later this year. Illinois, which has one of the country’s most poorly funded public pension funds, borrowed a total of $7.2 billion in 2010 and 2011.

This strategy could backfire if state retirement fund returns don’t rebound. Recent history isn’t encouraging: In the decade through June 2010, the nation’s biggest state retirement systems earned less than half of what they needed to keep up with pension obligations, according to a Bloomberg survey. Borrowing to pay pension benefits “is risky for a government,” says Douglas Wood, Fort Lauderdale’s director of finance. “If the market stays down and the pension systems don’t earn their fair share on their return, then over time the city has to make that up” from its general budget.

Pension fund managers are still trying to recover from the 18-month recession that pulverized stock and real estate markets. The California Public Employees’ Retirement System, the largest U.S. pension, voted in March to lower its assumed annual rate of return to 7.5 percent from 7.75 percent, matching its 20-year average gain. “The pension problem creeps closer and has gotten bigger partially because of investment returns and partially because states haven’t contributed all that they were supposed to,” says Peter Hayes, a managing director at BlackRock (BLK), which oversees about $105 billion of municipal bond investments.

Pasadena, a city of 137,000, is betting it will earn more from its retirement fund investments than the 1.76 percent yield it must pay on the $47 million of pension bonds it issued in March. That yield will change after three years. The city projects a 6 percent annual return rate for its Fire and Police Retirement System. By issuing the pension debt, Pasadena will avoid paying an additional $15 million annually from its general budget for at least the next three years to keep the system funded at 85 percent of its liabilities, says Andrew Green, Pasadena’s finance director. “The determination was made that this was the best route to go and the least impactful on service levels,” he says.

If the markets do not cooperate, states will have compounded their current troubles, says Jean-Pierre Aubry, assistant director at the Center for Retirement Research at Boston College. Pension bonds represent “a risk like any other in terms of investing in the market—but the additional risk is that you have a hard debt on your books that must be paid,” he says.

The bottom line: States are issuing pension bonds to cover an estimated $900 billion retirement fund shortfall, a risky move if markets don’t recover.