The Promise and Peril of Borrowing Money to Manage Pension Costs

Central to the plans Chicago Mayor Rahm Emanuel outlined last week for bolstering the city’s badly underfunded public employee pension accounts is a proposal to issue as much as $10 billion of bonds that would be deposited into retirement funds.

The thinking goes that the debt service costs would be less than the returns that the pension system could earn by investing the money. This is not a novel idea—other state and local governments, including Illinois, have carried out similar transactions dating back to the 1980s.

But is borrowing a wise strategy to help improve pension health? Some experts say flatly that it is not. Others say it can be, but the approach involves unique risks and whether it works out depends heavily on when the bonds are issued, and how the proceeds are invested.

“Can it work? Yes. Should it work? Yes. The mechanical challenges of executing properly are manifold,” said Girard Miller, who is retired now, but held multiple positions in the public finance and investment sector and co-authored the book “Investing Public Funds.”

“I think it’s a wonderful tool. But it has to be implemented intelligently and the public sector has a very, very difficult time accomplishing that,” Miller added.

Thad Calabrese, a professor at New York University's Robert F. Wagner Graduate School of Public Service, offered a harsher take.

“I don’t think it’s ever a good idea,” he said. “The idea of issuing debt to pay for things that are operating costs, but no one’s bothered to fund over time, it violates intergenerational equity, it violates principles of sound public budgeting.”

‘I Know This Plan Has Risk’

Borrowing is just one part of Emanuel’s pension blueprint.

It also calls for using revenues that could possibly flow in the future from sources like taxes on marijuana (if it is legalized in Illinois) or opening a city-owned casino. He also wants to amend the state constitution so there is greater flexibility to adjust retirees’ benefits.

“Those are all really strong ideas,” says Natalie Cohen, president of National Municipal Research, Inc. She raised doubts, however, about the bond component of the plan.

“What if the market goes way down?” she said. “Then all of the sudden taxpayers are covering the bonds and the pension obligations?”

But in contrast to other parts of the mayor’s plan, which would require buy-in from state lawmakers, his bond proposal could be realized under current law, with City Council approval.

If the full $10 billion were to be borrowed, that amount would be equal in size to all of the city’s bonded debt as of August, according to figures Emanuel’s office released last week. And it would rival the city’s total fiscal year 2017 revenues, which were about $9.6 billion.

However, the figures the mayor’s office issued show the city also owes about $28 billion in unfunded pension liabilities—the cost of benefits that will come due in future years.

“By issuing these bonds, we would immediately improve the health of each pension fund,” Emanuel said in a speech last week, according to a copy of his prepared remarks. Estimates from his office say the plan could result in around $6 billion of savings through 2055.

“I know this plan has risk,” the mayor conceded. “The truth is, there is risk in every choice and there is a risk if you do nothing. The question is: which calculated risk is worth taking for the benefit gained?”

A two-term Democrat, Emanuel is not seeking reelection, and is pressing for the pension package as his time in the mayor’s office winds down. His term will end next May.

The Chicago Civic Federation, a nonpartisan research organization that’s been around since 1894 and provides analysis on government finance issues for the Chicago region and the state of Illinois, as of Tuesday, had not taken a final position yet on the mayor’s plan.

“This is an enormous borrowing that the city is proposing,” the group’s president, Laurence Msall, said by phone.

“We have a lot of concerns about the risk,” he added. If the city were to borrow without other new steps to manage pension costs, Msall said “there’s not the confidence that they will have perfect market timing to ensure that the assumptions about returns outweigh the cost.”

Timing and Investments

Timing is a major factor in determining whether or not a state or local government comes out ahead when issuing pension obligation bonds, Miller said. Based on his past research, he said the most opportune time to issue the bonds is in the middle of a recession.

Issuing the bonds in the depths of a downturn, he explained, gives a government its best shot at taking advantage of market cycles to get investment returns that exceed debt service costs.

“No later than six months coming out of the recession if you want to have better than 50-50 odds of not ending up in a deeper hole in the following recession,” Miller cautioned.

Based on that guideline, now would not be an ideal time for the city to issue billions of dollars in pension obligation bonds. The economy is nearly a decade into an expansion phase, the stock market has been volatile, and interest rates are on the rise.

Miller said an option for a city in Chicago’s position might be to authorize the bonds now, and then wait until the economy tanks to actually issue them.

Apart from timing, Miller points out that decisions about how bond proceeds are invested is another crucial factor in whether benefits exceed costs with pension obligation bonds.

It’s not uncommon, he said, for a pension fund’s investment policies to call for around a third of investments to be placed in bonds, which would be unlikely to yield the sorts of returns needed to significantly outpace the borrowing costs on the pension obligation debt.

“You’re borrowing with the bond market to invest in bond markets, where is the profit to be found in that?” he said.

An alternative, Miller says, would be setting up an escrow account for the pension bond proceeds, and investing them mostly in riskier assets, like stocks, that can generate higher returns.

Cohen also highlighted that the city would likely need to turn to higher risk investments to deliver the returns needed for the pension obligation bond deal to work out in its favor.

She noted that, unlike other forms of municipal debt, pensions bonds are not tax-exempt. That means investors must pay federal income tax on their gains from them and, as a result, would typically demand higher interest rates than they would on tax-exempt public debt.

Emanuel’s office did not respond to requests for comment. But Msall said it is still not clear to The Civic Federation, based on information that the city has provided so far, what the timing would be for issuing the bonds, or what the plan would be for investing the proceeds.

One other aspect of the mayor’s plan that he expressed reservations about is that it would lock in, or “securitize,” specific future revenues to repay the bonds, something Msall said could reduce budget flexibility for the city government long after Emanuel leaves office.

“It really straight-jackets future administrations by narrowing the city’s revenue base,” he said.

A Proper Role For Public Debt?

Between 1986 and 2013, governments issued about $105 billion in taxable pension obligation debt, according to a research brief from the Center for Retirement Research at Boston College. The state of Illinois alone issued around $10 billion of the bonds in 2003.

California, New Jersey and Oregon were among the other states where the most pension obligation bond activity took place between those years, according to the report.

The 2003 Illinois deal remains notable for critics who say the state used the bond proceeds as a gimmick to plug holes in its operating budget. And, 15 years later, Illinois is still struggling with some of the worst-funded pension systems in the nation.

Moody’s Investors Service issued a report on Tuesday that said preliminary figures show unfunded liabilities for the state’s five statewide plans were about $133 billion in fiscal 2018.

The state’s largest plan, which covers teachers, had a funded ratio of just 40.2 percent in 2017, according to Public Plans Data.

In line with what Miller described, the Center for Retirement Research report found that whether the bonds worked out in favor of the state or locality issuing them depends on timing.

For example, from 1992 to 2007 the “average internal rate of return” for hundreds of bonds the researchers analyzed was positive, at about 0.8 percent. Extend the timeframe through 2009, and the Great Recession, and the average rate of return drops below zero, to negative 2.6 percent. Stretch the timeframe out further, to 2014, and the rate of return rises back up into positive territory to 1.5 percent.

Fred Thompson, an emeritus professor of public management and policy at Willamette University, and a former member of Oregon’s Bond Advisory Board, said in an email this week that there can be good reasons for issuing bonds to narrow a pension funding gap.

One, he said, is that it is better to make financial obligations “explicit”—in this case debt service payments, as opposed to the less ironclad requirements state and local governments have to appropriate money each year to keep pensions adequately funded.

Another reason, in Thompson’s view, is that it is “a lot cheaper to borrow in public markets than to borrow informally” by underfunding a pension system.

Calabrese doesn’t see it this way. The proper role of debt in public finance, in his view, is the acquisition of infrastructure, and other long-term assets. “It’s not to invest in the stock market.”

The only way to deal with ill-funded retirement systems, he contends, is getting more assets into pension trust funds—not by borrowing—but by actually diverting revenue from other places in public budgets, and then enacting reforms that shrink liability.

“This is a tough problem,” he said.

Beyond the Bonds

For officials in Chicago, Illinois, and other places with troubled pension systems, the thorny political and legal realities of tackling the problem are familiar.

A handout from Emanuel’s office shows steps his city and the state have taken since 2010 to address pension costs, like a $543 million property tax increase to fund police and firefighter pensions, and an agreement with teachers for new employees to make their full contributions to their plans, instead of employers picking up the bulk of the expense.

In 2015 and 2016, the Illinois Supreme Court overruled state laws meant to rein in pension costs. The state constitutional amendment that Emanuel is calling for would alter a clause protecting pension benefits that the court cited in its rulings.

He has singled out compounded 3 percent cost-of-living adjustments, or COLAs, as an especially problematic retirement benefit, ripe for change. The amendment he’s supporting would clear the way for this.

“A 3 percent compounded COLA in an era of very low inflation is not progressive and not sustainable,” the mayor said last week.

Emanuel cited estimates suggesting that over the next 40 years the city would contribute $42 billion to its pension funds to cover the cost-of-living adjustments alone.