August 31, 2018
With governments in Illinois facing steep increases in yearly pension contributions, new plans are being floated to borrow billions of dollars to stabilize ailing pension funds and relieve budgetary pressures.
The City of Chicago is considering issuing $10 billion in pension obligation bonds (POBs) to shore up its retirement systems. As part of a plan by the non-profit Center for Tax and Budget Accountability to stretch out and flatten the State’s required pension contributions, the State of Illinois would borrow $11.2 billion over eight years. Another idea, to eliminate most of the State’s unfunded liability by selling $107 billion in bonds, has not taken off.
In Illinois, talk of pension bonds conjures up memories of the State’s $10 billion POB sale under former Governor Rod Blagojevich. This blog post examines the 2003 borrowing—still a record amount for any POB issue, according to Bloomberg—and compares it with what is known so far about the City’s plans.
State’s 2003 Pension Borrowing
Illinois was in poor financial shape, with a looming budget deficit and poorly funded retirement systems, when it issued $10 billion of General Obligation bonds for pension funding in June 2003. Several aspects of the deal raised concerns from the start.
Unlike the majority of Illinois’ debt, the 30-year pension bonds were back-loaded, with much of the debt service deferred to the future. Normally Illinois statute requires bonds to be issued with level principal payments. This means that the interest payments get lower each year for the life of the bonds, resulting in a downward-sloping debt service schedule. However, with the 2003 POBs, the State opted to make most of the principal due between 2023 and 2033. This caused the debt service schedule to rise from just under $500 million in 2005 to nearly $1.16 billion in 2033.
Of the total bond proceeds, only $7.3 billion was deposited into the State’s five retirement systems to increase pension assets. Most of the remainder was allocated as follows (see pages 3 and 8 of the official statement accompanying the June 2003 bond offering for more details):
- $300 million to pay a portion of the General Funds pension contribution for FY2003;
- $1.86 billion to pay the full General Funds pension contribution for FY2004; and
- $481 million to make the first-year interest payments (known as “capitalized interest”).
The amounts used for annual contributions replaced payments that would have come from State coffers, but added to debt service costs. (The State also sold a combined total of $7.2 billion in pension bonds to make its statutorily required contributions in FY2010 and FY2011.)
The statute authorizing the 2003 POBs required the State to reduce its statutorily required contributions by the amount of interest owed on the $7.3 billion deposited into the funds beginning in FY2005. As explained here on page 16, effectively the reduction in pension contributions was used to pay the debt service on the bonds.
Information included in State bond documents on p. E-14 indicates how the bond sale was supposed to work. The $7.3 billion cash infusion reduced unfunded liabilities, thus lowering required future contributions. The State’s pension funding plan, which began in FY1996, requires annual contributions sufficient to achieve 90% funding by FY2045. However, the reduction of future contributions by the debt service payments had the effect of increasing unfunded liabilities. The State assumed that actual investment returns on the bond proceeds, measured in dollars, would be greater than debt service on the bonds, creating a net decrease in unfunded liabilities.
It should be noted that strategy’s success depends on actual investment returns—rather than assumed investment returns—in excess of debt service. As explained here, government officials and financial advisors often make the case that POBs save money because the assumed return will exceed the debt cost. Most public pension funds use the long-term assumed rate of investment return as the discount rate to determine the present value of liabilities, so lost earnings due to unfunded contributions accrue at that rate on paper. However, many economists argue that the discount rate should be much lower, reflecting the risk of pension liabilities instead of the risk of the pension assets. Using a lower discount rate would eliminate the favorable spread, or arbitrage, used to promote the sale of POBs.
Unlike assumed return rates, actual pension fund returns fluctuate from year to year depending on the performance of the stock market and other investments. An analysis by the Illinois General Assembly’s Commission on Government Forecasting and Accountability, pp. 121-122, shows that returns through FY2017 on the 2003 POBs ranged from 7.0% to 7.85%, depending on retirement system, exceeding the interest cost of 5.05%. During the period, the rate of return was less than 5.05% in five of the 14 years: FY2008, FY2009, FY2012, FY2015 and FY2016.
As noted above, the ultimate performance of the 2003 bonds depends on the dollar amount of investment returns compared with debt service payments. It remains to be seen whether this relationship will remain positive, given market fluctuations and increasing debt service payments.
After the 2003 POB sale, unfunded liabilities of the State’s retirement systems dipped to $35.1 billion at the end of FY2004 from $43.1 billion in FY2003. After that, they resumed their climb and now stand at $129.1 billion.
Some commentators have blamed the bond sale for the increase in unfunded liabilities. However, it is important to understand that, due to insufficient State contributions, unfunded liabilities were expected from the start to grow for the first 39 years of the 50-year State funding plan.
City of Chicago’s Possible Pension Borrowing
The City of Chicago is also facing budgetary pressure due to its four pension systems, which are collectively underfunded by $28 billion. Despite increasing revenues for the funds in recent years, the City faces increasing contribution schedules that jump by $370 million in FY2021 and $340 million in FY2023. To address these pressures, the City recently floated the idea of issuing POBs. In a presentation to investors, the City discussed issuing $10 billion of bonds, the proceeds of which would raise the pensions’ collective funded ratio from 26% to 53%.
The City has not proposed using any of the proceeds to cover current-year contributions, as the State did in 2003 and 2004. Nor has the City discussed putting a cap on current contributions.
The City would see near-term budgetary savings because the increased assets in the funds would reduce unfunded liabilities, lowering the contribution needed to amortize the pension debt. In the long run, savings to the City would depend on investment returns surpassing debt costs over the life of the bonds.
The last taxable bonds issued under the City’s General Obligation credit in 2017 had an interest rate of 7.045%. However, for the POBs the City has proposed to issue debt from securitized revenues, as it has recently done with the Sales Tax Securitization Corporation. That entity, which intercepts State distributions of sales tax collections and is designed to prioritize bondholders in the event of a bankruptcy, is rated AAA by Fitch and Kroll and AA from S&P, much higher than the City’s GO credit. The City has not stated whether it would issue the POBs under the Sales Tax Securitization Corporation or would seek to securitize another revenue source. Nor has the City yet detailed the structure of debt service payments on the POBs, and whether they would be back-loaded.
The performance of the invested funds depends on market conditions and is impossible to predict. However, the State’s 2003 POBs were issued less than a year after the end of a bear market, and the funds experienced strong growth until 2008. The City is contemplating issuing bonds nine years into one of the longest bull markets in history.