| Many state and local governments, facing ballooning pension promises
to police officers, firefighters, teachers and other public employees, are
rushing to sell bonds to cover the shortfall. That strategy has sometimes
backfired in recent years, leaving taxpayers on the hook for even more
debt.
States and municipalities are drawn to bond sales because they bring instant
cash, easing budget pressures without further tax increases or reductions
in retirement benefits.
But critics say the bonds could prove costly for some officials using them
— and for the local taxpayers. The cities and states have to pay a fixed
rate of interest on the bonds, and are essentially betting they can earn
a higher rate of return by investing the proceeds in their pension funds.
But recent investment losses have already left some cities and states on
the hook for a mounting debt, covering not just the retirement money for
their workers but also the interest on the bonds. New Orleans, Pittsburgh
and New Jersey have all placed losing bets in recent years.
Almost all pension funds have suffered sizable losses over the last three
years. Government pension plans can dig themselves into deeper holes because,
unlike corporate pension plans, they are not bound by federal requirements
to maintain a certain level of funding. Some have no reserves at all: they
just pay as they go, out of revenues.
With money tight, municipalities are looking for financial help. This year,
pension bonds will account for nearly 5 percent of all new municipal bonds,
up from less than 1 percent in each of the last five years.
In the first nine months of this year, Illinois, Oregon's school boards,
New Jersey's economic development authority and more than a dozen towns and
counties sold $13.3 billion in bonds for pension purposes, almost as much
as the total sold for pensions throughout the 1990's, according to Thomson
Financial.
More sales are coming. Wisconsin and Oregon each plan one before
the end of this year, and Kansas has authorized a sale. West Virginia, home
of the nation's weakest public pension plan — according to a study by
Wilshire Associates, the state teacher's plan has only $1 for every $5 is
owes — is fighting a court battle to sell $3.9 billion of the bonds
without first holding a referendum. In California, a planned $1.9 billion
bond sale for state employees' pensions contributed to the fiscal uproar
that led to the recall of Gov. Gray Davis.
Other officials have weighed the risk and declined. "It's really tough to
justify," said Robert C. North, the chief actuary for New York City's five
employee pension plans. For years, Mr. North said, investment bankers have
been urging the city to sell bonds to pay for its pension promises, and every
time, he argues against it because he believes there are sounder and cheaper
ways of financing pensions.
"On a risk-adjusted basis, the only people who can make money on this are
the investment bankers," Mr. North said.
This risk is not always made sufficiently clear, critics say, by financial
consultants who stand to make money from the bond sales.
New Orleans recently found out just how deep a hole it had dug for itself
by selling bonds in late 2000 to finance the pensions of 820 retired
firefighters. In May, city officials asked the manager of the bond sale,
UBS Financial Services, for a progress report and were shocked to learn that
the deal was expected to cost the city $270 million over time.
"We were thinking that we were going to make money on it," said Suzy Mague,
fiscal officer for the New Orleans city council.
City officials say their rosy expectations were created by PaineWebber, the
lead underwriter, when it described the bond transaction. (PaineWebber, which
collected a $3 million fee for its role in the bond sale, has since merged
with UBS.)
"It was basically presented to us as, `Look, this is really the way to go.
Even if you use the worst estimates, you still break even,' " said Scott
Shea, a former city council member who served on the budget committee at
the time.
According to Ms. Mague, PaineWebber said New Orleans would probably have
to pay about 8.2 percent interest on the bonds. PaineWebber predicted that
the city could expect to earn 10.7 percent a year, on average, by investing
the proceeds, mostly in stocks, a prediction based on returns from 1983 to
1999 — a period that encompassed the greatest bull market in history.
A spokeswoman for UBS said that the company did, in fact, include less favorable
possibilities in its presentation, and did not suggest that 10.7 percent,
or any other rate of return, was guaranteed.
Mr. Shea said he asked PaineWebber about risk. "I frankly don't recall anybody
telling me, `Look, if the market tanks, you'll be in worse shape than if
you had never sold the bonds,' " he said.
New Orleans issued bonds worth $171 million in December 2000, and almost
immediately, the stock market tanked. Instead of returning 10.7 percent a
year, the investments have suffered losses of about 3 percent a year.
By June, only $98 million was left — enough to pay the firefighters'
pensions for just a few more years. When the money runs out, the city will
still have to pay their pensions — about $17 million a year — but
then it will also have to pay interest on the bonds of $16 million a year.
Pittsburgh, likewise, sold $294 million of bonds in 1996 and 1998 to buttress
a skimpy pension plan for its workers. Before that, the city was spending
about $21 million a year from its operating budget to keep the plan afloat.
After an initial spurt, the pension plan slumped again when stock prices
fell. Today, Pittsburgh is paying a total of $26 million a year to shore
up the plan and to pay its bondholders. Two credit-rating agencies recently
said they were reviewing Pittsburgh and might lower its rating because of
its indebtedness.
New Jersey had similar results after issuing $2.8 billion of bonds in 1997.
The sale was the largest of its kind then and made headlines by generating
$53 million in fees for various securities and law firms.
In the first two years, the deal looked good. New Jersey earned more than
double the break-even amount. Then the markets turned. As of June, the pension
plan's five-year average return was 1.9 percent, nowhere near enough to cover
the pension costs and the bond interest, which this year totaled $890 million.
"This money didn't build a road or a bridge, but we still have to pay it,"
John E. McCormac, the state treasurer of New Jersey said. The bonds are not
callable, so the state cannot easily refinance at a lower rate.
Officials may look past unhappy outcomes like these in part because market
conditions have improved. Stocks are rising. Interest rates are very low,
and officials see an opportunity to lock in debt at historically attractive
rates. They can also allay workers' fears that no money has been set aside
to cover their promised benefits.
Even Orange County in California is considering an issue, despite lingering
concerns over its bankruptcy proceedings in 1994.
The county got into trouble after taking on undue investment risk, something
that critics of the new issues fear will happen again as states reach for
higher returns. New Jersey, for example, has restricted pension investments
to stocks and bonds, but is now reviewing its portfolio and whether to hire
an independent money manager, as other states commonly do.
The state's auditor has recommended investing a small amount in alternative
investments, perhaps real estate, venture capital or other instruments that
may provide greater returns, at greater risk. No decision has been made.
Some state employees oppose the change, saying the risks are too great.
Their view is supported by some government finance specialists and academics,
who argue that speculative investments, even stocks, are unsuitable in pension
funds. They say that people retire on predictable schedules, and it is safest
to invest conservatively, in bonds that will mature when people need the
money.
Depending on market conditions, though, the current crop of bonds could pay
off handsomely for the governments issuing them.
An Illinois official says that the state's $10 billion bond issue was based
on an assumption that the money would earn 8 percent to 8.5 percent annually.
Illinois will pay 5.07 percent interest on the bonds. "As long as the actuaries
are right," said a spokeswoman for the state budget bureau, "we should be
safe."
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