California agencies gamble on pension bonds to cover debts – and lose

The city of Richmond issued a $36 million pension obligation bond in 1999. Today, it owes more than $12 million on the bond, plus about $5 million in interest, and its pension fund remains roughly $12.5 million short.

Credit: Ramin Rahimian/For The Center for Investigative Reporting

Desperate to cover a $40 million shortfall in its pension fund for retired police officers and firefighters, the city of Richmond, Calif., turned to an exotic loan. 

But instead of tightening spending after it issued the $36 million pension obligation bond in 1999, city leaders turned around and increased the retirees’ pensions.

Today, Richmond still owes more than $12 million on the bond, plus about $5 million in interest, and its pension fund remains roughly $12.5 million short. To narrow that gap and cover the debt, the city is dipping into proceeds from a supplemental property tax on residents and businesses. The city’s fiscal approach has residents like Joe Bako scratching their heads.

“When you’re short on funds, you don’t start spending more,” said Bako, 33. “Do I want to be on the hook for paying for this bond? No, of course not. It’s another example of a lack of accountability. City officials made a bunch of bad decisions, and now the only recourse is to hit taxpayers.”

Some public officials and investment bankers have portrayed pension obligation bonds as a good way to shore up pension funds. Governments sell bonds to investors to plug shortfalls and reinvest in the hope of generating some profit for their pension funds. The proceeds can be invested in the stock market, reaping returns potentially higher than the bonds’ interest rate.  

But that gamble is not panning out so far for at least five pension obligation bonds issued by California public agencies between 1999 and January, an analysis by The Center for Investigative Reporting has found.

In addition to the City of Richmond Police and Firemen’s Pension Fund, agencies with pension bonds in the red include Merced County and the Pasadena Fire and Police Retirement System.

Average returns on investments also have not kept pace with net interest costs on recent bonds in two other California counties: San Diego and San Bernardino. But because those bonds were issued within the past six years – and won’t mature for many more – it is too soon to determine how they will perform in the long term.

Since 1999, local governments and special taxing districts in California have sold more than $11 billion in bonds to shore up their pension obligations, according to the state treasurer’s office. Despite the bonds’ risks, there is little regulatory oversight in California, financial experts say.

Emboldened by the infusion of cash from pension bonds, some municipalities have enhanced employee pensions or buttressed needs elsewhere by suspending pension contributions.

“It is basically a principle where they’re printing money,” said Chester Spatt, a former chief economist for the U.S. Securities and Exchange Commission and a finance professor at Carnegie Mellon University. “This is at the heart of one of the lessons of (the financial crisis of) 2008. These (bonds) strike me as irresponsible, especially in light of what we’ve learned. Are there free lunches in financial markets? No.”

The bonds do not require voter approval and, by the time they are paid off, many of the public officials who approved them are long gone.

“The decision happened before I got here,” said Bill Lindsay, who became Richmond’s city manager in 2005. “Applying hindsight to investment returns, I wish I could do that for my entire life. Investment returns over the last eight years have been terrible.”

Yet even after the downturn, and with growing knowledge of the risk involved, many governments continued to rely on pension bonds.

In the five places in California where pension bonds are underperforming so far, the shortfall also warns of deeper financial problems, said Thad Calabrese, assistant professor of public and nonprofit financial management at New York University. Residents of such areas might face service cuts and higher taxes, he said – or worse.

In many cases, pension obligation bonds signal a weaker financial condition,” Calabrese said. “Instead of negotiating with the unions and imposing pension reforms, for example, this is a way of kicking the can.”

Pension obligation bonds figured prominently in last year’s bankruptcy in Stockton, which issued $125 million in pension bonds in 2007 – after it had improved retirement benefits and compensation several times.

Stockton’s invested pension bond proceeds lost about a third of their value in the stock market crash. When the city filed for bankruptcy, it still owed $124 million, plus nearly $115 million in future interest. The city is seeking to wipe out at least some of this debt through the bankruptcy.

Detroit, the largest U.S. city to file for bankruptcy because of a shrinking tax base, declining population and other factors, failed to realize expected returns after issuing pension bonds in 2005 and 2006.

“Detroit, like most of the people that issue these, doesn’t have the ability to bear the risk involved in investing in these bonds,” said Jean-Pierre Aubry, assistant director of state and local research at Boston College’s Center for Retirement Research. “It’s the last resort. For the most part, the cities and counties that are issuing them don’t have many other options.”

Illinois, which has the largest pension shortfall in the U.S., sold more than $2.2 billion in municipal bonds from 2005 to early 2009, according to the SEC. In March, the agency charged Illinois with securities fraud, in part for misleading investors about the effect of the state’s pension contribution holidays enacted in 2005.

Credit rating agencies increasingly are downgrading the creditworthiness of public agencies with pension bonds – even those not in the red – which can make future borrowing more expensive. Earlier this year, Moody's downgraded pension bonds in California’s Santa Clara, Marin, Contra Costa and Sacramento counties.

In 2010, lawmakers in Pennsylvania prohibited the state from using pension obligation bonds, citing the financial risks. And the federal Government Accountability Office has warned that pension bonds can leave some governments “worse off than they were before.”

Pension bond pioneer Oakland struggles

The nation’s first pension obligation bond was issued in 1985 for $222 million by the city of Oakland, Calif., with the help of Wall Street.

Roger Davis, a lawyer who consulted on the deal, said it was pulled together by the then-city manager and Goldman Sachs, with assistance from his firm, Orrick, Herrington & Sutcliffe. It may well have been conceived, he said, to enrich the pension fund without adding to the debt load.

At the time, that was a safer bet. Public agencies could issue bonds at a tax-exempt interest rate and invest in annuities, in most cases guaranteeing a rate of return higher than the interest owed for the bond. The following year, however, federal legislation prohibited that practice by forcing municipalities to sell bonds that were subject to federal income tax.

A growing number of jurisdictions continued to turn to the bonds to cover raises and benefit increases given out in flush years. Then economic downturns sapped the investments.

That was the case in Oakland, which issued another pension bond for $436 million in 1997 and suffered heavy losses when the stock market plunged 11 years later. Had the city contributed annually to its pension fund instead of issuing this other pension bond, it would be about $250 million richer, according to a consultant’s report prepared for the city’s auditor in 2010.

Debt deepened when the city took a 15-year break from making police and fire pension contributions. The payments resumed in 2011, but last year, the city issued another pension bond for $212 million.

“They’re on their third credit card,” said Alameda City Manager John Russo, who voted against the 1997 bond when he was a member of the Oakland City Council and served as its finance and management chairman. “It is being used to pay the interest on the credit card, or bond, they took in 1997, which was dealing with the interest and payments that hadn’t been properly made on the bond issued in 1985.”

Oakland’s current plan is to help balance the budget by taking another pension contribution holiday through June 2017. Budget problems also have forced the city to shed a quarter of its police force since 2008, from more than 800 officers to more than 600.

Some city officials defend the recent pension bond as a strategic move that capitalized on low interest rates. A supplementary tax on property owners in the city will generate an estimated $68 million this fiscal year, said Scott Johnson, who until earlier this month was Oakland’s assistant city administrator. That will help repay some of the bond and the system’s unfunded pension obligations, he said.

“I feel we’re in a strong position,” Johnson said. “I think it was the right thing to do for our city.”

Falling short in Richmond

"Investment returns over the last eight years have been terrible,” said Richmond City Manager Bill Lindsay.

Credit: Ramin Rahimian/For The Center for Investigative Reporting

Richmond City Councilman Nathaniel Bates was concerned about going into such deep debt to close the gap in promised retirement benefits.

But minutes of a 1998 council meeting indicate then-Finance Director Anna Vega reassured him that the $36 million in pension bonds would “establish a reserve instead of having an unfunded liability.”

Bates joined the council in a unanimous vote. Later, he also agreed to approve inflation adjustments for current police and firefighters, which under the city’s charter meant increases also went to the roughly 65 retirees and spouses remaining in the city’s police and fire pension plan.

Through 2012, the most recent year for which figures are available, the return on Richmond’s pension investments averaged 4.9 percent, falling short of the bond’s net interest costs, 7.4 percent. The pension obligation bond will not be paid off until August 2029.

The city owes $2.3 million for debt payments on the bond this fiscal year, an amount that would cover compensation and health and other benefits for 15 police officers. Meanwhile, lower-than-expected property tax revenue will force the city next month to consider slicing $3 million from this year’s budget, though officials have not yet settled on specific cuts.

And the pension bond is not the only negative drain on the pension fix-it plan. Since the city issued that pension bond, police pensioners have received nine benefit increases ranging from 2.5 to 5 percent, and fire pensioners have received six bumps ranging from 2 to 5 percent.

Lindsay, the city manager, defended the pension enhancements, saying they were done out of fairness and were tied to salary increases for current police and firefighters.

“It was an equity issue,” Lindsay said. “The City Council felt like those employees contributed to the city and earned a pension. Part of it is about maintaining a standard of living in their retirement.”

Today, Bates says he regrets that taxpayers have had to pick up the tab for both the pension debt and retirement fund. But back in 1998, he said, he knew the city needed a quick infusion of cash.

“Maybe in hindsight, it doesn’t look good,” he said, “but there was no alternative available.”

This story was edited by Amy Pyle. It was copy edited by Nikki Frick and Christine Lee. 

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