Precisely because governments are viewed as perpetuities, public pensions use an “expected” rate of return on their invested assets rather than a more conservative, risk-free rate as is required of private companies. When the public plans’ investment returns fall short of the expectations, as they have in many plans over the past decades, an unfunded actuarial accrued liability is the result. Public employers are expected (and in some states, obliged) to pay an annual contribution for unfunded liability on top of their normal actuarial costs.
Needless to say, the public finance community is constantly looking for clever ways to reduce these annual burdens and improve the pension funds’ actuarial balance sheets. If they can find a way to pump up the assets held by the pension fund that requires lower annual costs for the employer, the hired financial professionals who collect fees for their ingenuity are rewarded for that fiscal alchemy.
The alchemists of old never did figure out how to turn lead into gold, but that doesn’t prevent the pension-finance wizards from coming up with clever new tactics to try to do much the same thing, and taxpayers have good reasons to be wary.
One way to put a quick sheen on pension funds’ balance sheets is to issue municipal bonds at a lower rate of interest than the pension fund is expected to earn. These “pension obligation bonds” (POBs) have a long and checkered history. The first one was sold tax-exempt by the city of Oakland, Calif., in 1985. It stirred up a hornet’s nest at the IRS, which quickly realized that the lower tax-exempt interest rate was subsidized by Uncle Sam in a no-brainer for the pension fund that in theory could just invest in taxable bonds to make a profit, even without risking money in stocks. Congress was prodded to prohibit the use of tax-exempt debt where there is a profit-seeking investment “nexus,” and thus was born a thick book of IRS “arbitrage” regulations. Consequently, POBs must now be taxable, with a higher interest cost.
When interest rates are low, as they are today, the underwriters and many financial consultants come out of the woodwork to pitch their POB deals. The lure is always the same: “Over 30 years, you will save money because history shows it’s almost a certainty that stocks will outperform low bond yields,” even if they are now taxable. I’ve written extensively on the foreseeable cyclical risks of selling POBs when the stock market is trading at record high levels: The underwriters and deal-peddlers will sneak away with their fees from the deal, and public officials will be left holding the bag whenever an economic recession or stock-market plunge drives the value of their pension funds’ “new” assets below the level of their outstanding POBs. The Government Finance Officers Association (GFOA) has long opposed POBs for this reason, among others. POBs make sense to me only when they are issued in recessionary bear markets.
California has seen a stream of POB deals because the state pension system, the California Public Employees’ Retirement System (CalPERS), has a unique practice in the way it credits municipal employers who belong to a special pooled investment fund that CalPERS administers. Unlike a traditional statewide pension fund where every employer contributes on equal terms (as is the case for the state’s teachers, who don’t fall under CalPERS), the CalPERS municipal pool keeps a separate actuarial account for each employer, which fluctuates uniquely on outcomes of its employees’ and retirees’ actuarially assumed behaviors, while sharing investment returns proportionately among all. (CalPERS’ system also establishes “sidecar” accounts for these employers, which seem to operate in mystical ways that may deserve a closer look by the alchemy detectives.)
Each employer has a unique annual contribution rate for its unfunded actuarial accrued liability (UAAL). When an employer prepays its UAAL, it enjoys a 7 percent (of prepaid UAAL) annual reduction of its required contributions. But if the CalPERS pool fund thereafter earns less than 7 percent compounded, a new unfunded liability will be attached to the POB issuer’s pension-asset subaccount, thereby starting another new round of unfunded liabilities. In other words, there is no free lunch, and there are no magic beans.
Another strategy that is gaining some traction involves the conversion of public assets into pension assets. This takes several forms. One is asset-in-kind (AIK) contributions, whereby a public employer transfers an income-producing asset it owns to the pension fund. Obvious candidates are public utilities and toll roads, which collect user fees. In New Jersey, the state transferred control of its state lottery to the pension fund as an AIK transaction that produces income for the fund. How such AIK assets are valued and how they will earn the actuarially assumed rate of return are debatable issues. And it’s a fair question to ask whether these deals just rob Peter to pay Paul, with little or no long-term intrinsic value.
Then we have the sale-leaseback deals. Here, a public employer sells property that it uses to a private counterparty, a “building authority” or a dummy corporation, with a long-term leaseback attached so that the public employer becomes a tenant and not the owner. The employer receives a lump-sum payment on the sale which is then contributed to the pension fund. The pension fund simply invests these assets like any other money it receives. UAAL is reduced, the employer’s annual contribution requirement is shaved, and its elevated pension cost is replaced by annual rent payments, which are hopefully less. But as with POBs, the risk here is that the pension investment returns fail to return enough to exceed the new annual rent payments.
In muni finance, it is often the case that a sale-leaseback can be structured as a tax-exempt lease. But if the proceeds of that transaction are ultimately used to fund pension investments, there is an obvious red flag of “nexus” under the IRS arbitrage regulations. Taxation of the rental payments could blow up such deals. Even if they somehow dodge that test today, it’s pretty certain that such shell games will be prohibited in future regulations, because it’s completely antithetical to the intent of muni tax policy.
A few bankers pitch the concept that public agencies inherently should not be property owners — that they should instead be tenants — on the theory that taxpayers should pay only for the use of buildings, not their ownership. That’s a cheesy rationale, given that profits will inure to owners under a sale-leaseback, and most taxable lease-purchase transactions will have a higher annual net cost to the public-sector tenants than they would pay using tax exemption.
In California, Idaho and other states with restrictions on public debt without voter approval, there may be instances where tax-exempt facility leasing is expedient. But expediency alone should not lead unwary local leaders into a such a pension deal. These deals will stink if the tax exemption blows up — or if employers are still paying debt service on the facility that’s in play, which would double-bill the taxpayers. There are plenty of smart taxpayers and watchdogs out there who can tell fool’s gold from the real thing.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management.
