As Oregon schools, municipalities and public agencies face another major increase in public pension costs come July, some are considering a risky solution: issuing more pension debt.
In late June, Portland Community College's elected board approved the issuance of $200 million in new pension obligation bonds, an amount that would roughly equal its entire unfunded liability with Oregon's pension system. Since it's not a general obligation bond, and no new taxes are being imposed to repay it, the additional debt does not require voter approval.
Carol Samuels, a managing director for the bank that would underwrite the debt, Piper Jaffray, said she is also talking with a group of K-12 schools who are interested in pursuing a pooled debt issuance for the same purpose, perhaps by the end of the year.
The strategy is fairly straightforward: Issue low-interest bonds to the public, invest the proceeds in riskier, higher-yielding assets managed by the Oregon Treasury's investment management division, and use any profits to reduce annual pension contributions.
In effect, PCC would be placing a major bet, doubling down on the expected returns from the Public Employee Retirement System's investment portfolio. If those returns consistently meet expectations — 7.2% a year — and the interest rate on the bond is only 5%, it could be a big winner. If not, and particularly if the investments sustain big losses in the early years, the college could end up worse off.
The bonding strategy has been used with great success in the past by scores of public entities in Oregon looking to reduce their pension costs. That includes a $120 million pension bond issued by PCC in 2003.
The timing was fortuitous. In the four years after it deposited those bond proceeds in a side account with PERS, investment returns averaged 13% — inflating the value of its account even as PCC tapped a fixed percentage of it each year to offset its normal PERS costs. Even after the 2008 downturn, it was ahead of the game.
To date, rate credits tapped from those bond proceeds and their earnings have "saved" the college $60 million over the last 15 years. And while the overall benefit won't be known until the last debt payments and rate credits are made, Piper Jaffray estimates that PCC could save another $36 million by 2028 — as long as PERS investment returns match its 7.2% expectation.
It's not all roses, however. A variety of borrowers issued pension debt at the tail end of the last economic cycle, and they saw their initial deposits with PERS immediately drop by 27% in 2008. Coupled with automatic annual withdrawals for rate credits, their PERS side accounts were depleted to the point that it's unlikely they will generate overall savings over the life of the bond.
It's hardly surprising that schools are scrambling for solutions. They have been absorbing major increases in pension costs for the last several years and will face another this summer. Last year, PCC's total pension outlay was $23.5 million, or more than 10.5% of its total expenditures. Come July, those costs will increase by another $6 million annually.
There are other legislative proposals that could cut employers costs, but after years of inaction, no one seems to be counting on lawmakers to come to the rescue.
One of the reasons employers find the bonding strategy so attractive is that no matter what, they immediately start tapping the proceeds deposited with PERS to offset their annual pension costs. A fixed percentage of the PERS side account is drawn down each year as rate credits. So short-term budget relief is guaranteed, whether the underlying investments perform well or not.
In reality, the actual savings from the bonding can't be ascertained until all the debt payments are made and the intervening rate credits are tallied — a 20- to 25-year process. Moreover, the debt payments are typically backloaded, escalating every year until the bonds are retired.
In that way, the strategy shifts risk into the future while taking the benefits today. It also takes a soft liability, one that fluctuates with investment returns and legislative decisions, and locks in a hard liability that must be repaid.
"When we think about pension bonds, we discount the notion that there are real costs savings to be captured at all," said Jean Pierre Aubry, associate director for state and local research at the Center for Retirement Research at Boston College. "You're restructuring your payments. You're getting cost savings now on the presumption that the investments will pay off. But if they don't, you have to pay the piper eventually.
"If the money was that easy, every pension fund in the country would be doing it," he added. "But you don't see that. You see those that are cash-strapped issuing bonds."
Samuels, the bank executive, is the center of the pension bond universe in Oregon. She has spent a good chunk of her career underwriting municipal bonds, including pension bonds, for public agencies, municipalities and schools around the state. She is the go-to resource on the subject for most employers in the system, though she is not an independent adviser, as she makes her money by issuing the bonds.
Samuels says she has provided a significant amount of material for employers, emphasizing that there are no guaranteed cost savings from pension bonds. If there is a major recession and resulting market decline right out of the gate, the borrower can lose money.
One of the stress scenarios she worked up for PCC, for example, showed how a $200 million bond might work out if the recent financial crisis and its aftermath repeated itself. The projections had the PERS investment portfolio suffering a 27% loss next year, as it did in 2008, followed by the string of strong returns it has generated since, then a 7.2% return (PERS' earnings assumption) over the remaining life of the 20-year bond.
Altogether, that pencils out to an arithmetic average return of 7% over the life of the bond — well above the 5% interest rate the university was assumed to be paying in the projections. Presumably, that's a winner. Yet the result was a $35 million loss over a 20-year period, which demonstrates how powerful the impact of initial profits or losses are to the outcome.
"If we head into a recession soon, there is still high probability that this will turn out well, unless the recession looks identical to what happened in 2008," Samuels said. "I don't know an economist out there who thinks there's going to be another 2008 in the next economic and market downturn. But if we were to have another event like 2008 shortly after issuance, then the odds are they would lose money."
Two other Piper Jaffray scenarios presented to the PCC board showed far rosier outcomes.
Eric Blumethal, PCC's acting vice president of finance and administration, said administrators also relied on a study produced earlier this year by the consulting firm EcoNorthwest that evaluated pension bond outcomes under various interest rates and thousands of investment return scenarios. Depending on the interest rate and whether the proceeds were invested over one or two years (which spreads the risk of a single big downturn), the pension bonds generated a positive outcome in 59 to 83 percent of the scenarios.
Blumenthal said the PCC president's executive team tried to do as much groundwork as possible to understand the potential outcomes, and in most of them they looked positive. He said the board had very few questions when the concept was presented in May, and its members voted to approve the issuance in June. Currently, the state bond calendar indicates that the bond will be issued in November.
Kali Thorne-Ladd, PCC's board chair, says nothing is finalized yet, and that the board plans to talk with a second independent expert to get more advice. Thorne-Ladd runs an educational nonprofit and admits she's no financial expert, but she says the board is committed to doing adequate due diligence.
Most studies show that the best time to issue pension obligation bonds and invest the proceeds is when interest rates are low and assets are cheap. The worst time is when financial markets are at or near a peak.
Despite recent interest rate increases, borrowing costs are still fairly low, which means the potential spread based on an assumed return of 7.2 percent are high.
But assets are not cheap. Most indicators show that equity, bond and housing prices are high by historical standards. And after a nine-year economic expansion, may economists — including Oregon's state economist — are forecasting a recession in 2019 or 2020.
"It's all in the timing," said Aubry, the researcher at the Center for Retirement Research. "Most outward signs show that the market is at some kind of high. It's closer to 2007 than it is 2002. So there is that concern."
