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Pension Obligation Bonds No Panacea for State Budget Liabilities

Illinois has a new governor and Chicago will soon have a new mayor—and the same old underfunded public pensions. Inheriting a predecessor’s debts is never fun, but the need to address them is unavoidable. The question is how, and there is both a right way and a wrong way.

The right way is to adopt policies that keep the debt from growing, help pay it down, and avoid it growing out of control in the future again. The wrong way is to kick the can down the road. Unfortunately, many state and local governments often opt for the latter route. One way they do this is by issuing pension obligation bonds, which as the Reason Foundation’s Marc Joffe explains, “just converts one type of debt to another.”

The attraction of pension obligation bonds—and idea outgoing Chicago Mayor Rahm Emmanuel has floated—is that they can superficially look like “refinancing,” but they’re not. State and local governments can use pension obligation bonds to lower their current payments into their pension plans, but long-term savings are illusory. As Forbes columnist and actuary Elizabeth Bauer explains:

Certainly, promoters of Pension Obligation Bonds are hoping to capitalize on the perception of “refinancing” as an ordinary household money-saving tool. Consumers with credit card debt can reduce the amount they spend on interest by taking out a home equity loan with a lower interest rate, then paying off their debt. Likewise, if your mortgage has an 8% interest rate and you have the chance for a 4% interest rate, you can reduce your spending on interest by paying off the 8% mortgage with the proceeds from a new 4% mortgage.

But that’s not how it works in the public sector, because the payment obligations are fixed. Bauer concludes:

Whether a 4% rate or a 7% rate or another rate is chosen to determine the present value of those benefits for financial reporting purposes will not change the future benefit payments. And issuing a bond and reducing the expense reported, in total, because of a lower interest rate, does not impact the ultimate cost of those benefit payments.

The liabilities are still out there. The bonds have to be paid back. The taxpayers gain only if the actual return on the money invested with those bonds exceeds the interest rate the city pays to bondholders.

The problem, Bauer notes in another column, is that current incentives such can-kicking practices.

[O]nce it’s accepted that pensions are funded at some point in the future, it creates conditions for gaming the system, a form of borrowing from future generations in which lawmakers can hide the full extent of their promises from taxpayers, and enable a whole chain of benefit-boosting practices such as pension spiking.

Long-lasting reform requires changing the rules of the game.

What should happen? In the first place, all new employees in these retirement systems should be moved onto Social Security, as is already the norm for teachers in 35 other states. Then, their employer-provided benefits should be provided in the form of fixed contributions, either via a benefit structure that’s the equivalent to private-sector 401(k) plans or via some version of a hybrid plan which provides for pooled investments and benefits but in which participants share and smooth risks rather than the state bearing the risk.

While Bauer focuses mostly on Illinois, her recommendations are applicable to other states facing similar pension underfunding problems.