By Eric Boehm | PA Independent
HARRISBURG — Sometimes the cure can be worse than the disease.
So-called “pension obligation bonds” offer an enticing way for Pennsylvania policymakers to avoid a steep increase in pension payments over the next few years, but experts warn to tread carefully.
The idea of swapping one type of debt for another can easily backfire and leave the state in even worse shape.
At a state budget hearing last month, lawmakers and the heads of Pennsylvania’s two major pension funds — the State Employees Retirement System, or SERS, and the Public School Employees Retirement System, or PSERS — discussed the possibility of selling bonds to pay off a portion of the combined $42 billion debt for the two systems.
In theory, the state could borrow up to about $10 billion on the private bond market and repay that at a lower interest rate compared to what it would pay into the pension funds.
This year, Pennsylvania is paying more than $1.5 billion in pension costs, which will grow to $4.3 billion annually by 2016.
“Generally speaking, we don’t favor borrowing to pay for debt,” said Jim McAneny, executive director of the state Public Employee Retirement Commission, which advises the Legislature on pension issues.
And while the pension debt is “ugly,” he said the bond approach would require borrowing billions to even make a dent in the obligations. Better to find a way to fund the obligations as they are, McAneny said.
Jeff Clay, PSERS executive director, told lawmakers at the February budget hearing that borrowing $9 billion — if the state could manage to do so — would only marginally reduce the contributions required over the coming decades as Pennsylvania grapples with its pensions.
Clay said bonds could be viewed as a piece of the overall solution, but he stressed there is no single answer to the problem.
It’s something of a moot point: Under current law, pension obligation bonds are illegal for the state to use.
But that rule, enacted as part of a pension overhaul in 2010, could easily be reversed, if the Legislature so desired.
State Sen. Vincent Hughes, D-Philadelphia, minority chairman of the Senate Appropriations Committee, said Monday the bonds should not be off the table, but the issue should be approached with care.
“We have to be very careful with pension bonds, because if you guess wrong, you’re in a very bad situation,” Hughes said.
He pointed to the problems that befell his hometown of Philadelphia after the city embarked on a $1.3 billion pension obligation bond sale in the 1990s.
Though the revenue from the bond sale briefly helped to right the ship, the city soon relapsed on pension payments and ended up with a deficit that was as large as it had been before the bonds entered the equation. The city then was faced with the debt to pay on the bonds, in addition to the regular pension debt.
Rick Dreyfuss, a senior fellow on pension issues with the Manhattan Institute, a national free market think tank, said the situation in Philadelphia was typical of what happens when governments use pension obligation bonds to cover pension debt.
“There are financial risks, and there are political risks,” he said.
The financial risks include using new debt to cover old debt – “like abusing your Visa to pay off your MasterCard,” Dreyfuss said. But, at least in theory, it can work by paying off the high annual costs of the pension funds with lower annual costs on the bonds, similar to how the state managed a $3 billion debt in its unemployment trust fund last year.
The political risks are far worse. With the pension funds already statutorily underfunded — and Corbett proposing a further reduction in contributions for the next five years — the pension bond can give lawmakers another incentive to underfund the plans, Dreyfuss said.
That’s exactly what happened in Philadelphia. The city used the bonds as an excuse for not fully paying into the system and soon fell behind again, into the very hole the pension bonds were supposed to have closed.
Philadelphia is not the only entity to have a negative experience with pension bonds. In fact, a recent study from the Center for Retirement Research at Boston College concluded that it was hard to find examples where pension obligation bonds worked, because they are usually undertaken by governments in poor financial straits and unable to shoulder the investment risk.
State Rep. Bill Adolph, R-Delaware, chairman of the House Appropriations Committee, said Monday that all options for dealing with the pension debt were being reviewed, but he was noncommittal on using bonds.
“I’d have to see how it affects the balance sheet, and whether it is something we would be able to pay off,” Adolph said.
Gov. Tom Corbett wants to reduce payments into the pension system for the next five years to free up money for other areas of the state budget. He has proposed tying that plan to long-term cost savings that would reduce future benefits for employees and would move all future hires into a 401(k)-style pension system, shifting the investment risk from taxpayers to employees.
But the use of bonds is not an active part of the pension reform plan, according to Jay Pagni, spokesman for the Office of the Budget.
And there is good reason for them to remain in the background.
Moody’s, a major credit rating firm, issued a statement in December warning governments about the risk of using pension bonds.
“If bond proceeds substitute for annual contributions to pension plans or are used to pay pensioners, we consider it a deficit borrowing and would view the financing as credit negative,” said Marcia Van Wagner, a vice president at Moody’s.
But if governments used pension bonds merely to shift from one form a debt to another, it would be viewed as credit neutral, Wagner said, though she warned that risks still remain.
Boehm can be reached at Eric@PAIndependent.com, and follow @PAIndependent on Twitter for more.