Government's Speculating or Gambling with Borrowed Money to Fund Public Sector Pensions

Many cities and states have borrowed money to fund their pension obligations.

Then they've gambled or speculated with that money in the stock market to meet taxpayer promised benefits to fund the pensions of future retirees, even though the vast majority of taxpayers don't even realize they've made such "promises" through their government knows best leaders.

This may not be actual theft, but it's at least gross negligence of the worst kind on the part of the government officials. In criminal law, the phrase often used to describe this behavior is "willful and wanton." While the person perhaps didn't expressly intend for such bad things to happen, he acted so irresponsibly that a reasonable person would not be surprised when the fit eventually did hit the shan.

How Plan to Help City Pay Pensions Backfired tells the story of bankrupt Stockton, California and its city officials' "willful and wanton" neglectful behavior, although this type of thing has happened in countless other U.S. cities and states as well:

{NOTE: In 2007 the City of Stockton, Calif., sold about $125 million in bonds to try to close a shortfall in its pension plans for city workers like police officers.}

"Stockton sold the bonds, about $125 million worth, to obtain cash to close a shortfall in its pension plans for current and retired city workers. The strategy backfired, which is part of the reason the city is now in Chapter 9 bankruptcy. Stockton is trying to walk away from the so-called pension obligation bonds and to renegotiate other debts. . . .

Financial analysts and actuaries say essentially the same pitch that swayed Stockton has been made thousands of times to local governments all over the country — and that many of them were drawn into deals that have since cost them dearly. . . .

There are about $64 billion in pension obligation bonds outstanding, and even though issuance has slowed, more of the bonds are coming to market, even now.

Officials in Fort Lauderdale, Fla., are scheduled to vote on a $300 million pension obligation bond on Wednesday, for instance. Hamden, Conn., has amended its charter to allow for the bonds to rescue a city pension fund that is wasting away. Oakland, Calif., recently issued about $211 million of the bonds, following the lead of several other California cities and counties.

The basic premise of all pension obligation bonds is that a municipality can borrow at a lower rate of interest than the rate its pension fund assumes its assets will earn on average over the long term. Critics contend that municipalities that try this are in essence borrowing money and betting it on the stock market, through their pension funds. The interest on pension obligation bonds is not tax-exempt for this reason.

Alicia H. Munnell, director of the Center for Retirement Research at Boston College, looked at outcomes for nearly 3,000 pension obligation bonds issued from 1986 to 2009 and found that most were in the red. “Only those bonds issued a very long time ago and those issued during dramatic stock downturns have produced a positive return,” Ms. Munnell wrote with colleagues Thad Calabrese, Ashby Monk and Jean-Pierre Aubry. “All others are in the red.” Only one in five of the pension obligation bonds issued since 1992 has matured, so the results could change in the future....

Stockton got a similar pitch in 2007 — that it could issue municipal bonds with a lower interest rate than the California state pension system, known as Calpers, expected its investments to return annually, on average. 

The year that Lehman Brothers made the pitch to Stockton, for example, the city had a shortfall of $152 million with Calpers, which administers benefits for Stockton’s retirees. The gap appeared because in 1999, Stockton increased the value of the pensions its workers were earning, without making a corresponding increase in the yearly prepayments it sent Calpers to cover the cost....

 

No one thought it had to; Calpers’s actuary had projected that investment gains would pay for most of the increase. Then the dot-com bubble burst, blowing that expectation to bits. But Stockton’s workers kept on building their retirement benefits at the richer rate, so by 2006, Stockton was $152 million short of what it should have had on hand at Calpers to pay for all of its current and future retirees’ pensions.

Calpers, meanwhile, was assuming that its investments would earn 7.75 percent a year over the long term. And when a city, like Stockton, had a shortfall, Calpers treated it as if that city had borrowed from the pension fund — and it charged that city 7.75 percent interest on the loan.

Not only that, but the Lehman bankers also explained that Calpers had recently switched to a new way of billing its member cities for these “loans.” It wanted to help them preserve their cash in the wake of the technology crash, so it had slowed the cities’ payments to Calpers. The bad news was that it had slowed them so much that the bills were compounding before any city could pay them down. That meant Stockton’s debt to Calpers was just going to get bigger and bigger over the years, the bankers said.

After laying out this daunting situation, the Lehman bankers said there was a way out: Stockton could raise the $152 million all at once in the municipal bond market, send the money to Calpers and get rid of the unpayable loan. The municipal bond market would charge Stockton just 5.81 percent interest. 

The city would come out way ahead.

What the bankers did not say was how seldom such pension bets ever pay off...

One of the Lehman bankers agreed there were risks.

"This is not a guaranteed deal," he said. He explained that no one would know whether Stockton had come out ahead until all the bonds had matured, 30 years in the future. He said “the ultimate benchmark” for Calpers’s investments was Stockton’s own borrowing rate, 5.81 percent.

If Calpers’s investment earnings 30 years from then did not average out to at least 5.81 percent a year, he said, the bond would have been a bad idea. But then he dismissed this possibility, saying that if Calpers could not earn that much over time, “you have much bigger problems.”

Calpers’s investments lost about 25 percent of their value in the financial turmoil that began in 2008. 

That meant the city had a new debt to Calpers, compounding at 7.75 percent, on top of its debt to the bondholders. Stockton was worse off than ever, with 29 more years to go."

Summing Up

Let's take the mystery out of this situation.

Pension benefit promises for Stockton's public employees were enhanced as a result of negotiations between the public sector union leadership representing public employees and officials representing the city of Stockton.

How to pay for those increased benefits became the issue since the city officials didn't want to ask taxpayers for an increase in taxes and union officials didn't want to ask employees for an increase in employee contributions.

So they decided to borrow $125 million and then "invest" the borrowed proceeds, expecting to earn more each year than the amount of interest paid on the borrowings. They didn't anticipate that the principal would decline and that this unexpected burden, in addition to the interest owing on the loan, would result in an unforeseen, huge and unaffordable cost for the city's taxpayers.

What they did by borrowing and "investing" was simple irresponsible gambling or speculation.

It's like someone buying a second house funded 100% on credit and hoping to flip it later for a higher price to another buyer. In other words, the buyer borrows $100 to purchase the "investment" house, plans to rent the house for more than the interest charged on the $100, and then waits for the house to gain enough in value to pay off the loan.

The "brilliant" and 100% leveraged borrower/buyer/speculator/gambler then proceeds to sell the house, pocket the proceeds and congratulate himself on how brilliant he is. Or at least that's the idea.

And if it doesn't work out that way, well, you know the story.

Except in the case of Stockton and other similarly situated cities and states, it wasn't even their own money they were speculating with or gambling. The obligation to pay off the loan belonged to the taxpayers instead.

Still, the borrowings were "invested" in the financial market on the assumption that the earnings and appreciation on the "investments" would outpace the debt servicing obligations, thus providing a "can't miss" windfall for Stockton and a "free" and rich benefit for its public employees.

But it didn't turn out that way. You see, this wasn't a long term legitimate investment plan with MOM. It was a short term speculation or gamble with OPM. And taxpayers, as always, were the ones on the hook.

If as individuals we borrowed $100 to buy stocks and expected that we'd pay only the interest thereon with dividends and that the stocks we purchased with the borrowed money would appreciate in price sufficiently and rapidly enough to pay off the loans, we'd be called irresponsible or perhaps even crazy. But at least it would be our own money and our own future we were gambling. It would be an example of stupid MOM instead of reckless OPM. And we'd have only ourselves to blame when the gamble failed to pay off as we had anticipated it would.

And we'd undoubtedly and INCORRECTLY think of ourselves as a smart or maybe even a genius investor if luck was on our side and the gamble worked. But even so, we'd probably keep playing and eventually we'd lose and the money we'd borrowed would be all gone. Then we'd be bankrupt as individuals.

But in Stockton and other cities and states, we don't look at things in that simple way when government officials do the unpardonable and unthinkable.

I wonder why. I really do.

Thanks. Bob.