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More municipalities betting on pension bonds to cover obligations

Local governments are increasingly borrowing money to plug shortfalls in their employee pension funds by exploiting a loophole in federal law. Market experts say the risks and long-term costs are frequently ignored.

March 26, 2012|By Nathaniel Popper, Los Angeles Times
  • Aerial view of Stockton, Calif.
Aerial view of Stockton, Calif. (Marcio Jose Sanchez/Associated…)

— — NEW YORK Struggling to pay employee pensions, local governments are increasingly borrowing money to cover their obligations — exploiting a loophole in federal law that allows them to issue taxable bonds without seeking voter approval.

Oakland took a bet on its pension fund that ended up costing the city an estimated $245 million — nearly a quarter of its annual budget. That hasn't stopped the city from looking to try its luck one more time.

The bets are being made using an exotic but increasingly popular financial instrument known as a pension obligation bond. Cities, counties and states use the bonds to take out high-interest loans from private investors to plug shortfalls in their employee pension funds.

If the pension funds make smart investments with the borrowed money, the returns can help pay the interest due to borrowers and sometimes even spin off some extra cash to pay pension costs. If they don't, the bonds can create additional costs for taxpayers, put the retirement funds of teachers and firefighters in jeopardy, and, in the worst case scenario, force municipalities into bankruptcy.

Municipal finance experts are sounding alarms about the practice, saying that local elected officials are taking unnecessary risk because they are afraid to anger voters by raising taxes. There is also the risk of instigating powerful public employee unions if pensions are cut.

"There are communities that just do not want to make the hard choices, even though it means the choices in the future will be worse," said Robert Doty, a municipal finance consultant in Sacramento. "They are just going to dig themselves deeper and deeper into a hole."

Oakland provides the clearest example of the risks and the allure of these bonds.

The city is credited with issuing the first pension obligation bonds in the 1980s. Another set of pension bonds the city issued in 1997 have lost Oakland $245 million, according to analysis by the city auditor. Those losses have helped push the city administration to propose more than $200 million of new pension bonds in the coming months.

"One would think they would have learned," said John Russo, the former city attorney who voted against the 1997 bonds when he was a City Council member and resigned last year because of disagreements over the city's budgeting. "This is a risk that may go horribly wrong."

Another California municipality to encounter problems after issuing pension bonds is Stockton. The city issued $125 million in pension bonds in 2007, a third of which promptly disappeared when the market crashed in 2008. But Stockton is still on the hook for the annual interest payments, some $6 million, or about 75% of the city's deficit this year. In late February, the city announced it was moving toward bankruptcy after determining it was unable to make the payments on these and other bonds.

Although local governments risk big losses from pension bonds, they carry profits with almost no risks for the law firms and banks that help arrange them. They aggressively market deals in which they get their fees up front, no matter what happens in the long term, according to several public officials.

"I was getting pitched the day after I arrived," said the chief financial officer of the University of California, Peter Taylor.

Since 2008 the dollar amount of bonds issued has gone up each year, rising from $1.4 billion in 2009 to $3.6 billion in 2010 to $5.2 billion last year, an analysis by The Times shows. With cities and states expected to encounter growing difficulty in funding their pensions, many insiders expect more municipalities to try them out.

Just in the last few weeks, proposals to issue the bonds have come out of Cincinnati; Fort Lauderdale, Fla.; Hamden, Conn.; and the Democratic mayoral candidate in San Diego, Bob Filner, who said he would use the bonds to help the city's budget crunch.

The argument for the bonds is almost always that they will fill a short-term budget hole and allow the city to maintain benefits for retirees. But market experts say the risks and long-term costs are frequently ignored.

Along with the interest rate payments and investment risks with which the bonds freight governments, they also provide another argument for opponents of public pensions, increasing the possibility that such benefits could be lost altogether.

"Municipalities find it attractive to think that there might be a free lunch — they can issue bonds and solve their problems," said Jeff Esser, chief executive of the Government Finance Officers Assn., which has issued an advisory cautioning its members against pension bonds. "Unfortunately there is no free lunch."

Pension obligation bonds are a product of the unusual way municipal pensions are funded. Unlike other divisions of local governments, which pay as they go, pension funds survive by taking annual payments from public employees and employers and investing that money to pay for future retirement benefits.

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