Financial play with pensions may force future cuts
By MACKENZIE RYAN
(Salem) Statesman Journal
Wednesday, November 4, 2009 11:14 AM PST
SALEM (AP) — A financial investment that has helped fill gaps in pension funding since 2002 quickly turned sour with the stock market’s misfortunes last year, losing $1.9 billion for nearly 140 government agencies in the state, according to a Statesman Journal analysis.
The investment strategy called for selling bonds and investing the proceeds. For several years, the strategy worked, making money and saving agencies millions. This year, Oregon might save $80 million, and Salem-Keizer School District might save $10.6 million.
But the controversial strategy also created a more volatile pension system, in which an agency’s pension costs are much smaller after good economic times and much larger after tight economic times.
That financial gamble might force school districts, cities and counties to consider layoffs or service cuts in 2011, when pension contribution rates reset. That amount will reflect 2008-09 investment returns, including 27 percent losses in 2008.
It’s a classic story of risk and reward:
— Of agencies trying new financial strategies in the wake of easy money despite having limited money in their budgets to fall back on.
— Of financial institutions which went on to profit from underwriting bonds helping to create state laws, educate business managers and fund statewide campaigns to make the strategy possible.
— Of never thinking the market could crash as badly as it has and struggling to live with the financial consequences.
In 2001 and 2002, state legislators passed laws that essentially allowed, for the first time in Oregon, the majority of public agencies to ‘‘refinance’’ their pension obligations by making a financial move called arbitrage.
Here’s how arbitrage play works: Cities, counties and school districts took advantage of low interest rates at the time and issued pension bonds. They then deposited bond proceeds into ‘‘side accounts’’ with the state pension system. The side account created a way to invest bond proceeds with other pension assets in the investment portfolio. If the rate of return on the investments (say, 8 percent) is higher than the bond interest rate (say, 5 percent), the agency makes money on the difference (in this example, 3 percent). That translates into a savings to an agency’s pension costs, as the difference helps an agency pay its pension contributions.
The arbitrage move does not affect employee benefits; it dictates how much agencies pay in pension costs. PERS, Oregon’s Public Employees Retirement System, aims to earn 8 percent return on its investments.
Historically, pension investments earned 10.25 percent from 1970 to 2008, said PERS actuarial-services manager Dale Orr.
Since 2002, agencies have issued pension bonds with interest rates of 4.7 percent to 7 percent, according to a Statesman Journal analysis of bonds issued in Oregon.
A handful of agencies issued bonds with a 7 percent interest rate, according to bond data from the state treasurer’s office — a smaller margin than most for the arbitrage play.
‘‘If everything goes right ... but of course, there’s risk,’’ Orr said. ‘‘There is risk that our portfolio won’t earn 8 percent.’’
It was cheaper to borrow money in recent years than at any time in the past 40 years. In 2001, interest rates were lowered 11 times.
Low interest rates and looser lending practices helped the housing market boom. At the same time, in 2002 and 2003, some public agencies from across the nation rushed to issue pension bonds.
Yet the financial play carries risks that some people think public agencies, with limited resources, have ‘‘no business’’ taking. Mark Thoma, a professor of economics at the University of Oregon, is one of them.
‘‘You could take that money and put it into assets and seem like you were making a lot of money,’’ Thoma said. ‘‘But they were also accumulating a lot of risk that they didn’t understand.’’
For example, the state issued $2 billion in pension bonds at a 5.8 percent interest rate. If investments earn 8 percent during the life of the bonds, the state makes 2.2 percent. Roughly speaking, in the first year, the state would earn $45.8 million.
Investment returns have averaged only 4.5 percent in the past 10 years, a time that includes recessions. If that continues during the life of the bonds, the state would be ‘‘upside down’’ 1.3 percent. Roughly speaking, in the first year, the state could be upside down $27 million.
Some disagree with that outlook, however, saying there were more factors at play than just the cost of bonds and interest earnings.
‘‘It does not mean you’re upside down ... it means your earnings on your account have not grown,’’ said Jim Green, a former lobbyist with the Oregon School Boards Association and a main proponent of the financial move.
Green also said agencies issued pension bonds to lower costs as PERS was charging interest at 8 percent on some of their unfunded liabilities. That’s the difference between how much the pension system has on hand and how much it needs to pay out to current and retired employees during the life of the system.
School districts, except for Portland public schools, were not being charged because they have always shared liability through a pool arrangement, Orr said.
Many agencies issued bonds just large enough to ‘‘refinance’’ that unfunded liability. By issuing a bond with a 5 percent interest rate and paying that liability off at once, for example, an agency can save money on the difference in interest rates. Paying 5 percent interest is cheaper than paying 8 percent interest to PERS.
Some agencies took it a step further, however, issuing bonds specifically for an arbitrage investment strategy. Some agencies issued bonds large enough to do both.
In Oregon, more than 90 percent of the 140 agencies that issued pension bonds did so from 2002 to 2005, according to a Statesman Journal analysis. The time frame is significant because it coincides with the housing market boom, Thoma said.
‘‘Its the same things that were happening in housing: People were convinced that there were these riskless ways to make money,’’ Thoma said. ‘‘It turns out it wasn’t risk-free.’’
The spread on interest rates and investment earnings was appealing. Oregon’s pension system had made tremendous gains in individual years: as high as a 25 percent return in 1999 and a 24 percent return in 2003.
‘‘They were caught up in the general mania that was pervading all financial markets,’’ Thoma said.
Some business or financial managers interviewed said there was a sense that there was a risk to not making the arbitrage play.
‘‘School district leaders have a fiduciary responsibility; that responsibility works both ways,’’ said Kevin McCann, now the executive director of the Oregon School Board Association, who believes the thinking then was sound. ‘‘Some people actually could have been labeled as imprudent by not taking advantage of something that’s well-researched and thought to be safe.’’
Starting in 2002, a wave of states issued bonds, including California and Illinois, to make an arbitrage play with their pension systems.
At the same time, from 2002 to 2005, Oregon agencies issued bonds and deposited about $5.3 billion in side accounts. In all, side account deposits total $5.5 billion, according to PERS documents.
School districts especially found the arbitrage play promising: 94 in the state have opened side accounts. So have 12 cities, seven counties and 16 community colleges.
Making the decision to issue pension bonds was not taken lightly, said Angie Peterman, the executive director for the Oregon Association of School Business Officials. She was a school district business manager at the time most bonds were issued.
‘‘I don’t think there’s a single district that got involved in the process that didn’t spend months, probably, doing revenue scenarios and looking at the what-ifs,’’ she said.
School boards, city councils and other boards of elected officials voted to allow their agencies to issue pension bonds, Green said.
The short-term benefit of side accounts has been immense in recent years. Agencies use money from the side accounts each year to offset some of their pension contributions. The amount of that offset fluctuates and depends on investment returns.
And that means that savings generated from the arbitrage play can be directed back into the classrooms, Peterman said.
At its peak in 2007, side accounts totaled $7.7 billion, about 40 percent more than initial deposits made during the years.
Salem-Keizer opened a side account in 2002 after issuing $114.6 million in bonds, according to the state treasurer’s bond data. The resulting side account offsets reduced its pension contribution rate. Instead of paying 11.11 percent of payroll to the pension system in July 2003, it dropped to 6.25 percent.
When the district issued a second pension bond in 2004, Salem-Keizer’s rate dropped further to 2.7 percent of payroll in 2004, according to PERS.
That translated into millions of dollars in savings after factoring in pension bond payments. This school year, Salem-Keizer expects to save $10.6 million in the general fund from the financial move, according to budget documents. That’s the equivalent of 138 teaching positions.
‘‘We’ve had a pretty good run of getting a benefit to the school district. I think over a 20-year period, it’s going to have huge savings,’’ Rich Goward, the district’s chief financial officer, said this summer. ‘‘Right now, it’s gone the other direction because of the market.’’
Other business managers say they have seen remarkable savings in the years since opening side accounts. Contribution rates for 67 agencies dropped to zero this year, when rates readjusted to reflect positive investment returns two years ago, according to a PERS document of contribution rates.
Every financial manager interviewed who was working with their agency when pension bonds were issued said that it was the right decision because it will save money in the long term.
‘‘Over 27 years, as long as we get a return in excess of 5 percent, which is what we’re paying for the debt, we have savings,’’ said Jon Ellis, assistant director of finance for the city of Salem.
Goward also stands by the decision Salem-Keizer School District made to take out bonds in 2002 and 2004 to make the arbitrage play, he said.
Seeing the risks, Salem-Keizer was among the agencies that used at least some of the savings to boost reserves in their budgets in case of an economic downturn.
‘‘We’ve had a pretty dramatic effect (from) the stock market,’’ Goward said. ‘‘We have some ability to deal with it, but the question is going to be: Is that enough?’’
In a year, the economy unraveled and the arbitrage play showed signs of running into problems.
The housing boom busted. Financial giants failed. Lending tightened and borrowing stalled. Investments nose-dived. Unemployment soared.
As a result of one investment year, Oregon’s unfunded actuarial liability in the pension system skyrocketed. In 2008, pension investments lost 27 percent, the largest loss in the agency’s history.
‘‘Our investment strategies are for the long term, and we recognize that the market is going to be volatile,’’ Orr said. ‘‘Twenty-seven percent is a lot to try and recoup. Most likely, it will not be recouped in one year or even two years.’’
At the end of 2008, side accounts statewide are estimated to total $5.3 billion — about 4 percent less than initial deposits. Actual impact varies widely, depending on the year side accounts were created. For an agency that created a side account in 2007, for example, the difference is about 30 percent less.
‘‘After a five-year run of good earnings, 2008 was not a good year,’’ Orr said.
In 2011, agencies with side accounts may have a larger hit to their budgets than those without, as that’s when new pension contributions and side account offset rates will take effect. The contribution rate is expected to increase and the offset rate to decrease a double hit.
‘‘That’s the next greatest looming crisis on the horizon,’’ said Doug Middlestetter, the business manager of the North Santiam School District.
In an example given in PERS documents, an agency with a side account could go from paying 0.2 percent of payroll in pension contributions to 10.6 percent of payroll.
‘‘We may have some that have a greater impact from the downturn on their side account,’’ said David Crosley, a PERS spokesman. ‘‘There are many that aren’t going to see this kind of change.’’
In the same example for an agency without a side account, their contribution rates may rise from 14.01 percent to 20.01 percent of payroll. They’ll pay more but not see as large an upswing.
Given the current budget crisis that state and local agencies are going through, the effect could be grim.
‘‘Had these been normal times,’’ Middlestetter said during the summer, ‘‘we would have spent a lot of effort talking and planning and saying, ’Gee whiz, what the heck are we going to do when ’11 gets here?’’’
Last year, Central School District’s auditor walked into the business manager’s office and threw down a piece of paper. On it was the schedule of payments the district would have to pay on its pension bond in the years ahead.
‘‘Do you know about this?’’ the auditor asked.
Business Manager Mary Knigge, who was hired three years after the pension bonds were issued, was well aware. And worried.
‘‘It’s a very scary deal,’’ she said. ‘‘It’s such a big elephant in the room.’’
In 2003, Central School District issued about $20 million in pension bonds. The district structured its debt payments to increase as the years went on, increasing by $70,000 to $100,000 each year.
‘‘I don’t think, when we initially did this, that a lot of thought was put into this,’’ Knigge said. ‘‘The thought of times like this, when the money is short, these obligations are out there. We have to pay them.’’
The extent and impact of the pending pension crisis is not known. Pension investments in 2008, including side accounts, lost 27 percent. In 2009 through August, investments have earned nearly 9 percent in returns.
Despite the market’s recovery, many business managers interviewed said that pension costs could have far-reaching consequences as early as 2011, from contract negotiations with unions to layoffs or service cuts.
‘‘If we get hit really hard from (pension contributions rising), we might have to cut positions,’’ said Middlestetter.
