Imagine getting a home equity loan for $100,000, spending $27,000 of it on a new car and investing the rest — then counting on the interest earned to cover the interest paid, as well as the cost of the car. That’s the essence of Gov. Rod Blagojevich’s $10 billion pension bonding plan, which became law in April.
This isn’t a new idea. Buying and selling in separate financial markets in order to profit from the difference in rates is called an arbitrage. It’s commonly used by banks, which invest their customers’ money for a higher rate of return than they pay on, say, checking or savings accounts.
In recent years, it also has become popular among municipal governments seeking to cover all or a portion of their pension systems’ unfunded liabilities — the difference between assets and what would be necessary to pay all benefits accrued by a system’s members. By selling bonds and dumping the proceeds into their pension funds, municipalities trade the cost of required contributions to their systems for the cost of debt service on the bonds. And, as long as their investments outperform the cost of their loans, the pension funds gain.
But counting on the performance of any investment is risky. When the market slumps, as it did during the last two years, an arbitrage can fail; there’s a chance the rate of return on the investment could be less than the cost of the loan. Pension bonding plans can put governments on the hook for additional, unforeseen contributions to their systems — while they continue to pay the debt service on the bonds.
This state’s pension bonding plan, which doubles the state’s total bonded indebtedness and constitutes the largest such scheme to date, is no exception to the rule. And there’s an additional twist that heightens the risk. Rather than realize gains as they occur, the administration is realizing, and spending, the projected 30-year gain in the first year of the plan. Like the homeowner who spent 27 percent of an equity loan for a car, the plan dictates that some 27 percent of the bond proceeds be spent immediately.
Budget officials intend to sell $10 billion in bonds by the end of fiscal year 2004. Most of the immediate spending, $2.16 billion, is earmarked for required contributions to the retirement systems during fiscal years 2003 and 2004. By using dollars generated from the sale of bonds to make these contributions, the state will free up dollars in the General Revenue Fund, the state’s main checking account, for those fiscal years.
This component of the plan was key to balancing the governor’s first budget. By offsetting the retirement obligation, the plan helps reduce a projected $5 billion deficit. And that was the General Assembly’s central consideration in approving it.
The risk comes in the long-term. In addition to $2.16 billion for immediate pension contributions, the administration intends to reserve roughly $500 million from the proceeds for debt service during the first year. The new law permits this. Statute allows the state to spend up to $50 million of those proceeds on fees paid to firms that handle the transactions, though budget officials argue those costs will not reach the cap.
The remaining sum, about $7.3 billion, will be invested in the state’s five pension systems in an effort to reduce unfunded liabilities. Over the course of 30 years, the state’s required annual contribution to those systems will be reduced by the amount of debt service paid each year on the bonds. The plan, therefore, is designed to have a neutral effect on the General Revenue Fund.
The state’s five funds, which cover pension obligations to state and university workers, teachers, judges and legislators, were 53.5 percent funded at the end of fiscal year 2002. They had combined assets of $40.3 billion against liabilities of $75.2 billion. Under a law implemented in 1996, those systems must be 90 percent funded by 2045.
To accomplish this goal, the state is required to contribute each year to cover annual accrued liabilities and to reduce total unfunded liabilities.
While the arbitrage will permit the state to aggressively reduce its unfunded pension liabilities in the short term, it’s not clear whether the five funds will be left in substantially better shape after the 30 years than they would have been under the previous scheme. If the gain simply cancels out initial contribution spending, then the funds would have the same unfunded liabilities as they otherwise would have.
Still, most officials at the Statehouse are focused on the short-term budget relief allowed by the plan, not whether the arbitrage will enhance the pension funds’ values over the long term.
“[The plan] generates about a $2 billion positive cash flow for us this year, in the year that we have a $5 billion hole,” says Rep. Gary Hannig of Litchfield, chief budget negotiator for the House Democrats. “In a perfect world I think we would have done this thing, but we would not have withdrawn the $2 billion. We’d have left it in there, and we would have let it percolate through, and we’d have let the 8.5 percent growth continue and we would have been significantly better off.”
The pension bonding model assumes the state will pay an average of 6 percent in interest over 30 years on the bonds, and earn an average compounded interest rate of 8.5 percent on the additional investment. The projected net gain — the projected value of the investment in 30 years minus the projected cost of the loan — should be “in excess of $2 billion,” says Blagojevich’s Budget Director John Filan.
The $2 billion would roughly cover the immediate contributions to the pension systems. It’s not clear whether the estimated $500 million for debt service during the first year would be accepted as a loss.
Blagojevich’s budget office has not provided a more detailed accounting of their projections. But, according to Joseph Starshak, a partner at Chicago-based investment firm Starshak Welnhofer & Co. who specializes in municipal finance, the $7.3 billion investment will be worth $84.3 billion after 30 years if it earns an average compounded interest rate of 8.5 percent. Meanwhile, he projects the state will pay $21.9 billion in debt service, including principal and interest, on $10 billion worth of 30-year bonds sold at an average 6 percent rate of interest. That would constitute a present value net gain of $62.4 billion. But the investment projection assumes no withdrawals from the investment for pension obligations, and that is unlikely.
There are few critics. Three of the four legislative leaders — Senate President Emil Jones Jr. and House Speaker Michael Madigan, both Chicago Democrats, and House Minority Leader Tom Cross, an Oswego Republican — supported it when it was presented to lawmakers. Senate Minority Leader Frank Watson, a Greenville Republican, was opposed.
Sen. Steve Rauschenberger of Elgin, chief budget negotiator for Watson’s caucus, says his chief concern is that Blagojevich intends to realize and spend immediately the expected arbitrage gain of more than $2 billion. “It is too risky to spend your profits in year one,” he says. In fact, Rauschenberger suggests the elaborate scheme was designed primarily to shelter the nascent administration from having to make politically unpopular decisions to balance the budget. “It is just risking an awful lot and taking your gains all in the first year and spending it because you don’t want to make hard decisions this year.”
For their part, administration officials argue the arbitrage is in fact designed to buttress the pension funds over the long haul. The governor likens it to refinancing a home in order to take advantage of a lower interest rate. And his deputies argue it would be irresponsible not to take advantage of the current low rates.
The administration intends to sell the bonds in three or four installments over the next year. Each installment, called a tranche, is expected to total $2 billion to $3 billion. The first was scheduled to be sold as early as last month.
Filan says there are varying opinions among investment bankers on how many installments will be necessary, and he adds that the first tranche could be larger than expected. “Until you get out there and know what supply the market demands, you don’t know.” In any case, he hopes the bonds are sold quickly to capitalize on historically low interest rates.
Budget officials also envision a diverse portfolio of bonds, which will make them more attractive to a broader range of investors in the international bond buying community. They expect maturation periods will range from 11 years to 30 years (the maximum allowed by law), with the average bond life being 24 years.
In addition, Filan wants the option of selling variable rate bonds. This would require legislative approval, and the administration was aiming to secure this before the end of spring session.
Variable rate bonds can be sold at a much lower interest rate than fixed rate bonds, but they can subject the state to more risk because those rates fluctuate. As a result, this aspect of the plan is controversial. The Civic Federation, a Chicago-based municipal tax policy watchdog, supports the move. Other analysts express concern.
Filan plays down worries. He says variable rate bonds sold by the state would be couched in fixed rate bonds to minimize the state’s exposure to risk — an instrument he refers to as a hedge. And here’s one possibility for how this might work. Starshak, the investment banker, suggests the state could establish a reserve fund to accept savings incurred by paying a lower interest rate on variable rate bonds. Should the rate on those bonds rise, those funds would cushion fiscal impact on the state.
Filan does say that only a small portion of the bond portfolio should be variable rate. “You don’t make the whole issue variable rate,” he says. “Typically, maybe 10, 15, 20 percent of a bond portfolio may be variable rate.”
The most important point, he argues, is having the authority to sell them. That, he says, increases the state’s negotiating power with fixed rate bond buyers. “When people out there want your fixed rate bonds, if they know that the only way you can sell is fixed rate bonds, then as a buyer they know they’re the only market in town,” he says. “That strengthens their negotiating position. But if they’re a buyer and they know you have an alternative market, meaning variable rate, if you don’t like their price, that helps them bring their price down.”
Filan says the assumption that the proceeds from the sales, when invested, will earn an average compounded interest rate of 8.5 percent is reasonable when viewed in light of returns earned by the pension funds over the last 20 years. He disputes criticism that this is an unfair measure because the late 1990s boom, which produced extraordinary gains for investors, is largely considered an anomaly. “You can pick good years and bad years and make an argument one way or another, but these are really all long-term portfolios and it’s that horizon that counts.”
In fact, the compounded annual rate of return for the state employees, judges and General Assembly retirement funds was above 8.5 percent during most of that 20-year period, according to figures provided by the Illinois Pension Laws Commission, which tracks laws and practices relative to public pensions. From fiscal years 1983 to 1992, they averaged 8.6 percent, and from fiscal years 1993 to 2002 they averaged 12.6 percent.
Yet in dollar terms the five funds sustained substantial losses during the recent market downturn. During fiscal years 2001 and 2002, they collectively lost $4.6 billion on their investments, according to the commission. The commission also reports unfunded liabilities in the five funds grew by almost $18 billion from fiscal years 1995 to 2002, due mostly to lower-than-assumed state contributions, lower-than-assumed investment returns and benefit increases.
New Jersey’s pension fund took even greater losses. That state implemented a $2.8 billion pension bonding plan in 1997, and it fell victim to bad timing when the market turned sour. The pension fund peaked at $83 billion in June 2000, according to the state’s Department of the Treasury, but it’s now worth only $55 billion. Other governments that sold pension obligation bonds in the late 1990s also lost money in the recent downturn, according to Parry Young, a director in the public finance department of Standard & Poor’s. “They have not even recovered the cost of pension obligation bonds,” he says.
When investments in those funds underperform, the government sponsor can be on the line to contribute additional dollars toward reduction of unfunded liability on top of the cost of the bonds. Under Illinois’ previous law, the state would have this responsibility to make up a loss in the funds. The distinction with the new law, though, is that the state would simultaneously be under the obligation to service the bonds. “When you don’t meet your assumed investment return, you may be incurring new unfunded actuarial liabilities and your contribution rates will be going up,” Young says. “So that constrains your financial flexibility.”
At least during the initial years, the Blagojevich plan appears to minimize the potential for additional financial responsibility. Hannig and Rauschenberger interpret certain language in the new law as a hold-harmless provision absolving the state from liability should the pension funds underperform.
“If they have some losses in the early part of the process, this sort of locks out the pension systems from asking the state to make up those differences,” Hannig says. “So it gives us on this side a little bit of breathing room. But clearly we are still liable as we go forward. So if they have three or four bad years, while this language may relieve us from having to make the payments, eventually those birds will come home to roost — as they will anyway if the pension system does a lousy job.”
There are other concerns. Though Illinois is obligated by law to make minimum payments to its pension funds each year, there is flexibility inherent in meeting expectations within a statutory formula that isn’t available when it comes to paying debt service on bonds.
As for Illinois’ bonded indebtedness, there is limited concern among analysts that adding $10 billion could hurt the state’s credit rating, especially in light of the state’s other fiscal challenges. Illinois had $9.54 billion in direct bond obligations at the end of fiscal year 2002, according to the state comptroller’s office. Blagojevich’s plan will more than double that obligation. Last month, Moody’s Investors Service reduced the state’s credit rating for long-term debt, while Standard & Poor’s and Fitch Ratings warned they may downgrade their ratings for the state. This could make bonding more expensive.
Still, credit analysts on Wall Street stress that they review a state’s entire budgetary picture when determining a rating. Timothy Blake, a senior analyst at Moody’s, says the company’s chief considerations were the state’s increased unfunded pension liability and declining general revenues. “Not only do you have this long-term pension issue,” he says, “but the near-term budget condition of the state is quite strained.”
Blagojevich’s plan has 30 years to perform. And it could take that long to know whether it’s worth the risk. This much is clear, though: The plan helped reconcile the state budget for one more year.
Illinois Issues, June 2003