401ks vs. pension obligation bonds: Not much common ground augers against quick budget deal
Republicans in the state legislature, led by Senate Majority Leader Jake Corman (R-Centre County), say they want to make the long-ignored state pension system a budget priority this year.
But Democrat Gov. Tom Wolf has his own ideas about what to do with the state’s under-funded pension system, and his ideas clash markedly from the Republican approach.
What’s the disagreement? Everyone seems to agree on the root of the problem. The disagreement involves what to do about it.
Years of growing unfunded pension liabilities
Leaders from both political parties have ignored state pension obligations since at least the early 2000s, if not longer. So the problem goes back a generation.
Some say the problem can be traced to the mid-1990s, when the pension system was flush with cash, and public employers like school systems lobbied the state to cut their contributions.
A big hit to the system came in 2001, when Republican Gov. Tom Ridge approved a 25 percent pension payout increase for the state’s 330,000 public employees and teachers, and a 50 percent pension increase for lawmakers.
Adding to this growing payout problem, beginning in 2004, Democratic Gov. Ed Rendell decided to under-fund the state’s pension contributions. In the last ten years the pension system fell from being fully funded, to having a $47 billion unfunded liability today.
Now the chickens have come home to roost.
To meet these ballooning unfunded pension obligations, the state general fund must pay $3.8 billion directly into pensions in the coming budget year, up from $2.8 billion this year. That’s almost $4 billion that could be spent on schools or other priorities. And that number will dramatically increase if nothing is done.
Two vastly different approaches: 401ks vs. pension obligation bonds
State senate Republicans, led by Corman, have advanced SB 1, which would place new state hires in self-funded 401k plans, and require all current workers and teachers to pay more into their plans if the want to keep the increased benefits that were approved by Gov. Ridge in 2001.
Payroll deductions for teachers would rise from 7.5 to 10.5 percent, while state workers’ deductions would go from 6.25 to 8.75 percent.
Trouble is, the state workers’ unions, and Gov. Wolf, don’t like the Republican senate plan.
Like much else in this year’s budget, Gov. Wolf has proposed a plan of his own.
Wolf wants to float a $3 billion pension obligation bond, a new form of arbitrage that is becoming increasingly controversial, if popular.
Proceeds from the pension obligation bonds are reinvested to earn more than the cost of servicing the bonds, acting almost as a refy.
Pension obligation bonds, The New York Times recently explained, “are generally pitched to state and local officials as an arbitrage play: The government will issue the bonds; the pension system will invest the proceeds; and the investments will earn more, on average, than the interest rate on the bonds. The projected spread between the two rates makes it look as if the government has refinanced its pension shortfall at a lower interest rate, saving vast sums of money.
“But that’s just on paper. In reality, the investment-return assumption is just that — an assumption, and a deceptive one at that because it does not take risk into account.
“Fiscal analysts say it is possible, in theory, to shape a pension obligation bond deal responsibly, but that is not what they usually see.
“Instead, the deals are typically used to make troubled pension systems seem a little less troubled for a few years, allowing elected officials to celebrate a pension reform without having to make the system sustainable over the long term.”
Wolf also proposes modernizations in the state liquor store system, which, he says, could bring in an additional $180 million in revenue, helping to underwrite the servicing of the pension obligation bonds.
Of course, as the Times points out, arbitrage involves risk, and a downturn in the markets could upset the apple cart, bringing more debt to the pension system.
Another risk involves what’s known by financiers as “the spread,” or the difference between the cost of borrowing the money at one rate, and the rate of return when that money is reinvested. If the cost of borrowing increases, the spread narrows.
Because Pennsylvania’s credit worthiness has fallen in recent years to a credit rating of Aa3, due to past borrowings and the unfunded pension liabilities, the state must borrow money at a relatively high rate of about 3.11 percent.
“With an investment-grade credit rating of Aa3, Pennsylvania credit (and the spread it has to pay) is worse than any other state except New Jersey and Illinois, which, like Pennsylvania, have yet to resolve the multibillion-dollar gaps between the public pensions they have promised to pay and the money they have set aside to pay them with,” the Philadelphia Inquirer reported this week.
For example, Pennsylvania this week closed a $1.2 billion sale of bonds for capital projects and to pay off past debt. The past debt was borrowed at a rate of of 4.25 to 5 percent. The new debt was financed at a rate of 3.11 percent, enabling the Wolf administration to say it had saved $7.4 million a year in interest for 12 years, or $73.4 million in all, by refinancing the old debt at a better rate.
But if Delaware had borrowed the same $1.2 billion with its AAA credit rating, it would have paid $10.3 million a year less to borrow the money, the Inquirer reports.
So risk doesn’t just involve a sudden economic or market downturn. Past irresponsible borrowing and pension problems make future borrowings more expensive, increasing the risk.
Complicated pension bond financings like this, including Wolf’s plan, recently caught the attention of The New York Times. In a May 27 article, the Times reports that states are increasingly turning to pension obligation bonds, particularly since the courts have made other options more difficult.
“Interest in so-called pension obligation bonds is expected to intensify in the wake of a recent Illinois Supreme Court decision that rejected the state’s attempt to overhaul its severely depleted pension system,” the Times reports. “The court ruled unanimously that Illinois could not legally cut its public workers’ retirement benefits to lower costs, forcing lawmakers to scramble for the billions of dollars it will take to keep the system intact.”
The concern in Pennsylvania is that GOP Senator Corman’s pension rollback plan would be quickly challenged in court by the unions, and shot down in the courts.
Were that to happen, the state would have no recourse but to float the pension obligation bonds as proposed by Wolf.
Not much common ground augers against quick budget deal
If this was a normal year, old hands in Harrisburg say they know what likely would happen with the state’s annual budget process.
The Democratic governor would, after a short delay of a few weeks, cut a deal with the majority Republican legislature over state’s ballooning pension obligations.
The governor and the legislative leadership would then use the pension deal as a cornerstone to cut a broader budget deal, and move on.
In normal years, state workers tell me, they would fully expect Sen. Corman’s Republican plan to carry the day.
That’s because state workers, simply stated, are used to lawmakers screwing with their pensions. The number of years state employees must work until their pension have vested, meaning they can draw a pension, has risen, in some cases, from less than four years, to as many as ten years of service. And payroll deductions have increased as well.
So, the thinking goes, if this was a normal political year, the governor would cut a deal with the senate leadership and agree to these pension changes, in return for a broader budget package.
Trouble is, this isn’t a normal political year.
With fundamental disagreements over pensions, property taxes, the funding of public schools, and whether to tax Marcellus shale gas drillers, it starts to look like there is simply too much daylight between Gov. Wolf and the GOP-controlled legislature to strike a budget deal any time soon.
Wolf has repeatedly signaled he’s prepared to wait out the Republicans, for months if need be, to get a deal to his liking.
As a newcomer and, essentially, an outsider, Wolf can say to the public that he came to Harrisburg to fix the problem for the long haul, and has provided a detailed plan to do so, but that threatened business-as-usual interests in the GOP legislature have brought the state to a standstill.
What can the Republicans point to in a protracted budget stand off?
That they’re protecting gas drillers from paying taxes?
That they want to short-change public schools by another $1 billion this year?
That they’re standing up for business as usual?
All that’s a little hard to run on.
PA has way too many state workers anyway. I’m sure the secret plan is to underfund their medical care so they all die before they can collect pensions anyway. It’s how the private sector and military do it.
Encourage poor health, bad food, smoking and drinking, no time for exercise and right on cue most people die before they can collect their pensions.