Bankers and new accounting rules are emboldening governments to borrow-and-bet their way out of pension problems, a strategy that’s backfired in the past
If there were ever a time not to bet the moon on the stock and bond markets, it's now, with U.S. stocks at near-record highs and interest rates on quality bonds at near-record lows. But Wall Street is urging state and local governments to do just that — and they're listening.
Despite the risks, governments are lining up to issue billions of dollars in new debt to replenish their depleted pension funds and, as a bonus, take some pressure off strapped budgets. In some cases, the borrowing makes their balance sheets look vastly better.
Bankers, who make fat fees for raising the money, are encouraging this borrow-and-bet trend. Their sales pitch is that borrowing at today's low interest rates all but guarantees a profit for the governments because they can invest the proceeds in their pension funds and for decades earn returns higher than the 5 percent or so in interest that they will pay on the bonds.
But there's a catch: If the timing is wrong, these so-called pension obligation bonds could clobber the finances of the government issuers. Pension funds and beneficiaries will be better off because pensions will be more soundly financed. But taxpayers — present and future — might be considerably worse off. They will be running huge risks and could get stuck with a massive tab.
"It's sold as a magic bean," said Todd Ely, a professor
at the University of Colorado at Denver who has studied pension bonds. "But when it goes bad it's not free. Then it isn't really magic. If it could be counted on to work as often as it's supposed to, then everyone would be doing it."
Plenty of takers are bellying up to the borrowing bar. Governments sold $670 million worth of pension bonds through the first half of this year, more than double the $300 million raised for all of last year, according to deal-trackers at Thomson Reuters.
That total would more than double if Kansas completes a pending $1 billion deal
, which would be its biggest bond issue. A $3 billion sale is under consideration in Pennsylvania, that state's largest as well. Lawmakers recently rejected record multibillion-dollar deals in Kentucky
, but those proposals are expected to resurface. And new proposals are being pitched to other governments.
Pension bonds have waxed and waned since the 1980s, but the current boom is different. An examination by The Washington Post and ProPublica found that it's being driven not only by the prospect of investment profits but also by a new accounting quirk that has largely escaped public notice while morphing into a major marketing tool for Wall Street banks.
The quirk stems from a rule change
that, ironically, was meant to force governments to more clearly disclose
the health of their pension funds. But a side effect is to allow governments with extremely underfunded pensions to slash reported shortfalls by $2 or more for each $1 borrowed.
Here's how: If a pension plan is so poorly funded that it is projected to run out of cash, the new rules require it to make less optimistic projections about future returns. That increases the reported pension shortfall. But if governments infuse a big slug of borrowed money into the fund, they can resume using optimistic projections, and the shortfall shrinks.
It's like getting a new credit card, borrowing on it to pay off part of an existing loan, then having the total amount owed magically shrink by more than what is borrowed. Sounds impossible — but it's true.