RETURN TO FIRST PRINCIPLES

Providence's pension obligation bomb

By STEVEN FRIAS
Posted 6/9/21

Mayor Jorge Elorza is urging the General Assembly to allow Providence to borrow, without voter approval, at least $750 million for a 25-year pension obligation bond (POB). Providence plans to invest the POB proceeds and reduce its $1.2

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RETURN TO FIRST PRINCIPLES

Providence's pension obligation bomb

Posted

Mayor Jorge Elorza is urging the General Assembly to allow Providence to borrow, without voter approval, at least $750 million for a 25-year pension obligation bond (POB).

Providence plans to invest the POB proceeds and reduce its $1.2 billion unfunded pension liability. Essentially, with a POB, you take on another debt to pay off an existing debt, and bet that you will earn more by investing the borrowed money in the stock market than you will pay in interest costs.

POBs should be avoided. They are high-risk, highly dependent on timing, and can fail miserably.

In general, for a POB to save taxpayers money, two conditions should be met. First, the difference between a POB’s interest rate and the expected return on investing the POB’s proceeds must be large. If the difference is small, it leaves little margin for error. A low-interest rate to borrow the POB is necessary.

Also, the estimated return for investing the POB proceeds needs not only to be high, but also realistic over the long-term. In recent years, the estimated returns for pension funds have come down from over 8 percent to close to 7 percent. These estimated returns will likely need to come down further. In the long-run, stock market performance is linked to real GDP growth, and real GDP growth in the United States has declined over the last two decades.

Second, because the POB proceeds are being invested all at once, the investment into the stock market must be made when stock prices are low such as right after a crash. If the POB proceeds are invested towards the end of a stock market boom, the consequences will be disastrous. Timing is everything. As noted by the Center for Retirement Research at Boston College, “even over 15 to 20 years, the duration of most POB debt, interest costs can exceed asset returns.”

If either of these two conditions are not met, a POB can turn into a fiscal fiasco. For example, in 2002, the General Assembly authorized Woonsocket to issue a $90 million POB. The interest rate for Woonsocket’s POB was about 6.25 percent. Although the interest rate was high, Woonsocket believed that it could cover the borrowing costs because its assumed investment return was 8.25 percent. To assist them in achieving this return, Woonsocket hired Wilshire Associates, a nationally recognized investment advisor.

At first, it seemed to go well. From 2003 to 2007, Woonsocket’s pension fund averaged a return of 8.58 percent. Although this was below what other pension funds were achieving, it was higher than its estimated return of 8.25 percent.

Then the stock market began to crash. For fiscal year 2008, the return was about negative 9 percent. Woonsocket switched investment advisors and investment strategies. Woonsocket adopted a more conservative approach, which protected its pension fund assets but also lowered its investment return.

Then state aid was cut. The school department ran deficits. Woonsocket failed to contribute millions to the pension fund. Woonsocket’s pension plan went from over 100 percent funded to less than 60 percent funded.

It was a fiscal meltdown. A state-appointed budget commission took over the city’s finances. Taxes went up by nearly 23 percent in one year. The cost-of-living adjustments (COLAs) for retirees were periodically suspended. In 2015, Richard Lepine, the chairman of the Woonsocket Pension Investment Commission, lamented, “that bond was a problem … We are the poster children of what not to do.” Today, Woonsocket’s pension plan is about 30 percent funded.

Furthermore, the last time Providence toyed with a POB, it nearly led to disaster. In 2006, under Mayor David Cicilline, the Providence Pension Study Committee recommended the city issue a POB at a 6 percent interest rate on the assumption that its investment return would be 8.50 percent. In June 2007, legislation was proposed to allow Providence to issue a POB of up $700 million. Fortunately, the legislation died because, within a year, the stock market began crashing. Years later, in 2018, the Providence Pension Working Group stated: “Fortunately, the City did not follow this recommendation [to issue a POB], which would have increased the City’s investment losses during the 2008-09 stock market reversals.”

Providence’s POB would be risky. First, the margin between borrowing costs and a realistic investment return may be too small. Even if the interest rate on the POB is close to 4 percent, according to a recent actuarial experience study, Providence’s investment return is expected to be 6.40 percent over the next 20 years. The difference between the borrowing cost and the expected investment return is between 2 to 3 percent. The difference between Woonsocket’s POB interest rate and its estimated return was around 2 percent, and that margin proved to be insufficient.

Second, and most concerning, while interest rates are low, stock prices appear high. The S&P 500’s P/E 10 ratio, which measures the value of stocks by comparing current stock prices to corporate earnings over a 10-year period, is currently at its highest level since the dot-com stock market bubble 20 years ago. With a POB, Providence would invest hundreds of millions into the stock market all at once. The amount being invested would be about double what Providence now has invested in the market. Making such a large investment when stock prices appear high could prove to be disastrous if the market significantly declines in the next few years.

Because so much can go wrong with POBs, they should be avoided. Not surprisingly, the Government Finance Officers Association does not recommend the use of POBs. However, for politicians, it is easier to gamble in the stock market with borrowed cash than to reduce pension benefits for government employees.

Instead, Providence should bring its employee pension benefits into line with the private sector. First, close the pension system to new hires. Second, require new hires to enter 401k type plans, which occurred in Cranston for clerical employees in 2010 and manual laborers in 2013. Third, reduce the pension benefits of current employees, which occurred with state employees in 2011, through a hybrid pension plan and by raising the minimum retirement age. Fourth, for retirees, partially suspend pension COLAs for a specific time period consistent with recent R.I. Supreme Court decisions.

Providence’s unfunded pension plan is a ticking time bomb. To diffuse it, pension benefits must be reduced. A POB won’t diffuse the bomb; instead, it may set it off.

Steven Frias is Rhode Island’s Republican National Committeeman, a historian, recipient of The Coolidge Prize for Journalism, and former Chairman of the Cranston Charter Review Commission.

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