By: Mark Glennon*
A debate is emerging over whether Illinois’ pension obligation bonds, seen through the rear view mirror, were wise.
The idea behind pension obligation bonds is actually pretty simple. Instead of the state funding its pensions, it borrows from the public by issuing bonds and uses the borrowed money to fund the pension, with the pension then investing the proceeds. Whether that works out depends, at least in part, on whether interest the state pays on the borrowed money exceeds the returns the money earns on the investments the pension makes.
In 2003 Illinois issued $10 billion of those bonds to fund pensions at an interest rate of 5.05%. Last week the Civic Federation issued a report about whether that worked out, comparing the returns the pensions made on that borrowed money to the interest paid. In seven of the ten years since that bond issuance the returns exceeded that interest, but the state lost money in the other three, according to that report.
Unfortunately, the Civic Federation did not quantify that in dollars. You really need to have those dollar numbers to see whether the good years cancelled out the bad years. The Civic Federation doesn’t like pension obligation bonds, so we figured there might be a little more to the story and we did not link to the report, pending looking at it further.
Well, sure enough, some of the supporters of that 2003 bond offering went to a reporter with their numbers showing how smart they had been — a reporter they figured would probably be sympathetic to borrowing to fund pensions. That would be Greg Hinz at Crain’s. Today, he published their numbers, which indicate the state is about $8.5 billion ahead thanks to the pension bonds. Hurray, we borrowed low and invested high, they’re saying.
While that $8.5 billion number is probably correct, the Civic Federation is right to dislike them. They are a gamble, shouldn’t be judged with hindsight, and are fundamentally wrongheaded. The state may have made a profitable trade but the $10 billion principal obligation at issue was pushed from one credit card to another.
First, we won’t really know whether they work out until the bonds are paid off twenty years from now. Markets have good years and bad years. As any number of experts said when the bonds were issued, they are a dice roll.
Second, $8.5 billion may sound like lots of money, but it didn’t help much. The unfunded liability of the state’s pensions totaled about $43 billion when the bonds were issued. Today, it’s officially around $97 billion, and really more like $186 billion according to Moody’s, using realistic assumptions.
Third, there’s another aspect to pension bonds rarely discussed. Like all general obligation bonds, they are entitled to a statutory payment priority. They get paid first before other state expenses. Pension deficits have no such priority. While the constitution prohibits reductions in pension benefits paid out, it does not require appropriations in. By shifting part of the pension deficit into a bond obligation the pensions effectively prioritize themselves. The pensions are, in essence, calling dibs on some of the state’s body parts. Taxpayers no doubt don’t realize that these bonds put pension funding ahead of schools, roads, and everything else.
Finally, and most importantly, it’s morally wrong to stick young people and our kids with the bill, payable by them through a 30 year bond issuance, for an expense we incurred today. Regardless of whether the earnings on bond proceeds exceed pension costs, that’s no excuse for deferring pension cost; the principal amount at issue still has to get paid, and that’s getting kicked down the road. It went from one credit card to another. Pension defenders like to say that we’ve raided pensions to fund other things, but they forget about these bonds. And the state sold another $7 billion of them in 2010 and 2011. No word on how those are working out.
Explain it to your kids.
*Mark Glennon is founder of WirePoints