The Manhattan Beach City Council faces a $91.5 million dollar question that it will answer at its meeting on November 4: whether or not to utilize a low interest bond to pay down a sizable chunk of its rapidly accruing employee pension debt.
This financing maneuver, called a pension obligation bond (POB), is an increasingly common although sometimes maligned practice among municipalities in California saddled with ballooning pension costs. The idea is to pay off the city’s Unfunded Actuarial Liability (UAL) owed to the California Public Employee Retirement System (CalPERS) by replacing it with cheaper debt currently available due to historically low interest rates.
Finance Director Steve Charelian said a POB could save the city up to $31.8 million over 25 years. The savings comes from the difference between the forecasted 7 percent rate paid to CalPERS and the 3.1 percent fixed interest rate of a POB.
“It’s an opportunity to reduce city borrowing costs,” Charelian told the Council at its October 20 meeting. “Refinancing is not an additional debt. It’s not a new debt. It replaces our current debt at a lower cost.”
This was a point that Councilperson Steve Napolitano drilled down on.
“Some folks are saying that we’re taking on an additional debt of $91.5 million,” he said. “Is that true or not true?”
Charelian said it’s simply a matter of lowering interest rates, not increasing debt.
“It’s replacing a 7 percent interest rate,” he said. “It’s similar to a mortgage. It’s refinancing your rate for a lower rate. And so we are not adding debt. This is a pure replacement.”
Charelian said several factors are at play in making the opportunity available, including low interest rates and the city’s AAA bond rating.
“It’s a moment in time that we are utilizing a tool in our toolbox, as I call it, to be able to get a low interest rate,” he said. “We finance a larger debt, a higher cost debt, to a lower cost debt…We do know [CalPERS debt] is not a localized problem. It’s a statewide problem, and all municipalities are going to face it. It’s just what you do and how you do it and how you are positioned to do it. This is a prudent management practice to be able to even get a rate this low.”
The council considered the recommendation, which represents its single biggest financial decision outside approving the city budget, at both its October 6 and October 20 meetings. The issue received little public input and no public testimony. Councilperson Suzanne Hadley implored her colleagues to wait when the discussion of pension obligation bonds began after 11 p.m. at its last meeting.
“This is our largest debt. It’s not even close,” Hadley said. “It’s 11:05 [p.m.]. It’s COVID. We’ve had no community input….I don’t think this helps us look good, with two very, very late night discussions on this topic.”
While Hadley credited staff with facing the issue of unfunded pension liability, she also ridiculed any notion that a pension obligation bond would solve the problem.
“We owe a lot in pension benefits, but we don’t owe $90 million in unfunded,” she said. “We don’t have a $90 million UAL; we have more like $200 million. The $90 million UAL is calculated by CalPERS using a worthless 7 percent discount rate. Seven percent is a fiction.”
CalPERS investment shortfalls and a tangled history dating back to legislation passed in 1999, which vastly increased state employee pension retirement benefits, has left nearly every public agency in the state swimming in debt. AB 400 was enacted by the California legislature at the peak of the dot.com bubble, a time memorialized by former Federal Reserve chairman Alan Greenspan as one of “irrational exuberance.” It allowed state public safety employees to retire at age 50 with 3 percent of their highest annual salary for each year they worked — up to 90 percent of their final salary for a 30 year career. Other public employees were allowed 2 percent per year worked, up to 60 percent. Local agencies such as Manhattan Beach were not required to follow the formula but nearly every city and county in the state did. At the time, CalPERS was prospering, with a 20 percent return on its investments over the previous two years and a 13.5 percent average over a decade. A pamphlet produced by CalPERS promoting AB 400 promised, “No increase over current employer contributions is needed for these benefit improvements.”
This proved to be wildly untrue. The bursting of the dot.com bubble caused CalPERS investments to crash during the subsequent decade. The state, cities and other public agencies who were a part of the system were left to pick up the tab. According to the California Policy Center, the state now pays 30 times more in pension costs than it did prior to AB 400. Over the past 20 years, CalPERS return on investment has averaged 5.5 percent, including 4.7 percent during the last fiscal year. CalPERS calculates its own unfunded liability at $160 billion, using a 7 percent return on investment, when in actuality that figure likely exceeds $200 billion.
Hence Hadley’s description of CalPERS 7 percent discount rate “a fiction.”
“Warren Buffett uses 6 percent for his pension liabilities…Moody’s uses 4 percent,” Hadley said. “That means our UAL is so much more than 90 million.”
Hadley said she wasn’t against the POB strategy but wanted the city to be more clear regarding what actually would be achieved. Because the city’s pension debt will likely be much larger than $91.5 million, it will incur the low-interest POB debt yet still have ongoing debt payments to CalPERS.
“We’re not paying anything off. We’re not getting rid of it,” she said. “The 7 percent from CalPERS is really not an interest rate. They can call it that, but it’s not…it’s a method of calculating a payment schedule over the mandatory 25 years. It’s not like a mortgage. You don’t go up. You only go down.”
“We probably will earn more than 3 percent, but it makes it a lot riskier bet to say I’ve got to make it between 3 and 4 percent,” Hadley said. “This only works because CalPERS has made up this ridiculous number of 7 percent.”
Hadley is not alone in her assessment of POBs. The Government Finance Officers Association (GFOA) in 2015 issued an advisory against their use. A Bloomberg News analysis, referencing bankruptcies caused by the maneuver in Stockton and San Bernardino, said Pension Obligation Bonds are “practically a four letter word” in parts of the finance world.
“The debt, which raises money to plow into public retirement systems, is deemed risky and dangerous, nothing more than a gamble on future market moves by state and local government leaders who are too clever for their own good,” Bloomberg reported, citing a study by the Center for Retirement Research at Boston College, which found “the jurisdictions that issue POBs tend to be the financially most vulnerable with little control over the timing.” The LA Times ran an article similarly skeptical of POBs, with one municipal finance consultant telling the paper “There are communities that just do not want to make the hard choices, even though it means the choices in the future will be worse. They are just going to dig themselves deeper and deeper into a hole.”
Councilperson Nancy Hersman asked Manhattan Beach’s municipal finance consultant, Mark Youngs, if it wouldn’t be better to make an assessment of POBs by not using CalPERS 7 percent figure.
“Let’s use the real numbers, and compute what we owe based on what we think are the real numbers,” she said. “I mean, couldn’t we do that?”
Youngs agreed that the $91.5 million figure was just a “snapshot” of current projected liabilities and noted that recommended policy accompanying the issuance of a POB included setting aside money for increased future liabilities.
“This is our UAL today, with fixed interest costs to CalPERS,” he said. “So we have an opportunity to refinance that and get savings. That savings will [go] to the general fund. In our UAL policy, staff has suggested taking between 40 and 60 percent of that savings annually and setting it aside for the future UAL that we know will come in. There’s the suggestion that the council not approve any enhanced benefits to employees while the pension obligation bonds are outstanding. There’s nothing that constricts the city, as you go through your bargaining process, from looking at increased employee [pension] contributions. That’s the negotiable part of labor, asking them to contribute to pay future UAL, or a portion of the pension obligation bond debt service.”
Youngs also said that much of the notoriety attached to POBs had to do with cities like Oakland, who had their own pension system and acquired relatively high interest debt through POBs.
Hersman suggested that 100 percent of any savings be earmarked for paying future liabilities not covered by the POB. Hadley said she’d be more likely to approve the issuing of pension obligation bond if Hersman’s suggestion were followed.
“That is a gift we will be giving to future councils,” she said. “I don’t want to eat all the spinach, but earlier councils ate all the ice cream and made all the promises and racked up all the UAL. And then there are staff cuts, and service cuts, and program cuts, all the spinach and all the bad news, now…I think Nancy hit the nail on the head, but I’d rather address the pain now, and leave things better off for the next council, and the next one, and the next one. But again, that $91 million is still kicking the can down the road. We’re not defeasing debt. We’re not getting rid of it.”
Mayor Richard Montgomery moved that the decision wait until the November 4 council meeting. Napolitano requested that all unanswered questions about pension obligation bonds be posted on the city website in hopes of more public engagement.
“This demands, given its size and its importance, that we get a level of comfort, and that it can be explained clearly to the public,” Napolitano said.
“We are going to hold this over because we are still going sideways on it,” the mayor said. “But we are going to make this our number one issues on 11/4 and make sure there is no one else in the universe.”
