Originally published at Forbes.com on August 24, 2018.
The Wall Street Journal brought the Chicago pension obligation bond proposal, which I first addressed in an article last week, into the national spotlight yesterday, in a (nonpaywalled) article, “Chicago’s New Idea to Fix Its Pension Deficit: Take On More Debt,” which reports that:
Finance Chief Carole Brown said she would decide in the next week whether to endorse a $10 billion taxable bond offering that would be used to help close Chicago’s $28 billion pension funding gap. If the proposal is accepted by Mayor Rahm Emanuel and approved by the City Council, it would become the biggest pension obligation bond ever issued by a U.S. city.
The article further reports that the city is expecting a 5.25% interest rate for the bond; its bet is that it will earn more by investing those assets than it has to pay out in interest.
Easy money, right? Eh, not so fast.
The municipal pension valuation interest rate is currently set at 7%; it is the nature of government pension accounting that, in general, valuation interest rates are set at the plan sponsor’s assessment (working with investment advisors) of the expected long-term return on fund assets. This means that, based on the pension board’s own assessment, there isn’t much room for error. And, indeed, Thurston Powers, writing at ALEC (American Legislative Exchange Council), is skeptical:
Unfortunately, the pension funds’ return expectations are overly optimistic. The Chicago pension system’s assumed rate of return of 7.5 percent is well over the national average of 6.9 percent in 2017. The past 30 years of investment returns are, unfortunately, unlikely to mirror the next 30 years. Some leading financial analysts estimate that only a 5 percent rate of return can be safely expected.
It is always the case that there is no free lunch, and that the very reason why the stock market has, on average, higher returns than bonds, is because these are riskier investments.
What’s more, the WSJ notes that the projected bond interest rate is higher than you’d expect for a municipal bond because
The debt would be taxable since the federal government typically doesn’t allow cities and states borrowing for pensions to take advantage of the tax exemption usually afforded to municipal bonds.
And, at the same time, the bonds would be in the form of a “sales tax bond.” Since the city’s bond ratings are below investment grade (Ba1 at Moody’s, that is, one notch below investment grade), Chicago is now resorting to an alternate method of issuing bonds, in order to avoid the very high rates they’d otherwise have to pay: this is the use of future sales tax revenue as collateral. Regarding an issuance of bonds earlier this year via its Sales Tax Securitization Corporation, Reuters reported,
The bonds are rated AAA by Fitch Ratings and AA by S&P Global Ratings, both of which are several notches higher than the city’s GO ratings of BBB-minus by Fitch and BBB-plus by S&P.
This is the not good news it appears to be.
This means that, not only is the city mortgaging its future to try to cope with overpromised and underfunded benefits, it’s doing so in a way that traps residents far more deeply.
Chicago is not the first city to issue such bonds; again, the WSJ notes that Detroit, Stockton, and San Bernardino did so likewise, and subsequently declared bankruptcy. But pledging future sales tax revenue, in a manner that’s inescapable even in bankruptcy, in a city that’s already sold off (sorry, 100/75-year-leased) future Skyway toll road revenues and future parking meter revenues, to plug municipal budget holes — that makes the proposal far more worrisome than even the market risk of a conventional pension obligation bond.
December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.
The plan is a good idea, but not thiught through. Chicago wants to raise money for its pension fund. There are many ways to do this that can be explored , skyway deal is a type of option.
One problem is that if the investments dont return 7.5 in any year, but debt still has to be paid , city is in cash flow crunch. Lots of potential solutions , but it requires deep analysis and not tweetable answers. But is anybody really listening? Happy to do guest column .
Question.. Does Chi city borrow on the pre pension monies? Does IL not passing a state budget for over 700 days impact Chi city pension issues?
Look forward to someones reponse and learning.