Tom Sgouros: Jorge and John bet big
“In the movie Casablanca, Rick advises Annina’s husband Jan at the roulette table to bet it all on 22, twice. It worked out for them, but not because they were lucky. The stock market is not as friendly a gambling house. Without a sympathetic proprietor to whisper in their ear, do Mayor Elorza and Council President Igliozzi want their legacy to be a big bet on 22?”
The City of Providence is proposing to sell a $704 million bond to pay off part of its pension liability. In the trade, this is known as a “pension obligation bond” or POB. Is this a good idea? Do you like to play roulette?
The Government Finance Officers of America (GFOA) is actually pretty blunt in their advice: “State and local governments should not issue POBs.” Other national groups are more equivocal, but GFOA is an important voice.
Providence’s pension plan is in dire straits, hamstrung by Buddy Cianci‘s absurd gift of pensions with cost-of-living adjustments (COLAs) far in excess of inflation, as well as a few years he totally skipped payments in the 1990s. The plan has only $350 million on hand, against around $1.5 billion in pensions it will eventually owe.
These COLAs, some of which increase a pension payment by 6% every year, are the big villain here. Someone who retired in 1995 with that benefit has seen their pension grow by a factor of two-and-a-half, after adjusting for inflation since then. There was a court settlement that curtailed most of these, but a few dozen retirees objected, and won a judgment last summer, and so are still receiving these COLAs.
This is a benefit that no pension plan was designed to support. While one can feel a certain sympathy for retirees wanting the city to make good on its promise to them, these people were made a stupid promise by a corrupt mayor. Their determination to extract this promise from a city whose finances are so weak shows they feel no loyalty not only to the city they served, but also to their own younger comrades who are also counting on having a pension.
But given the situation – retirees who refuse to moderate their claim to these benefits, state judges who refuse to acknowledge Providence’s claim of fiscal exigency when they offered so much more deference to the state’s much weaker claim under Gina Raimondo‘s pension reform, a state government that refuses to acknowledge that Providence’s problems are also their problems – what should the city do?
On the face of it, a POB appears to be a fabulous idea, a way to replace a 7% debt (the pension liability) with a 4% debt (the bond). Stated this way – and this is precisely the way the bankers and bond lawyers who will profit by the deal will portray it – it’s a no-brainer.
But the problems arise as soon as you look a bit closer. A pension debt isn’t a debt in the same way as a bond. The last dollar of a pension debt isn’t due until the youngest current employee dies, which might be 70 or 80 years in the future. There is quite a bit of flexibility in how to meet a debt with a schedule like that, while there is zero flexibility in how to meet a bond obligation.
This is not a detail. If investment returns over the course of the bond are not substantially better than the bond’s interest rate, the plan’s condition will not improve and everything will get worse. This was the experience of Woonsocket, who issued a POB in 2003 and failed to find investment returns to match the bond’s interest rate. As a result, their pension obligation didn’t go down appreciably, plus they now owe the bond, too.
A 2009 report and 2014 update by the Boston College Center for Retirement Research reviewed a few thousand POBs and concluded that whether a POB was a success depended almost exclusively on market timing. Some POBs worked out, but most did not, and what made the successful ones work was mainly just luck. Worse, the report points out that the fiscally strapped governments are the least likely to have any discretion about the timing. This finding is behind GFOA’s blanket advice.
In the movie Casablanca, Rick advises Annina’s husband Jan at the roulette table to bet it all on 22, twice. It worked out for them, but not because they were lucky. The stock market is not as friendly a gambling house. Without a sympathetic proprietor to whisper in their ear, do Mayor Elorza and Council President Igliozzi want their legacy to be a big bet on 22? The stock market is currently at a 5-year high. What confidence can we have that it is going to keep going up? If it does not, this bet will fail. One cannot avoid the suspicion that the timing these two are suggesting here has more to do with their imminent departure from office (they are both term-limited and will leave office next year) than with any kind of canny market-timing strategy.
There are other options. “Dollar-cost averaging,” the practice of parceling out a large investment over time is pretty routine as investment advice goes. Rather than bet $714 million on 22, the city could bet $100 million per year over the next 7 years and thus hope to even out some of the fluctuations of the stock market. Obviously, the city might lose some potential investment upside, but it would lose some potential downside, too, which is what hedging risk is all about. The Boston College report suggests this as a strategy.
Providence and its pension plan are in a hard place, but the forces that brought it to this place are still acting, even if the situation is better than it was. The POB plan involves making a gigantic gamble to bail out a ship that is still leaking. It should be obvious to anyone that bets made under these conditions must be approached with great skepticism.
In presenting the idea, the mayor said, “Doing nothing is not an option.” He may be quite right about that, but that doesn’t mean that “Doing what the bankers and bond lawyers tell me to do,” is the best strategy, either.