Chicago Pension Obligation Bonds, a Strategy or Gamble?

Chicago Mayor Rahm Emanuel’s administration is exploring the possibility of issuing billions of dollars of pension obligation bonds and investing the proceeds in order to reduce the city’s $28 billion in official net public pension liabilities. If the investment returns exceed the borrowing costs, the annual pension funding cost to Chicago taxpayers will be reduced, diminishing the need for tax hikes to resolve the problem. However, if the return on the invested bond proceeds falls below the interest rate on the pension obligation bond series, the existing pension liabilities will grow even larger, leaving Chicago taxpayers worse off. With interest rates on the rise and equities markets that have already realized long-term gains, the latter outcome of this arbitrage gamble appears increasingly likely.

The success or failure of a pension obligation bond is largely dependent on timing. Ideally, a pension obligation bond is issued during the intersection of historically low interest rates and the recovery period after a recession. The time between these windows of opportunity can span a decade or more whereas political considerations rarely extend beyond the next election. For politicians, a pension obligation bond may provide a solution to a cash flow problem; but these bonds are rarely suited to be part of a comprehensive liability management strategy. Indeed, most pension obligation bonds have been issued out of desperation. Despite their theoretical usefulness, most pension obligation bonds have poorly performed and tainted the reputation of the entire asset class.

Several factors influence the interest rate of a bond. Certainly, Mayor Rahm Emanuel’s administration will attempt to secure as low of interest rates as much as possible to increase the probability of successful arbitrage. For example, Mayor Emanuel plans to issue “sales tax revenue bonds” where sales tax revenue is diverted to debt service before it can be appropriated to core services. In the context of a pension obligation bond, this approach would ensure bond payments from tax revenue are guaranteed priority over the funding of core government services.

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 of6.9 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. In fact, a bevy of plans have cut their assumed investment rate of return in 2018. Rosy assumptions create an illusion of a higher probability of arbitrage success than exists, putting Chicago taxpayers at risk.

With rising interest rates and equities markets appearing to have already priced in strong economic growth, equities markets are at risk from an unexpected economic slowdown or impacts from new tariffs. Mayor Emanuel’s proposal is likely driven by a short-term cash flow problem rather than a measured strategy to reduce Chicago’s liabilities.

The incentive to overestimate the future investment rate of return on the proceeds of the bond is strong. After all, this increase in estimated cost savings relaxes the issuance requirements, such as the maximum interest rate the city will pay on a bond. Issuing these bonds may resolve the cash flow problem for the remainder of Mayor Emanuel’s term and temporarily lift public approval ratings. But ultimately, Mayor Emanuel should abstain from gambling with the future paychecks of Chicago residents. Structural reforms, such as switching to defined contribution plans, cash balance plans, or creating a set of automatic triggers that ensure solvency, rather than a gamble is needed.