Add Oakland to the list of cities struggling to pay old pension debts. Recently, we took a look at PFRS -- the Police and Fire Retirement System. Let’s recap:
PFRS closed almost 40 years ago, when an audit revealed the system was underfunded by about $300 million. In 1981 Oakland residents approved a property tax to help remedy that shortfall. (The tax is about point one percent of a property’s value.) That tax -- and the fiscal maneuvers the city has used in the meantime -- have been insufficient, however, to get PFRS funded. Today, the system has half-a-billion dollars less than what it needs. Closing that gap means making hard choices between service cuts now and risky bets on the future.
Look at the graphic accompanying this article. It shows a $36 million gap last fiscal year between what the city owed (in PFRS and PFRS-related debt) and what it had. Oakland bridged that gap using a special reserve fund. But that fund is quickly dwindling, meaning the city’s general fund -- which pays for things like parks and libraries and police and firefighters -- will soon be at risk.
As you can see, the amount the city owes annually grows each year for more than a decade. This means that, barring some remedy, Oakland will have to cut services. Lots of them. But deficits the last four years means the city already has. Libraries are at their lowest possible level of funding. Oakland’s police force is barely half what it should be. Using the general fund to pay PFRS would be bad. Really bad. But it’s not clear if the alternative might be worse.
To keep PFRS funded, and out of the general fund, Oakland’s polishing off an old fiscal tactic. On June 28th, 2012, city council voted 6-2 to issue a $210 million “pension obligation bond” to help fund PFRS.
Last time Oakland tried this it was 1997. The stock market was booming, and the city wanted in on the action. So, it borrowed more than $400 million and gave that money to PFRS, which put a big chunk of it into the stock market. (It’s actually kind of interesting, the shift in how much pension funds like PFRS can put in the stock market vs. what they have to put in safer investments, like bonds -- but that’s another story.)
With the bond, Oakland bought a 14-year pension “holiday.” This meant it wouldn’t have to make its annual yearly payments. To pay off the bond debt, the city used the money from the property tax. In the meantime, the stock market went way up (think dot-com bubble), and way down (think 2008-2009 financial crisis). By the time we get to 2010, near the end of the city’s pension “holiday”, the city auditor’s office asked a question: how’d Oakland do with its bonds? It’s an important question, because what the city learned from its 1997 pension obligation bonds can teach a lesson about the up and downsides of doing the same thing today. If the city, in 2012, wants to make a sequel to POB 1997, it should know: Was it a hit, or a flop?
In 2010, City Auditor Courtney Ruby contracted the firm Aon Hewitt to prepare a report on the impact of the 1997 POBs. You can read it here. The main finding was that the city ended up $250 million behind where it would have been had it not borrowed any money and, instead, just made its payments to PFRS annually.
How would that happen?
First, you have to look at what the city owes PFRS. It might help to imagine a tank of water. The tank is constantly emptying, and, ideally, constantly being refilled. But in the years before Oakland issued the bonds, the tank was emptying faster than it was being filled. By 1996, Oakland owed $626 million dollars to PFRS -- $626 million it didn’t have. Experts say pensions systems should be in the 70-80% funded range to be healthy. PFRS was at half that level. The tank was going dry.
The 1997 pension obligation bonds helped fix that. Oakland poured $417 million in PFRS. That brought its funding percentage up to a healthy 82%. Then, that invested money took a ride (to switch metaphors) on the stock market roller coaster.
In 1997, the roller coaster went way, way up. The PFRS portfolio increased by 15.5%. It was now 88% funded -- a really happy number. The next year, the stock market roller coaster climbed even higher. PFRS’ portfolio grew another 19.5%, and by 1999, the system was 107% funded. It had more money than it ever expected it would need. (Excess funds, if you’re curious, return to the city of Oakland after its PFRS obligation terminates.)
But roller coasters also go down. And In 2008 and 2009, the stock market roller coaster went way down. In 2008 the PFRS portfolio lost 33.8%; in 2009, it lost 18.2%. And by 2010, PFRS was only 40% funded -- essentially back to where it started. The city still owed the system nearly $500 million dollars. And on top of that, it owed an additional $510 million dollars to repay the bond and the interest on the bond. In total, the amount the city still owed came to just over a billion dollars.
So that’s what actually happened. To compare, the auditor’s report conjures a scenario where Oakland has not taken a loan. In this hypothetical case, the city paid roughly $30 million into PFRS each year. This would not have helped fill the tank very much. By 2010, in this scenario, the city would owe PFRS a whopping $760 million. But, on the plus side, it wouldn’t have any bond debt. Therefore, the report concludes, issuing the 1997 pension obligation bonds cost Oakland $250 million.
Representatives from the PFRS board and the Retired Police Officers Association (RPOA) dispute the report’s analysis. Bob Muszar, president of the RPOA, says it was a 2001 refinancing of the 1997 bond that caused the problem. According to city documents, the 2001 POBs refinanced about $200 million in debt. Like today, the purpose was buying breathing room. Oakland got smaller debt payments in the present, in exchange for more total debt in the long run. Repaying that $200 million will cost the city more than $500 million. Without that refinancing, Muszar says, the 1997 POB would have put the city ahead.
He also points out that it’s too early to assess the success or failure of the POBs. Retirement systems use long time windows, 25 years or more, to evaluate market growth. He says the 1997 POBs may yet prove their value.
It’s important to emphasize that the question isn’t should Oakland invest in the stock market to fund its pension system? Pension funds are always playing the stock market. Rather, the question is, should Oakland use borrowed money to do it? The 1997 pension obligation bonds offer a clue. Yes, they can return huge gains. And yes, they give a city breathing room, time for economic growth to put the city in better fiscal shape. But they also create huge debt -- debt that future Oakland residents are forced to pay. And whether the gains outweigh the debt, no one can know beforehand. So the city has to guess. It’s complicated stuff. And Oakland’s future depends on it.
What do you think Oakland should do? Let us know.