(James Saft is a Reuters columnist. The opinions expressed are his own)
By James Saft
May 1 (Reuters) - Atlanta Public Schools is considering selling up to $540 million of bonds to make a leveraged bet on the stock market, an idea so bad it almost goes beyond the meaning of ‘idea’ much less ‘bad’.
But like so many bad ideas, pension obligation bonds are a hard one to kill, probably because they are profitable for service providers and allow those in responsibility to shift risks and costs away from themselves.
Struggling with a massive deficit - it holds only 16 cents of assets for each dollar of benefits promised and is paying out money nearly as fast as it is coming in - the Atlanta Public Schools’ pension fund is mulling a 20-year bond issue of as much as $540 million.
It is hoping to plunk the money down on investments and earn more than it will pay out in interest, using the difference to keep a lid on what otherwise would be painful rises in local taxes or a diversion of existing revenue away from other uses.
The Atlanta Journal Constitution ran an excellent piece which is worth reading in full for the complete rundown. (here)
The school district figures it can make about 7.5 percent annually on its investments, as compared to a 4.5 percent annual rate of interest on the bond.
Though not new - many other pension funds around the country have issued similar bonds with very mixed results - this is just a spectacularly wrong-headed approach towards investment, and towards meeting the obligations of the fund.
While the 4.5 percent interest rate is probably broadly correct, though it is unclear if that includes amortization of the likely considerable upfront fees the fund will be charged for selling the bond, that 7.5 percent return, without which the arbitrage fails, is far more speculative.
The fund may not be able to reach that benchmark for a host of reasons. Global markets might create lower returns in the coming two decades due to demographics or simply because of an inopportune entry point. Remember that after the blood bath at the end of the last decade, many investors were looking at a decade-long loss in their equity portfolios. Should the Atlanta fund suffer such a loss over the coming decade, the leveraged nature of the bet combined with the already very poor funding position would put it, its pensioners and the taxpayers of Atlanta in an extremely difficult position.
That’s not to mention the possibility that the fund simply chooses its managers badly and suffers a loss or poor performance despite market gains. And while we won’t know for sure who will manage the money or what strategy they will follow, I am betting that a pension fund which thinks it is a good idea to borrow money to speculate on markets won’t be going the low-cost, passive route.
Now, you could defend this move by comparing it to retirement savers, many of whom hold a sizable mortgage while also investing in the stock market for their retirements. That argument won’t float. Owning a house is a perfect hedge against needing a place to live, first off. More importantly, the person taking the risk of holding a mortgage and funding a 401(k) is the same person on the hook for the results.
That’s simply not true when it comes to school boards, municipalities or states and pension funds.
What is really going on here is a convenient shifting of risk from those currently responsible for the pension fund and Atlanta’s schools to future and current retirees and Atlanta residents and schoolchildren.
This is a generational risk shift. Voters who approve such a plan avoid taxes or worse services in the near future but create a rump risk of much higher taxes further down the road if the gamble doesn’t work.
Not only will many of today’s voters not be around to pick up the tab when it comes due, the experience of Detroit shows that tomorrow’s voters may choose not to be around either if the bill becomes too large. Why would someone want to pay high property taxes in 2033 to make good for a bad pension gambit in 2014? Just move to the suburbs.
This is also unfair to pensioners, for whom it creates a larger risk that, if things go bad, there won’t be political will to pay their earned benefits in the future.
In fact, there is only one group for whom this is a definite home run: financial intermediaries, who will earn fees by selling the bonds and further fees by investing the money once it is raised.
Leverage has its place, but not in public pensions. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at firstname.lastname@example.org and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)