Oakland's city leaders took a risk when, rather than lay off more staff or cut services, they decided to borrow nearly $213 million to cover pension payments owed to retired city workers. They're betting that the pension fund's investments will earn more than the cost of issuing pension obligation bonds.
If they're right, a financial burden is eased. If not, the city is saddled with paying interest on top of the payments it has promised retirees.
Len Raphael, an accountant and former candidate for city council, says officials who approved the bonds last year acted without understanding the risks or crafting a long-term plan to bring the city's finances in order.
"They were saying, 'Let's borrow the money now, and later we'll figure out how are we going to repay it,'" Raphael said. "That was nuts."
The struggling city in the San Francisco Bay Area made a similar gamble on pension bonds 15 years ago, and the move ended up costing taxpayers $250 million because the pension fund's investments didn't yield as much as the interest owed on the bonds.
This time, Oakland officials believe the combination of record-low interest rates and an improving stock market make it a prudent move to take out a loan to cover soaring pension costs for public employees.
Governments across the country, including Fort Lauderdale, Fla., and the state of Illinois, have taken the same approach as Oakland in recent years, borrowing a combined $53 billion between 1986 and 2009 as their retirement liabilities have grown, according to a 2010 study by the Center for Retirement Research at Boston College.
Cities and states struggling with pension obligations can choose to borrow, or they can make difficult choices, as some governments have, to raise taxes, cut services and staff, or try to reduce retirement benefits.
By some estimates, Oakland has an unfunded liability of $2 billion for the pensions and medical benefits owed to all its current and retired workers. It's trying to reduce the amount owed to 1,000 retired police and firefighters with the $213 million it borrowed in July at an interest rate of 4.46 percent.
If the investments in the city's police and firefighter pension fund yield at least that much, Oakland's gamble will pay off. The borrowing has improved the status of Oakland's system from 37.5 percent funded to nearly 70 percent, with assets now valued at $466 million.
Assistant City Administrator Scott Johnson said the move is fiscally responsible because interest rates are low and the city will be able to repay the bonds using a dedicated parcel tax.
The city is projecting a return of 6.75 percent a year — a conservative rate compared with the stock market's long-term average. But there's always the possibility of a poorer performance. The average return on Oakland's pension fund for the past five years — amid the housing market crash and the Great Recession — was 2.5 percent, according to the fund's September performance report.
It can be a dangerous gamble, said Marcia Van Wagner, a senior analyst at Moody's Investors Service.
"It's like borrowing money to pay your groceries. If you do that every month, you're going to end up with a lot of debt, and you continue to need to pay your groceries," Van Wagner said.
The Government Finance Officers Association advises state and local governments to use "considerable caution" when considering pension obligation bonds. Despite low interest rates for borrowing, the stock market remains volatile.
Still, against the backdrop of municipal budget deficits, borrowing can be an appealing alternative for elected officials who otherwise would have to cut jobs and services or raise taxes to give retirees their pension checks. That helps explain why, in the three decades since Oakland became the first government to use bonds to cover pensions costs, hundreds have followed suit despite the risk.
The Center for Retirement Research's study, which examined nearly 3,000 pension obligation bonds issued by 236 governments between 1986 and 2009, found that most of the bonds did not work as government officials had hoped.
"Only those bonds issued a very long time ago and those issued during dramatic stock market downturns have produced a positive return; all others are in the red," the report stated.
Issuing such bonds can also hurt a government's credit rating and increase the cost of borrowing. According to a December report by Moody's, pension obligation bonds tend to reflect poorly on the quality of management and is viewed as "part of a continuous pattern of reliance on one-time resources."
When the city of Stockton, Calif., filed for bankruptcy, it blamed its problems in part on pension bond debt.
"They're assuming the bond proceeds will be invested and earn a healthy rate of return, and that creates savings for them in their budget," said Tim Blake, managing director in Moody's public finance ratings group. "But our view would be that those savings are subject to risk."
Illinois, which has one of the lowest state credit ratings, is by far the largest issuer of pension bonds, with more than $17 billion. Much of that was used to keep up with required contributions to pension funds. Illinois issued the bonds in 2003, 2010 and 2011 but will not use the strategy again, said John Sinsheimer, the state's director of capital markets.
Kansas, New Jersey and Oregon are among the other states that have borrowed to keep up with public employee pension costs.
In Kentucky, the Pew Center on the States recommended issuing pension bonds along with other reforms to cover an ever-growing unfunded liability that now stands at about $33 billion.
Yet a legislative task force studying the state's pension crisis rejected that recommendation in November and instead embraced other recommendations, such as repealing cost-of-living increases for new retirees and moving workers to a hybrid plan that blends defined benefits with defined contributions.
Other governments continue to take the plunge. Fort Lauderdale approved borrowing up to $340 million in pension obligation bonds to cover much of the city's $400 million in unfunded pension liabilities at an estimated 3.9 percent interest rate.
Last month, officials in Baltimore County, Md., sold $256 million in pension bonds, projecting the move will save $343 million over 30 years.
"Given that interest rates are at historic lows and Baltimore County's superb bond rating, I have every confidence that this pension bond sale will benefit taxpayers over the years," Councilman Tom Quirk said.
Associated Press writers Roger Alford in Frankfort, Ky., and Sara Burnett in Chicago contributed to this report.