For the fifth year in a row Pension Obligation Bonds have been proposed by Scott Walker as a solution to the chronic underfunding of the Milwaukee County Pension system.  After securing bipartisan political support for the idea in 2008, even though it was rejected 57-43% in a 2004 referendum, it appears that the 2009 county budget may be the first to actually implement the proposal.  But with the lingering effects of the 2001 pension scandal and subsequent litigation against the county’s pension consultant Mercer Inc., the question that remains to be answered is whether the issuance of $400 million in Pension Obligation Bonds will result in any actual savings for county taxpayers.

The main goal behind issuing $400 million in Pension Obligation Bonds is for the county to stabilize the funding level of the pension fund by borrowing money in order to prepay 95% of the Unfunded Actuarial Accrued Liability (UAAL) as of July 1, 2008, which is approximately $396 million.     The UAAL is the gap between the assets of the county pension fund and the expected pension benefits it will pay out.   In the 2008 budget, this amount was $329 million; as of September 2008, the UAAL ballooned to staggering $700 million due to the recent stock market collapse.

By issuing taxable bonds that they project will pay 6% interest, the county hopes to achieve an 8% rate of return from the immediate reinvesting of the $400 million bond proceeds.  Over a period of 30 years, the projected savings would be $320 million.   The immediate benefit would be a fixed debt payment of $48.4 million in 2009, rising to a stable $56.8 million payment in 2010 and the years to follow.

Is this the right time for the county to dip its toes in the waters of actuarial arbitrage?  As the Public Policy Forum’s 2009 Executive Budget Analysis describes the situation, it may not matter to Scott Walker or the county board because of the budgetary pressures they’re facing:

Failure to move forward as outlined in the recommended budget would require policymakers to identify an additional $8 million in property tax levy to fulfill the actuarially required pension fund contribution.

The main concern about Pension Obligations Bonds lies in the very narrow spread between the expected interest rate the county will pay in order to borrow the money and the rate of return they hope to earn.  In the proposed Executive budget, the county expects to borrow at 6% and invest at 8%.  At a time when the typical investor likely saw their investments take a 20-30% haircut, the idea of earning such a rate on investments may seem irrational.

In fact, it probably is.

Among investors, none other than Warren Buffet finds the idea of pension funds achieving an 8% rate of return to be illogical and practically impossible under a conservative investment approach.  In his 2007 letter to shareholders he writes:

The average holdings of bonds and cash for all pension funds is about 28%, and on these assets
returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss.

This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.

How realistic is this expectation? Let’s revisit some data I mentioned two years ago: During the
20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.

Think now about this century. For investors to merely match that 5.3% market-value gain, the
Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.

As of July 2008, the Milwaukee County pension fund’s investment portfolio consists of 46.3% fixed income, 50.2% equities and 3.5% in real estate.  Essentially, the county’s pension fund’s investments are more conservative than Buffet’s typical pension fund estimation and would require an even higher rate of return on its more risky investments.   In order to achieve an even higher rate on the county’s stock holdings it would require even riskier investments.  In the rush to achieve higher rates of return, the slightest setback in the next few years would exert far greater pressure on the pension board to push for higher returns, potentially leading to even riskier investments.

Pension Obligation Bonds may be good policy for the county’s investment advisors, who stand to benefit from $400 million in new investment capital and the fees such a large amount of money will generate for them, but in the event that the County’s investments fail to yield an 8% return all we as taxpayers will have financed is a short-term delay.   For should this plan fail, the day will come when the pension fund requires an even greater amount of taxpayer’s dollars and the problem will have only been passed on to the next County Executive and put upon the backs of the next generation of Milwaukee County taxpayers.    Undertaking such a precarious strategy in order to achieve relatively minimal yearly savings requires more scrutiny from the county board and a clearer presentation of the associated risks to the taxpayers.