Can tax alchemy strengthen public pension funds?

The way state and local governments keep their books is uniquely different from how the private sector operates. Public sector organizations are meant to be “perpetuaries” – never going out of business – and providing a common good. They therefore record assets and liabilities in a unique way. The same goes for their pension funds.

Precisely because governments are considered perpetuities, public pensions use an “expected” rate of return on their invested assets rather than a more conservative, risk-free rate as is required of private companies. When public plan investment returns fall short of expectations, as has been the case in many plans over the past few decades, the result is an unfunded actuarial liability. Public employers are expected (and in some states, required) to pay an annual unfunded liability contribution in addition to their normal actuarial costs.

Needless to say, the public finance community is constantly looking for clever ways to reduce these annual charges and improve the actuarial balance sheets of pension funds. If they can find a way to increase the assets held by the pension fund that requires lower annual costs to the employer, hired finance professionals who receive fees for their ingenuity are rewarded for this tax alchemy.

The alchemists of old never figured out how to turn lead into gold, but that doesn’t stop pension finance wizards from coming up with clever new tactics to try to do much the same thing, and taxpayers have good reasons to be wary. .

One way to give a quick shine to pension fund balance sheets is to issue municipal bonds at a lower interest rate than the pension fund should be earning. These “pension bonds” (POBs) have a long and checkered history. The first was sold tax-exempt by the city of Oakland, California in 1985. It stirred up a wasp’s nest for the IRS, who soon realized that the tax-exempt interest rate lower tax was subsidized by Uncle Sam in no way. an idea for the pension fund that, in theory, could just invest in taxable bonds to make a profit, even without risking money in stocks. Congress was pushed to prohibit the use of tax-exempt debt where there is a for-profit investment “link”, and so a thick book of “arbitration” regulations was born. from the IRS. Therefore, POBs must now be taxable, with a higher interest cost.

When interest rates are low, as they are today, underwriters and many financial consultants come out of the woodwork to present their POB offers. The bait is always the same: “Over 30 years you will save money because history shows that equities are almost certain to outperform low bond yields”, even though they are now taxable. I’ve written extensively about the foreseeable cyclical risks of selling POBs when the stock market is trading at record highs: underwriters and peddlers will sneak in with their fees from the transaction, and officials will end up with the bag every times an economic recession or stock market crash causes the value of their “new” pension fund assets to fall below the level of their current POBs. The Government Finance Officers Association (GFOA) has long opposed POBs for this and other reasons. POBs only make sense to me when issued in recessionary bear markets.

California has seen a stream of POB deals because the state’s retirement system, the California Public Employees’ Retirement System (CalPERS), has a unique practice in how it credits municipal employers who belong to a fund. mutual investment fund that CalPERS administers. Unlike a traditional statewide pension fund where each employer contributes equally (as is the case for state teachers, who do not fall under CalPERS), the municipal CalPERS pool holds a separate actuarial account for each employer, which fluctuates solely on the results of the actuarially assumed behaviors of its employees and retirees, while sharing the investment returns proportionally among all. (CalPERS’ system also sets up “sidecar” accounts for these employers, which seem to operate in mystical ways that perhaps deserve closer examination by alchemy sleuths.)

Each employer has a unique annual contribution rate for its unfunded actuarial liability (UAAL). When an employer prepays their UPHA, they benefit from an annual reduction of 7% (of the prepaid UPHA) of their mandatory contributions. But if the CalPERS pooled fund subsequently earns less than 7% compounded, a new unfunded liability will be attached to the POB issuer’s retirement asset sub-account, thus beginning a new round of unfunded liabilities. In other words, there is no free lunch and there are no magic beans.

Another strategy that is gaining traction is converting public assets into pension assets. It takes many forms. One is in-kind contributions (AIK), whereby a public employer transfers an income-generating asset it owns to the pension fund. Obvious candidates are utilities and toll roads, which charge user fees. In New Jersey, the state transferred control of its state lottery to the pension fund as an AIK transaction that generates revenue for the fund. How these AIK assets are valued and how they will earn the actuarially assumed rate of return are debatable issues. And it’s a fair question to ask whether these deals are simply robbing Peter to pay Paul, with little or no long-term intrinsic value.

Then we have the sale-leaseback agreements. Here, a public employer sells a property that it operates to a private counterpart, a “building authority” or a fictitious company, accompanied by a long-term sale-leaseback, so that the public employer becomes a tenant and not owner. The employer receives a lump sum payment on the sale which is then paid into the pension fund. The pension fund simply invests these assets like any other money it receives. The UAAL is reduced, the annual employer contribution requirement is reduced, and its high retirement cost is replaced by annual rent payments, which are hopefully lower. But as with POBs, the risk here is that retirement investment returns may not be enough to exceed new annual rent payments.

In muni finance, it is often the case that a sale-leaseback can be structured as a tax-exempt lease. But if the proceeds from this transaction are ultimately used to fund retirement investments, there is an obvious red flag of “nexus” under IRS arbitration regulations. Taxing rents could blow up such transactions. Even if they somehow dodge this test today, it’s pretty sure that such shell games will be banned in future regulations, because it’s completely contrary to the intent of municipal tax policy.

A few bankers pitch the concept that public bodies shouldn’t inherently be owners—rather they should be tenants—on the theory that taxpayers should only pay for the use of buildings, not their ownership. That’s a corny justification, given that the profits will accrue to landlords under a sale-leaseback, and most taxable lease-to-own transactions will have a higher annual net cost to public sector tenants than this they would pay using the tax exemption.

In California, Idaho, and other states where public debt is restricted without voter approval, there may be instances where renting tax-exempt facilities is appropriate. But opportunism alone should not lead reckless local leaders to such a retirement deal. These deals will stink if the tax exemption blows up — or if employers continue to pay debt service on the facility at stake, which would charge taxpayers twice. There are plenty of smart taxpayers and watchdogs out there who can tell the gold of the fools from the real thing.


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