Bad timing for Portland’s pension bond balloon payments 

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Portland is facing difficult choices about what to cut in its next budget as it struggles to deal with a projected revenue loss of $8 million to $10 million resulting from the coronavirus pandemic.

One area that cannot be cut is ballooning debt service on pension obligation bonds. 

Almost half of the city’s total debt service – $15.47 million this fiscal year – is for bonds that were issued in 2001 to pay Portland’s unfunded pension liability. These payments will grow by $1 million per year for the next five years until the final payment of $22.3 million in 2026. 

The sale of bonds was proposed in 1999 by the finance committee as a way to save money on interest for the $107 million the city owed the state in unfunded pension liability – the gap between the amount the state has in its pension fund and the amount it is obligated to pay. Portland is a participant in the state pension system. 

While the refinancing saved money on interest, because the city’s debt service to the state would have been about $850,000 more than it is paying on the bonds each year, city Finance Director Brendan O’Connell said he would have structured the bond debt differently so it would not place such an uneven burden on future budgets. 

A statewide referendum in 1996 amended the Maine Constitution to require that the unfunded pension liability at the time be completely paid off by 2028, after decades of politicians deferring pension allocations and extending amortization periods. At the time the Maine State Retirement System, which covers state employees, public school teachers, and employees in participating local governments, was the third most underfunded state pension system in the nation, exceeded only by West Virginia and the District of Columbia. 

Portland’s debt would have followed the statewide amortization schedule, to be paid off over 28 years at an 8 percent interest rate. 

(Source: City of Portland)

But instead, the finance committee proposed issuing pension obligation bonds with lower interest rates and using the money raised to pay its debt to the state all at once. This refinancing plan was projected to save the city anywhere from $10 million to $55 million over the next 28 years. 

The plan required a charter amendment to allow the city to borrow money to pay debts, and was approved by the City Council and then Portland residents in a referendum in 1999.

Walston “Bud” Gallie, president of the Portland Taxpayers Association at the time, told the Portland Press Herald in 1999 before the vote, “This may be a little bit of a gimmick, but for $55 million, I’ll take it.” 

Then-City Councilor James Cloutier, who was a member of the Finance Committee, told the paper, “We’re basically borrowing interest to pay interest.” 

When the bonds were issued in 2001, the unfunded liability bill to the state had grown to $111.8 million. The payment schedule for the bonds compared to the payment schedule the city would have paid the state showed Portland saving $21 million in interest. 

But O’Connell questions why variable-rate bonds were issued and whether all of the costs were considered in the analysis. 

“If the city was facing the same issue it had back in 2001 … in the 2020 market environment I certainly would not opt for the same solution,” O’Connell said. “I wouldn’t encumber future city councils with significantly increasing debt service principal payments over time. … I would always issue my regular debt for the city as fixed rate because you want predictability in your budgets.” 

The bonds were sold as variable-rate demand obligation bonds. The payment schedule had only interest due for the first five years, and a small $100,000 principal payment for the next seven years. Starting in 2015, however, principal payments increased by about $1 million per year. 

O’Connell also said he would not choose a variable-rate debt instrument fixed to a derivative. He explained that the city entered into a derivative called an interest rate swap so that it could pay fixed rates while the bank it swapped with – BNY Mellon, the successor to UBS – pays the variable rates. The fixed rate is currently set at 8.9 percent.

The swap is preventing the city from refinancing that debt now that interest rates are lower because there is a fee to break the agreement. That fee would currently be about $29 million, O’Connell said. 

Variable-rate demand obligation financing also requires a “standby purchase agreement” and remarketing agent, which O’Connell said do not appear to have been considered in the cost analysis. The fees are variable based on current market interest rates and the amount of principal outstanding on the bonds. For fiscal year 2021, he said, they’ll be just under half a million dollars.   

Shortly after O’Connell became Portland’s finance director in 2015, the city renegotiated the standby bond purchase agreement, moving it from J.P. Morgan to Sumitomo Mitsui Banking Corp. O’Connell said this saved the city $1.56 million over the duration of the agreement. Financial services firm Raymond James is the remarketing agent.  

Pension obligation bonds have led to problems in other municipalities when the money from the sale of the bonds is invested on the assumption that more interest can be gained than is promised in interest to the bondholders. If the investment doesn’t perform as expected, the governments end up losing money.

In Portland, the money from the bonds was used to pay off the unfunded liability to the state as a lump sum, and the state is now investing that money separately. The bond payments are not tied to the performance of those investments. 

One benefit of the city refinancing its liability to the state when it did was that the state assumed a higher rate of return on its pension fund in 2001 than it does today.

The state calculated what Portland owed in 2001 for its future pension obligations assuming 8 percent growth per year. Over the past several years, economists have seen the dangers of assuming such high rates of return in pension funds and recommended using lower rates in projections. Today, the Maine Public Employee Retirement System assumes 6.75 percent growth (known as a discount rate) when setting contributions. 

“If we had issued a (pension obligation bond) in 2001 using a 6.75 percent discount rate, the actual amount of the bonds would have been tens of millions higher,” O’Connell said, “so in that respect, it was a good move to address our liability sooner rather than later.” 

The three-year average return for the state’s total pension fund is currently 6.5 percent, according to the Maine Public Employee Retirement System. 

The contributions by employees and employers, including the city of Portland, are set by law and are adjusted each year according to an actuarial method that tries to match the contributions to the amount needed to pay future benefits. 

“Maine’s pension plan has been one of the consistently most healthy plans in the country in terms of funding percentage, and they take a lot of pride in that,” O’Connell said. 

Maine was ranked 13th in the nation for the ratio of pension obligations that were funded, according to a study done by the Pew Charitable Trusts using 2017 data, when Maine’s pension obligations were funded at 82 percent. In 2019, the ratio was 83.3 percent. 

As of the first quarter of 2020, returns on the Maine PERS total fund dropped 5.6 percent. 

Sandy Matheson, executive director of Maine PERS, said rates are already set for fiscal year 2021 for municipalities, so there will be no changes in those contribution rates. This year’s gain or loss will be set by June 30 and will affect municipal contributions for the 2022 fiscal year.

“There is still a lot of time to go (two weeks) before we will know how this year’s earnings compare to our earnings expectation of 6.75 percent,” Matheson said in a June 16 email. “We have learned not to anticipate prior to June 30th because major market swings, both up and down, can occur in a two-week period.”