One of the most dramatic proposals made by Mayor Nutter on Thursday was floating ("to float" is to issue a security, though if you keep reading, maybe one of the other definitions of that word could apply) a $4.5 billion bond to fully fund the city's pension plan. It made headlines in both the Daily News and the Inquirer. If you're like me, a lot of the terms were somewhat unfamiliar. Let's break it down.
The city provides employees with a retirement plan called a pension. Municipal workers, like garbage collectors or police officers, contribute a portion of their salary to a fund that is matched by the City. The pension is called a defined benefit plan and requires the city to make fixed payments to individual over time. These payments are required regardless of the financial situation of the city.
The problem is that the cost of the pension program is skyrocketing because there are now more retirees than employees in the system. In 2007, more than $400 million of our tax dollars went to the pension fund. That number is expected to rise to nearly $500 million by 2012. A report entitled "The Silent Crisis" by the Pew Charitable Trusts and Pa. Economy League estimated that the city owed $3.9 billion to the pension fund.
Ok, so that explains the pension side. But what exactly is a bond? A bond is essentially a loan made to the city by banks and other financial institutions. It's somewhat similar to when a company goes public and issues stocks. The big difference is that stock-holders are partial owners of company and bond-holders are only lenders to the municipality. Cities that issue bonds must eventually pay back both the principal and the interest to the bond holders.
Nutter's wants to issue a $4.5 billion pension obligation bond to fund retirement benefits. This is the largest bond in the history of Philadelphia. The money will be placed into the pension fund and then invested into the stock market. The mayor believes that this will free up some money for the general fund in the short term and lock pension payments into a predictable schedule.
However, there are some who see it as a potentially risky proposal. In 1999, Philadelphia tried issuing a pension bond for $1.25 billion. The deal wound up costing the city millions because it was poorly structured and the city pension plan lost money in the stock market.
It will be interesting to see how the troubled national (and international) economy impacts the bond proposal. Markets are volatile, the bond insurer market is very troubled, so there are many questions: Will Philadelphia be able to secure a good interest rate? Does it make sense to put a huge infusion of cash into the stock market while things seem so shaky?
This pension obligation bond is complicated stuff. Can anyone think of a clearer way to explain this situation? And if so, can they explain it to Council, who will have to approve this idea?
Comments (2)
I think this is a very good explanation, thanks. When I heard MN's proposal, I focused on the fact that he was addressing the issue as a whole and since I'm part of the 'cult' of MN right now--and I think that means I trust him, I accepted his proposal at face value and did not question the risk element. So this explanation is helpful in bringing me back to skeptic earth.
So I can't help you explain it better. But I think this means MN already understands the risks. So now I'm thinking about his strategy. I wonder if he's putting this option out there because it would be great if it worked, but also because he expects it to be challenged. And that challenge could create greater success if it draws out better solutions/compromises and reveals other resources. So, does he see it as a starting point? And how can citizens support the debate and not leave it to the sharks? Since this is complex finance, I and other non-financial people are inclined to let the numbers guys figure it out. But that's sort of how we got into this mess in the first place (city and nation).
Is the pension problem really so serious that there are no other solutions? Who else besides pensioners would profit from the creation of this financial instrument? (law/acctg firms with billable hours? financial institutions? consultants? etc) Are taxpayers left holding the bag?
Posted by mb | February 16, 2008 1:57 PM
Yeah, it's risky, especially since Street already put the city farther in debt than it should be with all the bonds he floated (our bond rating was cut once or twice on his watch, IIRC). A couple observations, though:
- Imagine your spouse is going to graduate school for a couple years and the loss of a second income has made it so you're having a really hard time paying the bills until s/he is back in the workforce. Given the situation, you decide to take out a home equity loan to pay them. The situation with the pension fund is similar.
- Putting the money in the stock market is always risky, at least in the short term. However, I would think that some of it would go into more conservative investments (bonds and money market?) that could be tapped in the shorter term. The stock market being down actually makes it a great time to invest in stocks for the long term, though. I've been taking advantage of the market downturn to add a couple new funds to my IRA and diversify it a bit.
Posted by Dave | February 18, 2008 11:42 PM