Can San Jose reduce its pension debt by issuing bonds?

As San Jose prepares its annual budget proposal, one factor looms larger than any other: Pensions.

As of June 30, San Jose had $3.5 billion in unfunded liability—pension debt owed to city retirees that’s not covered by the return on investments made by the city’s two retirement plans. The city’s retirement plan for police and firefighters was 73% funded as of June 30, while the city’s federated plan was 52% funded.

San Jose pays hundreds of millions of dollars each year out of its general fund to cover this unfunded pension debt. Next year, the city estimates it will pay $304 million to cover these debts—20% of the general fund—and by 2029 annual debt payments will increase to $342 million.

“We have more retirees than we do active members,” said Cheryl Parkman, assistant to the city manager, during a Friday study session on the city’s pension debt. “We’re not getting a one-to-one ratio of pension contribution(s) versus the benefits that are going out.”

The city is looking at issuing pension obligation bonds, which cities sell to investors and then repay at a fixed rate of interest over a set term. Cities in California sold more than $13 billion in these bonds between 1992 and 2009, according to a report from the state treasury.

Finance officials haven’t decided on the amount of bonds the city would issue, and would rely on municipal advisors to help select the amounts and timelines if the City Council directs staff to craft a policy. Advisors from Urban Futures Inc. modeled a hypothetical finance strategy for the city that looks at selling $300 million in pension obligation bonds each year through 2029.

Cities sell these bonds in order to obtain money to pay down retirement debts sooner rather than later, thus accruing less debt in the long-term. Proceeds from the sale of these bonds are put into investments that—while riskier—offer a potentially higher rate of return than the city’s current funds.

The Governance Finance Officers’ Association—a group of finance officials in the U.S. and Canada—advises against pension obligation bonds.

“Failing to achieve the targeted rate of return burdens the issuer with both the debt service requirements of the taxable bonds and the unfunded pension liabilities,” the association states on its website. “Local jurisdictions across the country have faced increased financial stress as a result of their reliance on POBs.”

The sale of these bonds is not without risks. The city last studied the bonds in 2010—during the Great Recession, when people were wary of investing due to the stock market crash. The city’s finance and retirement directors recommended against issuing the bonds at that time.

Now leaders from San Jose’s finance department—who did not take a position on whether the city should sell these bonds—say they’re less risky than before. Finance Director Julia Cooper said San Jose is only looking at issuing fixed-rate bonds, and that the city would not likely face a lower credit rating.

“The credit agencies are already taking into account our unfunded liability in the evaluation of our credit strength,” Cooper said.

City officials said it would be the city’s advantage to sell the bonds while interest rates are low. Right now, interest rates for pension obligation bonds are between 3% and 3.5%. The city would pay less money back to investors than if it were to sell the bonds in a period where interest rates are higher.

However, investment advisor Girard Miller said the city needs to issue the bonds in a smart way. He said the city should not invest all of its money from the sale of the bonds at once—rather, the city should invest in tranches in order to even out the risk in case the stock market suffers a downturn.

“The issue today is whether we’re in the second inning or the eighth inning of this business cycle,” Miller said. “When stocks are already trading at levels above the previous peak, the expected returns are not so favorable.”

Deputy Finance Director Nikolai Sklaroff said on Friday that pension obligation bonds are the “last tool in the toolbox” the city has in lowering its pension debt in a significant way.

“After years of various attempts to manage the city’s (pension debt) and improve the funding of the retirement plans… POBs are the last tool that the city could use that would have a meaningful impact,” Sklaroff said.

To reduce its pension debt in the long-term, San Jose must address its fundamental cause: increases in pay and benefits to the city’s 6,000 employees. And those rising pension costs, city officials warn, are draining resources from other city services such as parks, libraries and public safety.

“You still should look at how to reduce that liability… not making significant increases in (payroll costs),” said Julio Morales, a municipal advisor to the city.

The City Council will vote on whether to direct staff to prepare documents and craft a pension bond policy on May 11.

Contact Sonya Herrera at [email protected] or follow @SMHsoftware on Twitter.