Public Pension Fund Buyouts
A tool catching on with governments
Low interest rates, stock market volatility and retirees’ increased longevity: The past decade has brought a perfect storm of issues for public pensions, experts say. The result is that state and municipal pensions in the U.S. are underfunded by $1.6 trillion, the Federal Reserve estimated in 2017. Moody’s Investors Service recently put that number closer to $4.4 trillion, which is larger than the entire U.S. municipal bond market.
The solutions to the mounting debt, at a basic level, include increasing pension funding, earning more in pension investments and paying out fewer benefits. The third choice, trimming benefits, is difficult given the legal and contractual restrictions on such a move in many areas of the country. However, it has proved successful for some governments.
Missouri’s 2017 pension buyout in particular may serve as a model for other entities with mounting pension debt. Nearly 22% of those offered a buyout under this voluntary program took the offer of a lump-sum payment that closed their eligibility for future retirement payments. The state estimated first-year savings for the pension fund of $2.5 million and long-term savings of nearly $90 million.
“Buyouts have been done in hundreds of cases in corporate pension funds,” said Kemp Lewis, senior managing director and head of Raymond James’ public finance office in New York. “There have been very few done in the government world. I’m firmly of the opinion that you will increasingly see them used by state and local governments in the future. It’s one way that they can materially affect the promises made to current and former employees about their pensions.”
Illinois, which has been trying to tackle billions in unfunded pension liabilities for years, recently followed in Missouri’s footsteps when lawmakers passed a pension buyout option as part of the 2018 state budget. The state has projected that the measure may result in $41 million in savings. The buyouts are yet to be formally implemented.
“A pension buyout eliminates the actuarial risks of people living longer than you projected,” Lewis said. “It eliminates the investment risks of not earning the average 7.5% earnings rate on the funds invested in the pension fund. In general, it’s a win-win.”
“Buyouts have been done in hundreds of cases in corporate pension funds. There have been very few done in the government world. I’m firmly of the opinion that you will increasingly see them used by state and local governments in the future.”
– Kemp Lewis, Senior Managing Director, Raymond James Public Finance
However, it’s likely not a cure-all for governments whose pension debt has ballooned. Illinois, whose unfunded pension liability is roughly $130 billion, paired its buyout measure with another that seeks voluntary reductions in cost of living adjustments for retirees in exchange for a lump sum. The state plans to issue bonds to cover the cost of both of these efforts. “Many governments are going to have to tackle the problem of pension underfunding with a variety of tools, including buyouts,” Lewis said.
He acknowledges that any solution to shoring up pensions will have its detractors. “You’re affecting people’s future. … You have a lot of stakeholders, and these issues are very political.” However, the states that have blazed a trail by offering pension buyouts have offered governments another tool to tackle this challenging situation.
POSSIBLE BUYOUT BENEFITS
For governments, a pension buyout has the potential to:
- Materially reduce the cost to governments of underfunded pension liabilities.
- Eliminate the risk that the assumed investment earnings rates are not achieved.
- Eliminate longevity and other actuarial risks.
There are two common ways to fund them:
- Funding buyouts with bond proceeds will lock in savings, reduce the pension plans’ net pension liabilities and increase funded ratios. Debt service payments can be more than offset by reductions in employer contributions from smaller actuarially determined contributions.
- Funding buyouts with plan assets will produce actuarial savings if less than 100% of the actuarial value is offered.
There is no assurance that any investment strategy will be successful. Investing involves risk and investors may incur a profit or a loss. Debt securities are subject to credit risk. A downgrade in an issuer’s credit rating or other adverse news about an issuer can reduce the market value of that issuer’s securities. When interest rates rise, the market value of these bonds will decline, and vice versa.