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Chicago’s pension obligation bonds – swapping one credit card for another?

August 16, 2018

The City of Chicago is reportedly considering a pension obligation bond offering. The city could issue $10 billion in bonds, and use the proceeds to fund its pension plans. A decision could come as soon as Friday.

The idea has been criticized from several quarters. One critic called it “just swapping one credit card for another.”

It could be significantly worse than that. Here’s a simple scenario illustrating what can happen with pension obligation bonds, depending on how they are structured.

Let’s assume a simple city that has two main parts – a pension plan for employees, and everything else in city government. Assume the rest of the city’s government has $500 in assets, no debt, and therefore a net position (assets less liabilities) of $500. The city’s pension plan has assets of $500, but a liability (to pensioners) of $1,500, and therefore a negative net position ($1,000).

Consolidating the rest of the city with its pension plan, you have an organization with $1,000 in assets, $1,500 in liabilities, and a negative net position of $500.

Now, let’s ‘fix’ that pension plan. We borrow $1,000, selling a pension obligation bond. We take the proceeds, and put them into the pension plan.

Poof, problem solved? The pension plan’s funded ratio goes from 33 percent (500/1500) to 100 percent (1500/1500).

But what about the rest of the city, and the consolidated balance sheet?

The consolidated balance sheet a) gets bigger, and b) gets more risky. Total assets go from $1,000 to $2,000, as assets managed for the plan go up. Liabilities go up by the amount of the bond offering, rising from $1,500 to $2,500. The net position ($2,000-$2,500) is unchanged (negative $500), consistent with a neutral ‘swapping one credit card for another’ interpretation.

But consider a 20 percent decline in the value of the investments in the pension plan, and what happens to the consolidated net position before and after the pension obligation bond.

Without the pension obligation bond, assets in the pension plan fall $100, leaving a net position for the consolidated enterprise of $900 less $1,500, or negative $600 (down from a negative $500).

Adding the pension bond, and assuming the same 20 percent decline in the value of invested assets in the pension plan, the pension plan assets fall from $1,500 to $1,200, leaving the consolidated enterprise with $1,700 in assets, $2,500 in liabilities, and a negative net position of $800 – a bigger hit (from a negative $500 to negative $800) than the impact that would have arrived without the pension bond.

How about the rest of the city? Before the pension bond, the rest of the city had $500 and no debt. With the pension obligation bond, the city issues the bond, puts the proceeds in the pension plan. Total assets stay the same ($500), while total liabilities rise (from $0 to $1,000), turning a positive net position of $500 into a negative net position (negative $500).

But the pensioners feel better, given that fund assets are higher and more unambiguously in the pension plan.

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