May 20 (Bloomberg) -- Allentown, Pennsylvania, is leasing its water and sewer systems instead of borrowing to fund pension payments set to double by 2020. The deal shows how localities are exploring alternatives to debt to meet retirement costs.
Mayor Ed Pawlowski, a 47-year-old Democrat, didn’t want to sell bonds to plug an unfunded pension liability of as much as $170 million. Instead, the city of 119,000 will hand over its systems to a regional water agency for an upfront payment of $220 million in a 50-year lease that will finance pension costs.
The case of Allentown, about 60 miles (97 kilometers) north of Philadelphia, reflects how debt is losing its appeal for U.S. cities grappling with retiree obligations after the recession that ended in 2009. Municipalities have sold $312 million of pension bonds this year, data compiled by Bloomberg show. That’s down from last year’s pace, when issuance tallied about $1 billion, the most since 2008.
For localities, a deal such as Allentown’s “could be a lump-sum benefit to help other issues they have on the balance sheet,” said John Loffredo, co-head of MacKay Municipal Managers, which oversees $7.6 billion of munis, including Allentown general obligations, in Princeton, New Jersey. “The outcome is you have better, efficient services” and lower costs for taxpayers.
The decision to forgo debt may reward Allentown with lower borrowing costs. Moody’s Investors Service, which rates Allentown A3, seventh-highest, said the lease deal is a “credit positive” because it reduces general-fund obligations.
Investors have been bidding up some city bonds. Tax-exempt Allentown general obligations maturing in August 2018 were valued at a yield spread of about 1.1 percentage points over benchmark munis this month, down from about 1.5 percentage points in mid-2012, BVAL pricing data show. The securities are insured by Assured Guaranty Municipal Corp.
Pension securities are riskier for cities facing fiscal strains since interest payments are fixed while pension contributions can be deferred, said Jean-Pierre Aubry, assistant director at the Center for Retirement Research at Boston College. The issuance is a bet that investment returns will exceed borrowing costs.
“They really would have no buffer” if investments trailed expectations, he said from Chestnut Hill, Massachusetts. “They’re really giving up a lot of flexibility, and for cash-strapped localities that’s a problem.”
Municipalities are contending with a pension-funding crisis left over from the 18-month recession. The Standard & Poor’s 500 Index fell about 38 percent in 2008, the most since 1937.
Local plans had 72 percent of assets required to meet pension obligations in 2011, down from 81 percent in 2007, according to a February report from the Boston College center. Allentown’s ratio was 64 percent in 2011, according to the state’s Public Employee Retirement Commission.
Some issuers have seen pension-related borrowing weaken their credit. Standard & Poor’s revised its outlook to stable from positive on Hackensack University Medical Center last week because the New Jersey facility funded its plan with debt.
Loffredo said he expects more communities to tap assets such as water and parking systems to generate funds.
Bayonne, New Jersey, and Rialto, California, have struck deals to turn over municipal operations of their water systems. Philadelphia plans to sell its gas utility and may use proceeds for expenses such as pensions.
In Allentown, Pennsylvania’s third-largest city and formerly a manufacturing and shopping hub, 26 percent of residents live below the poverty level. The local jobless rate was 10.4 percent in March, compared with 7.9 percent statewide, according to preliminary data from the Bureau of Labor Statistics. City officials have embarked on projects to revive the downtown, including an arena for minor-league ice hockey.
Pension strains were exacerbated by labor agreements struck in 2004. Police and firefighters were allowed to retire early and select the period to use as the basis for retirement benefits, which “artificially inflated” them, said a 2011 audit.
The annual pension payment required by state law, at $13.6 million this year, will jump to $29.2 million in 2020, according to actuarial projections. The city’s general fund is about $89 million this year, the mayor said.
Pawlowski, who is running for a third term this year, said once the lease with the Lehigh County Authority closes in July, proceeds will first go toward retiring about $30 million in water and sewer bonds. At least $160 million would be used for pensions.
He also wants to retire some pension debt, which totaled $30.6 million as of the city’s 2011 audit released in July 2012. Allentown issued pension bonds in 1996 and refinanced that borrowing in 2004.
Opponents of the leasing plan said officials were giving up an asset at the expense of future generations. They also said customers will face higher water fees.
“Fifty years is a long time,” said Councilwoman Jeanette Eichenwald, a 69-year-old Democrat who called the deal “a tax on the tap” and voted against it. “Water will only become more precious.”
The mayor said the lease was the best option. Issuing more pension bonds wouldn’t solve the city’s challenges since it would be “exchanging one debt for the other,” he said.
Pawlowski said the lease takes care of the city’s biggest challenge, the unfunded pensions.
“It’s going to cripple us and cripple our economy and cripple our potential for growth for decades to come,” he said. “To ignore it and do nothing, that would be irresponsible and bad government. This is a good deal.”
In the municipal-debt market this week, issuers led by New York City plan to offer $5.6 billion of bonds with benchmark yields close to a five-week-high, Bloomberg data show.
At 1.83 percent, yields on benchmark 10-year munis compare with 1.95 percent for similar-maturity Treasuries.
The ratio of the two interest rates, a gauge of relative value, is about 94 percent, after rising from a two-month low reached last week. The higher the figure, the cheaper local bonds are when compared with federal securities. The ratio has averaged 92 percent since 2001.
To contact the reporter on this story: Romy Varghese in Philadelphia at email@example.com
To contact the editor responsible for this story: Stephen Merelman at firstname.lastname@example.org