Online Extra: How the Garden State Dug a Hole

Borrowing aimed at boosting the assets of New Jersey's pension plans went way awry. It's a lesson to governments everywhere

It must have seemed like a good idea at the time. Back in 1997, New Jersey borrowed $2.7 billion in pension obligation bonds to fill a gap in its plan funding. These bonds –- sometimes called POBs -- are general obligation debt much like any other municipal borrowing, but they're issued in order to put the proceeds into the pension funds, not the general government coffers. The issuing city, county, or state bets that the borrowed money can be invested to earn more than the interest rate that the bonds must pay.

In recent years, these bonds have become a common tool for filling holes in city, county, and state pensions. According to bond-rating agency Standard & Poor's, the Garden State's 1997 deal was part of some $30 billion that has been raised in this manner over the past decade. New Jersey's was the first state POB, and because it was issued only a few years before a big drop in the stock market, it has now become a cautionary tale of how wrong that bet can go.


  For a few years, New Jersey's gamble paid off. Along with the rest of the state's pension assets, the bond money was invested heavily in equities and rose in value as the stock market boomed in the late 1990s. The pension accounts climbed at a double-digit annual rate for several years, well above the 7.6% the Garden State promised in interest on the bonds.

Then came the market bust in 2000, followed by two years of depressing returns that turned what once looked like a winning strategy into a dud. Since 1997, New Jersey's POBs have averaged an annual return well below the 7.6% they owe in interest, according to State Treasurer John E. McCormac. And that's before factoring in whatever the state paid its investment bankers to get the deal done.

Worse, the borrowing, which was intended to boost the plan's assets, has instead become a painful multiplier of the state's existing pension problems. Currently facing a pension deficit of at least $25 billion, the state will have to contribute more than $1 billion to its pension fund next year, up from $100 million this year.


  At the same time, the interest payments on its pension obligation debt are escalating -- a structure built into the bonds from the start. Now about $170 million a year, that bill is steadily rising and will hit $500 million annually by the end of the issue's 30-year life.

"The decision looked good for a couple of years and has not looked good at all the past couple years," says McCormac, who wasn't treasurer in 1997. He's trying to improve investment returns by diversifying the pension portfolio in private equity and other asset classes. But that's unlikely to be enough.

He believes the state will also have to chip in to help halt what he calls a "crisis" at the pension funds. To do so, the legislature, which created the POBs eight years ago, would likely have to either make spending cuts, increase taxes, or both. "Without a doubt states should look at all these experiences, recognize all the risk, and go in eyes wide open to a transaction like this," McCormac warns.


  Critics of POBs say those risks rarely if ever make the move worth it. Jeremy Gold, a pension consultant based in New York, argues that POBs are always a bad deal, no matter how the investments perform.

First, they're expensive. In addition to underwriting costs that can easily reach the millions of dollars for larger deals, there's the fact that the pension fund could more cheaply borrow money using other mechanisms, including swap transactions, that would hold a far shorter term than a 30-year bond.

Gold also objects to fixing a current budget problem by pushing off payments onto future generations. "This is a bad idea that keeps on giving," he says. "It lowers the burden for the current government, usually at the expense of some future taxpayer either in the form of risk or losses."


  In addition to pushing the bill off to future generations, it also makes these deficits a fixed general obligation of the state or municipality that issues the POB.

S&P credit analyst Parry Young notes that pension shortfalls are somewhat flexible. Though they must be made up at some point, as long as current pensioners are getting their check, it's possible for employers to time their payments to suit their other financial needs.

By issuing POBs, a state or municipality takes an off-balance-sheet and somewhat flexible obligation and makes it a fixed general obligation of the government. When Illinois issued a $10 billion POB in 2003 at the favorable interest rate of 5%, its debt instantly doubled.


  The pension bonds weren't New Jersey's only misstep. It probably should have put more into its plans over the years and not relied so heavily on a strong stock market. The Garden State's elected legislators also gave away expensive pension sweeteners that just deepened the hole.

Many states made similar mistakes. Now they're searching for ways to fund their pension shortfalls. New Jersey's experience is a cautionary tale about how dangerous such borrowing can be.

By Nanette Byrnes in New York

Edited by Patricia O'Connell

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