Puerto Rico’s Worst-Funded Pension Risks Bondholder Showdown

  • Pension liabilities push island obligations to $113 billion
  • Commonwealth and its agencies already owe $70 billion of debt

As if $70 billion of debt wasn’t enough.

One of the toughest tasks that awaits the federal control board charged with overseeing Puerto Rico’s finances may be how to strengthen the island’s retirement system, the worst-funded pension program among U.S. states and territories. That’s because whatever is done will likely pit bondholders against public employees since the legislation authorizing the restructuring of the commonwealth’s obligations didn’t provide any fresh cash.

Investors are already troubled by what they’re seeing. The commonwealth is increasing its contribution to the system in the current fiscal year that began last month to $747.3 million, while at the same time declining to allocate money to pay interest on its bonds. That prompted hedge funds holding Puerto Rico’s general-obligation debt to file suit against Governor Alejandro Garcia Padilla, claiming the administration is diverting cash in violation of its constitution and citing the additional funds going into the pension system this year.

“Everything is coming to a head on the pensions versus debt question and the oversight board will have to quickly take charge of this and try to determine how to prioritize and manage this situation in a way that’s consistent with the law,” said Ted Hampton, an analyst in New York at Moody’s Investors Service.

Prior workouts in the Detroit and Stockton, California, bankruptcies gave pensioners a better outcome than bondholders. A similar result in Puerto Rico’s restructuring may shape future debt workouts across the U.S., Hampton said.

President Barack Obama has until Sept. 15 to form the seven-member panel, part of a federal law, called Promesa, enacted on June 30 to give Puerto Rico a way to restructure its debt. The board will need to approve a fiscal plan for the island that “provides adequate funding for the public pension systems,” according to the statute. The legislation doesn’t give pensioners priority over bondholders or detail how the plans need to be funded.

While analysts speculate over the control board’s moves, the retirement system is running out of cash. The largest plan, the Employees’ Retirement System, is set to deplete its assets in the fiscal year that begins July 1, 2017, according to Puerto Rico’s latest audit. Of the $30.2 billion the plan promised to current and future retirees, it only has 0.27 percent of assets to cover those payments. The total unfunded liability for the island’s three retirement plans is about $43 billion.

“That is a challenge,” said Daniel Solender, head of municipals in Jersey City, New Jersey, for Lord Abbett & Co., which manages $20 billion of state and local debt, including Puerto Rico bonds. “Clearly bondholders need to be paid and pensioners need to be funded and there has to be some plan to work on both directions.”

Taxable pension bonds sold in 2008 that mature 2038 traded Wednesday at an average 38.7 cents on the dollar, for an average yield of 16.6 percent, data compiled by Bloomberg show. While that’s up from about 24 cents at the start of 2016, the debt has been trading below 50 cents for nearly two years.

Puerto Rico’s public workers may fare better than investors given the high percentage of island residents who belong to public retirement plans, according to an Aug. 11 Moody’s report. The government serves as the largest employer on the island, according to the island’s Department of Labor and Human Resource.

Nearly one in 10 people on the island are public employees, retirees or beneficiaries, according to the retirement system. For the first time in its history, the island’s largest pension plan has more retirees than active participants. It has 118,780 employees and 120,169 retirees and beneficiaries.

“If this highly unusual Promesa process yields an outcome that seems to put a federal seal of approval on more favorable treatment of pensions compared with bondholders, that could be a very important precedent in how any future Chapter 9 proceedings play out where pension liabilities and bonded debt are both factors,” Hampton said.

Recovery Rates

Moody’s calculates that Detroit bondholders received a total recovery of 25 percent on their securities, compared with 82 percent on pension liabilities, or 52 percent on the portion of benefits not covered by trust assets, according to the report. Stockton, California, investors received half of their holdings, while public workers were unharmed.

Given the size of Puerto Rico’s obligations, the pension systems will need to undergo changes, Jim Millstein, chief executive and founder of Millstein & Co., said Aug. 9 during a conference at the CUNY Graduate School of Journalism in New York. The firm is advising the commonwealth on its debt restructuring and negotiating with creditors.

“Compromises are going to have to be made on the expense side, on the debt-service side, on the pension side, on the size of the government itself in order to take the existing revenues -- or some incremental amount but not a burdensome amount of incremental tax revenues -- and spread them across all of these claims for debt service, pensions and the like,” Millstein said.

Pension Changes

Puerto Rico workers have already accepted changes. Current and prior administrations have altered Puerto Rico’s pension system and reduced benefits, including raising the retirement age, increasing worker contributions and closing the program to new employees and offering them annuities instead.

Even with those changes, the system’s funding levels continue to shrivel. While new employees since 2000 aren’t eligible for traditional fixed-benefit pensions, their contributions are being used to pay current retirees, further deepening the commonwealth’s growing liabilities.

“A lot of these issues can be solved long term if their economy grows, they create jobs and they collect more revenue,” Solender said. “They need some short-term ways to take some of the pressure off while they rebuild the economy. And if that can happen, then a lot of these issues can be solved and in a more beneficial way for everybody.”

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