NCPA - National Center for Policy Analysis

Cities Turn To Stocks To Prop Up Pensions

June 3, 1999

A growing number of cities are issuing so-called "pension- obligation" bonds and investing the proceeds in the stock market. Officials are betting that the return on stocks will exceed the approximately 6.5 percent they must pay bondholders. The difference would be used to fortify the cities' ailing pension funds.

  • Northeastern cities with relatively weak economies are the primary issuers -- their goal is to avoid raising taxes or cutting benefits to city workers.
  • Twenty-eight pension bonds were sold last year -- up from just one in 1991, 11 in 1996 and seven in 1997.
  • So far this year, $1.4 billion in such bonds have been issued.
  • The roaring stock market has helped a number of cities bolster their pension plans -- such as Los Angeles, which sold $2 billion of the bonds in 1994 and has enjoyed a 14.3 percent annualized rate of return.

The risk, of course, is that if and when the stock market takes a dive the funds will be hit hard if stock returns fall below the 6.5 percent needed to service debt on the bonds. A downturn of a year or two would not be a disaster, so long as average stock returns exceeded obligations over the life of the bond. However, the stock market has experienced long periods of low growth -- for example, from 1966 to 1982, the S&P 500 stock index grew at an annual rate of only 2.7 percent.

"Governments shouldn't be taking on financial risk trying to do financial arbitrage," says Herman "Dutch" Leonard, professor of public-sector finance at the John F. Kennedy School of Government.

Source: Gregory Zuckerman, "Cities Are Hoping Bull Market Will Heal Ailing Pension Funds," Wall Street Journal, June 3, 1999.

 

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