Addressing Unfunded Pension Liability: Pension Bonds in the City of Philadelphia.

• Author: Hayllar, Ben
• Position: Statistical Data Included

In 1984, the City of Philadelphia had a 95 percent pension liability. In order to avoid a payment plan that would strain the city budget, Philadelphia decided to issue pension obligation bonds. This article highlights the benefits and risks of pension obligation bonds.

Like many municipal pension funds in Pennsylvania, Philadelphia's municipal pension was seriously underfunded. Instead of paying benefits for 30,000 retirees with the revenue from investments, retirees were paid by an annual allocation from the general fund.

The cause of the crisis was a history of bad public fiscal policy. Historically, labor negotiations were highlighted by modest pay increases and generous improvements to pension benefits, without thought to how current and future benefits would be paid. At first, local governments found that they could make their annual pension payments directly from tax revenues, but, as the pension liability grew, the result was a huge unfunded liability which threatened the financial stability of many of the state's large and small municipalities.

In 1984, the Pennsylvania State General Assembly responded to the impending crisis through Act 205, which classified the severity of municipal pensions' distress, combined each municipality's separate pensions into one pension, reduced some benefits, and required funding plans to eliminate liabilities. The cities of Pittsburgh and Philadelphia were the most severely distressed with liabilities of 83 percent and 95 percent respectively. Encouraging compliance with supplemental aid from state insurance taxes, the state required municipalities to develop a plan to pay off their liabilities over 40 years. Philadelphia chose a payment schedule that was low at first but would rise 5 percent each year until the liability was paid off in 2020.

After almost 10 years of payments to reduce its deficits, Philadelphia's pension still had a $2.7 billion liability, representing almost 50 percent of what the fund would need to pay all benefits from investment earnings. This affected the city in a number of ways.

* The pension was inefficient because it did not have the assets to support the $33 million monthly payment. A pension of $2.7 billion was forced to act as if it were a $5 billion pension, which meant that the fund had to break longer-term and higher-earning investments and hold high amounts of low-yielding cash for monthly payments.

* The rating agencies looked at the unfunded liability in much the...