Pension obligation bonds: practices and perspectives.

As more and more news articles report the issuance of bonds by public pension systems for the purpose of covering unfunded liabilities, the editors of Government Finance Review invited four officials to relate their experiences or perspectives on this form of financing pension fund obligations. Below are comments received from the vantage point of a school district issuer, a city that considered and rejected the idea, an official preparing a statewide pooled pension bond program, and a debt manager in a state treasurer's office.

Pension Cost Refinancing

Roger J. Dickson, assistant superintendent, School District of Kettle Moraine, Wisconsin

The School District of Kettle Moraine in Wisconsin recently issued 10-year general obligation bonds in the amount of $3.2 million to repay its pension fund obligation with the state retirement system. This obligation, called the prior service obligation, is a liability that was imposed on the district when the legislature merged three separate retirement systems into one - the Wisconsin Retirement System (WRS) - and increased benefits. At the time of the merger, the legislature mandated that every participating municipality and school district would be assessed its proportionate share of the unfunded liability, a payment schedule would be established for repayment in 40 years, and interest would be charged for unpaid balances at the end of each calendar year.

The payment schedule provided for a specified percent of payroll to be applied to the prior service obligation. The specified rate would remain unchanged for the entire repayment period and would result in full repayment based on assumptions as to rate of growth in payrolls. If the payroll rate of growth varies from the assumptions, the repayment period would be less or greater than 40 years. The interest rate is set at the "assumed long-term retirement investments earning rate" and subject to yearly changes.

The WRS permits early repayment of the prior service obligation. A municipality may 1) negotiate a schedule that results in faster repayment, 2) make lump sum payments as funding allows, or 3) repay the obligation in full. The School District of Kettle Moraine became interested in a full repayment of the liability when the interest rate charged by the WRS increased to 8 percent. Rules regarding school finance, however, made such repayment impractical without receiving taxpayer referendum approval.

Rather than making these pension obligation payments from the general fund, the Kettle Moraine School Board wished to find an alternative means of financing the prior service obligation, an approach that would provide an effective means for long-term financial planning. The School District of Kettle Moraine is a growing district with an identified need for an additional elementary school within the next few years. The school finance regulations in Wisconsin create a circumstance whereby the cost of direct instruction for additional students can be funded, but the school finance formulas do not provide funding for the indirect costs necessary to open and operate an additional school. Financing the prior service obligation through borrowing, if approved by the taxpayers, would result in its costs, which were paid from the district's general operating fund, being shifted to the debt service fund. The amount to be shifted would approximate the indirect costs necessary to open a new elementary school.

The variable interest rate charged by the WRS, the uncertain repayment schedule, and the need for greater flexibility under school finance regulations were primary factors in the school board's decision to consider borrowing to repay the prior service obligation. The school board directed that the borrowing should be structured to achieve maximum interest cost reduction while assuring a cost to the taxpayer of no more than $.17 per $1,000 of equalized property value.

The amount the school district would need to borrow to repay the prior service obligation fully was about $3.3 million. The district could refinance the obligation for 10 years at current interest rates within the $.17 per $1,000 tax impact restriction imposed by the school board. It was estimated that this financing method would result in a reduction in total interest costs of more than $1.7 million compared to the interest to be paid according to the retirement system assumed schedule.

In seeking taxpayer approval, the school board recognized the difficulty of explaining the complex issues...