For years, taxpayer advocates have warned about local governments’ increasing reliance on pension obligation bonds (POBs) to paper over fiscal mismanagement. Like other bonds, POBs are instruments of indebtedness issued to fund the unfunded portion of pension liabilities by creating new debt. It’s a bit like paying your Visa bill with a Mastercard.
The use of POBs rests on the assumption that the bond proceeds, when invested with pension assets in higher-yielding asset classes, will be able to achieve a rate of return that is greater than the interest rate owed over the term of the bonds. However, POBs involve considerable investment risk, making this goal highly speculative. Failing to achieve the targeted rate of return burdens the issuer with both the debt service requirements of the taxable bonds and the unfunded pension liabilities that remain unmet.
It’s not just conservative taxpayer groups that have warned against the dangers of POBs. The Government Finance Officers Association (GFOA), made up of public sector finance officials, staunchly opposes the issuance of POBs for a number of reasons including fluctuations in interest rates, exhausting the capacity of traditional bonds, and negative perception of POBs by rating agencies.
For California taxpayers, there’s good news and bad news. The good news is that the state constitution gives the voters the final say on new debt. Since our constitution’s adoption in 1879, voters have had the right to vote on state and local bonds. Subject to a carve-out for school bonds, Article XVI provides that no local government “shall incur any indebtedness or liability in any manner or for any purpose exceeding in any year the income and revenue provided for such year, without the assent of two-thirds of the voters.” Naturally, one would think that a $3.5 billion bond, which obviously can’t be repaid within one year, should be subject to voter approval.
Sadly, one would be wrong.
The bad news is that courts have now refused to extend this constitutional protection to POBs. On April 29th, the Sixth District Court of Appeal in San Jose decided the first of three pending cases on the issue of citizens’ right to vote on POBs. Attorneys with the Howard Jarvis Taxpayers Association contend they do have that right under the letter and spirit of the California Constitution. Unfortunately, this Court of Appeal found that voters in the city of San Jose do not have that right.
Counsel on both sides had argued over whether San Jose’s unfunded pension liability – always fluctuating dramatically, but presently estimated at $3.5 billion – is somehow an “obligation imposed by law” that is now due payable and must be fronted today. The retirement boards – constitutionally charged with the duty of actuarial soundness and competency of assets – are not demanding any such payment. The issuance of POBs would be a discretionary act of the City Council.
The Court of Appeal reasoned that the 1879 voter approval requirement is inapplicable, concluding that, “The actions that incurred the city’s existing liability – enacting the pensions plans and employing the individuals covered by them – have already occurred.” Again, this decision validates the “paying Visa with a MasterCard” theory of finance notwithstanding the fact that POBs, by any definition, constitute new debt.
One of the biggest problems in this case is the fact that unfunded liability is always fluctuating depending on the performance of the pension fund investments, including the stock market. But there are other risk factors over which voters have no control.
Under other court rulings, voters are prohibited from voting on increases in pensions. Big increases can easily balloon unfunded liability. If this prohibition were lifted by statute that would be one thing because voters could start rejecting unaffordable increases as they occur. But today, by deciding that voters can’t vote on a POB, they are effectively locked out of the process entirely.
The Howard Jarvis Taxpayers Association will petition the California Supreme Court in early June. Soon, HJTA will also be arguing the same type of case in the Fourth and Second District Courts of Appeal. Before Californians are saddled with debt by their government, they should have the right to vote on it.
Jon Coupal is president of the Howard Jarvis Taxpayers Association.