The Bond Buyer

Pension 'Reform' Plus Smart Lawyers May Help Save States

Monday, August 16, 2010

States continue to grapple with ongoing budget imbalances.

The Center on Budget and Policy Priorities reports that for the third year in row shortfalls will exceed $100 billion, with the current year expected to approach $200 billion. Unfortunately, 2012 offers no relief with the CBPP estimating a $120 billion gap.

So far, state officials have addressed the shortfalls in a variety of ways, including reducing personnel, cutting benefits in social programs, using rainy-day funds, finding accounting gimmicks, making changes in Medicaid, and a wide array of other budget measures.

They have also increased a wide variety of tax increases, including those on sales and use, cigarettes and alcohol, hotel rooms, and, of course, on income. And let's not forget increases in user fees for everything from license plates to visas. One thing is certain: if there were any easy budgetary balancing decisions, they have already been made.

Having already gone to the well on a wide variety of budgetary measures, states are increasingly eying pension benefits for potential savings. This is an obvious choice since, as bank robber Willie Sutton said, "That is where the money is."

The vast storehouse of wealth represented by pension assets and the ongoing liability to fund more of it creates opportunities for significant expense reduction.

Conveniently, since pension costs are widely regarded as having gone out of control, there is also some political cover in correcting overly generous pension "schemes". There is no doubt that pension "reform" offers a large untapped source of ongoing savings. For states in need of vast reductions to their ongoing budgetary burden, changes in benefits for employees who are vested, or who are even already pensioners, is the holy grail of budget savings.

Many states have taken the first step by limiting benefits to new employees. Illinois is a good example. The state recently passed a new and reduced benefits package for new employees.

While this is an easy first step, it offers little current relief. The cost reduction from limiting benefits to new employees comes out of an expenditure stream that starts in the future, creating a net present-value savings with no change in current cash flow.

This was the path of least resistance since the affected group, by definition, has no political voice as it doesn't exist yet. The real bite out of the budgetary apple can only come when benefits are reduced to current and future pensioners with vested benefits.

With some states having success in reducing benefits to new employees, states are emboldened to pursue other pension savings. A second battlefront is cuts to programs that provide inflation protection for pensioners. The need to balance budgets has motivated some states to reduce the inflation adjustments on pension benefits substantially.

Those that have taken this approach, like Colorado, are now facing litigation by the affected parties. It is not yet clear if these moves can withstand legal challenges. It's a riskier political gambit, but the financial savings, unlike the reduction in benefits to new employees, are greater because they start in the present and extend in perpetuity.

How can governments do this? States offer different levels of protection to their pension funds.There are nine states with protection afforded directly by their constitutions: Alaska, Arizona, Hawaii, Illinois, Louisiana, Michigan, New Mexico, New York, and Texas, according to Many states have explicit statutory protections.

While not as strong as constitutional language, explicit statutory protection has historically been regarded as providing significant protection to pensioners covered by state plans. A layer of protection provided to all plans - constitutional or statutory - is the contracts clause of the Constitution, which expressly prohibits states from abridging any contracts by this clause.

These constitutional protections would seem to shut the door on expense-reduction efforts. However, an op-ed piece in the Chicago Tribune by Dennis Byrne, called "The Pension Check May Not Be in the Mail," may provide a legal argument to keep the door to pension-benefit cuts open a little.

The article, dated Aug. 10, referenced a Sidley Austin opinion that was recently released to the Civic Committee of the Commercial Club of Chicago stating "that if a state pension fund runs out of assets 'any pension payable under any law shall not be construed to be a legal obligation or debt of the state ... but shall be held to be solely an obligation of such pension fund, unless otherwise specifically provided in the law creating such fund.'"

A rough translation of the Sidley Austin passage would seem to be that what the Illinois constitution really says, contrary to accepted beliefs, is that it's the pension that has the obligation to pensioners and not the state of Illinois. Very interesting.

Any conspiracy theorist worth his salt might imagine that creative - and useful - opinions like this might start popping up in various states like mushrooms after a spring rain. All of a sudden, such opinions open the door to the assertion that the state can legally reduce benefits since it's the plan that has the obligation and not the state.

This scenario might seem vaguely familiar since many of us have been down this road before. Just ask the holders of WPPSS #4 and #5 bonds. Economic (financial) necessity gives rise to political and legal strategies (wrangling) designed to upend the basis for the maintenance of the obligation. Once the path to excision of the financial liability is identified, the obligated entity attempts to undermine the legal support.

Sound farfetched? The National Federation of Municipal Analysts just filed an amicus brief on a bond issue last month in a case between trustee Wells Fargo Bank NA and Wisconsin-based Lake of the Torches Economic Development Corp. The corporation is the corporate entity of the Lac du Flambeau Native American tribe.

In this case the issuer is basically trying to assert that they did not have the authority to borrow, so they don't have to repay what they did borrow illegally.

What should bondholders want? Greater flexibility and authority to reduce pension benefits stands to provide a previously impossible strategy for budget balancing - a good thing for bondholders. On the other hand, bondholders generally like to see the maintenance of the "sanctity" of contracts because, ultimately, that's what the bond indenture comes down to. One thing seems fairly certain: it's going to get bloody out there.

In the end it's possible that the states with the best lawyers may be the best credits because creative lawyering has opened a path towards budgetary solvency.

There is no doubt that many law firms are chomping at the bit to muscle their way into the wide open field of Chapter 9 bankruptcy. Recent opinions like the one from Sidley Austin could help aspiring public finance attorneys get a toehold in the municipal market.

Christopher Mier is managing director of the analytical services division of Loop Capital Markets in Chicago.