Pre-Paying Pension Debt in Arizona

By Rushda Mustafa

Paying off unfunded pensions as soon as possible can save a municipality significant General Fund dollars. Pension bonds may be a tool to pre-fund employer contributions to the two state-wide retirement systems, the Public Safety Personnel Retirement System (PSPRS) and the Arizona State Retirement System (ASRS). As an allocated costs plan, PSPRS has benefited from over $1.9 billion in supplemental pre-payment contributions from participating employers since 2020. ASRS is in the process of launching a voluntary Contribution Pre-Funding Program (CPP) for employers to make supplemental contributions to the system in exchange for guaranteed offset credits.

What Is Pension Debt, and How Is It Impacting Municipalities?

Legacy unfunded pensions are a debt growing at the actuarial rate.

Any unfunded portion of a pension liability represents a dollar that cannot be invested to grow like other plan assets. Thus, the opportunity cost of lost investment earnings becomes the “interest” that accrues on the unfunded liability (UAAL) every year it remains outstanding. An example is a debt growing at the actuarial rate that must be amortized. Because of the steep debt accrual (7% to 7.50%), even as municipalities continue making accelerating payments every year, they are not making significant headway in paying off the UAAL.

In Arizona, municipalities participate in the Public Safety Personnel Retirement System (PSPRS) and Arizona State Retirement System (ASRS). PSPRS is an allocated costs plan – which means each employer has a distinct liability and payment profile – while ASRS is a pooled, cost-sharing plan, whereby all participating employers pay the same annual contribution rate into the System.

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Overview of Key Terms

Actuarially Accrued Liability (AAL): The value in today’s dollars of all future benefits payable to current and future retirees

Actuarial Value of Assets (AVA): The current value of all assets held/invested by a pension fund to generate returns and make benefit payments to retirees

Funded Ratio: The ratio of AVA to AAL; 100% funding implies Assets = Liabilities

Actuarial Rate: The assumed rate of return on a pension plan’s assets; typically between 7.00% to 7.50%

Unfunded Actuarially Accrued Liability (UAAL): The difference between the AAL and AVA. The UAAL is a debt accruing at the Actuarial Rate. This debt has to be repaid by a municipality like any other loan (UAAL Payment)

Pension Cost: The current year’s cost (Normal Cost) + Past accrued costs being amortized (UAAL Payment)

The Impact: Pension costs are crowding out other General Fund expenditures for municipalities in Arizona and around the country.

Pension contributions are annual expenditure line items in a municipality’s budget. In recent years, the PSPRS annual contribution rate has escalated to over 40% of payroll on average, whereas the ASRS rate has been approximately 12.2% for all employers. This cost escalation is not the result of rising benefits but a result of systemic underfunding and large legacy UAALs. In fact, a 2018 study found that employer normal cost has declined from 7.1% of payroll in 2001 to 5.6% of payroll by 2017.1

This trend also applies nationally: a 2018 study by Standard & Poor’s found that this cost could represent up to 27% of annual expenses for most large cities nationally, crowding out other important capital and operational expenses:

“These pension contributions – which in many places have been driven higher by the additional amortization payments needed to help pay down unfunded liabilities – represent large portions of budgets that cities could have otherwise used to finance other crucial public needs, like road infrastructure, hiring more public safety officers, or tackling drainage and stormwater issues. Instead, these funds are increasingly being used to pay off legacy pension debt and the related interest that accrues on this debt.” 2

In addition to crowding out essential services, pension underfunding can also negatively drag a municipality’s credit rating, making it more expensive to fund other capital projects through debt.

How Can This Problem Be Tackled Head-On?

Like any high-rate debt, early repayment can help reduce the total interest paid on unfunded pensions.

To the extent possible, paying off a UAAL as soon as possible can help reduce the budgetary impact of growing interest payments on this debt. However, most legacy UAALs are very large and cannot be repaid with existing cash on hand in one or two installments.

Pension bonds can help bridge the gap.

Pension bonds are a debt instrument that refinance the legacy UAAL accruing at the actuarial rate with taxable bonds accruing at a market-based borrowing rate. The difference between the market borrowing rate versus actuarial rate could potentially generate annual cost savings for a municipal entity.

In order to repay the UAAL, municipalities make annual UAAL amortization payments that are computed using the assumed actuarial rate (typically 7.00% to 7.50%). Instead of paying down this debt over a defined period, an issuer can access debt markets to generate proceeds for funding some or all of the unfunded liability, such as effectively refinancing the UAAL at a lower borrowing cost. The General Fund revenue going toward making annual amortization payments to the pension fund is now redirected to repay bond holders. The lower debt rate means that the annual amount payable to bondholders is likely lower than the annual payment that would have otherwise had to be made to the pension fund.

While there are market and actuarial risks associated with pension bonds, employers can implement mitigation tools such as funding a Contingency Reserve Fund (CRF) to manage future variances in pension fund performance.

The current low-rate environment has allowed over 27 municipalities in Arizona to refinance their PSPRS UAAL from 7.30% to ~2.80% on average; many of these entities have generated over 50% expected net present value savings for their budget in the process.1

Employers participating in PSPRS receive a required contribution rate (as a percent of payroll) from PSPRS every year. A portion of this rate addresses the year’s Normal Cost, while the balance goes to address the UAAL amortization. Because PSPRS is an allocated costs plan, this rate differs for every employer depending on their individual liability profile. Given the high level of underfunding for many employers, the UAAL portion of the rate has increased to over 40% of payroll in recent years. Employers who have accessed debt markets to repay PSPRS have been able to reduce their rate down to the Normal Cost only.

Arizona cities, towns, counties and fire districts can utilize pledged revenue or excise tax obligations and certificates of participation to issue debt. Figure 1 on the next page highlights the one-year experience for the City of Flagstaff, which utilized Certificates of Participation to pre-pay its $116 mil PSPRS UAAL in July of 2020. Flagstaff expects to generate over $78 million (58.2%) in net present value savings for the City over the next 20 years.

ASRS is currently rolling out a voluntary Contribution Pre-Funding Program (CPP) that would enable participating employers to make additional contributions against their unfunded liability.

While the ASRS annual contribution rate is uniform across all participating employers, ASRS will provide participating employers with offset credits against future payments under the CPP. This means that for any given year, a participating employer would receive the same annual rate from ASRS as everyone else. However, the ultimate dollar payment due for a pre-funded employer would net the offset credit from that homogenous contribution rate, thereby generating savings for that employer’s budget.

At the option of the employer, these offsets will be calculated either at a risk- adjusted fixed accrual rate (RAFAR) or the Actual Rate of Return Accrual Amount (ARORAA). The former option bakes in an estimated risk premium and allows ASRS to provide guaranteed offset credits. While the latter provides the potential to benefit from periods of great investment performance (such as in 2021), it also potentially exposes a participating employer to variance in annual offset credits.

Conclusion

The PSPRS and ASRS pre-funding efforts are both significant positives for individual employers as well as the general fiscal health of the State of Arizona. Ultimately, the successful implementation of these pre-payments will generate positive impacts for employers, employees, retirees and taxpayers. l

1 https://publicplansdata.org/ ² The Reason Foundation, “City Budgets Bend Under Growing Pension Costs and Dwindling Revenues.” https://reason.org/commentary/citybudgets-bend-under-growing-pension-costs-anddwindling-revenues/

Rushda Mustafa, Vice President, joined Stifel’s Public Finance Department in 2012 and has provided quantitative and banking support for $4.2 billion of lead-managed transactions across a variety of credits for large issuers. Over the past 18 months, Mustafa has worked closely with her colleagues to structure and execute 31 PSPRS pension refinancings for cities, towns, counties and fire districts that participate in the Public Safety Personnel Retirement System, totaling approximately $1.9 billion (31 transactions). Contact her at mustafar@stifel.com.