No preview available
HomeMy WebLinkAboutPacket - 01/14/2020 - Police Pension Board POLICE PENSION BOARD OF TRUSTEES Tuesday, January 14, 2020 2:30 PM Municipal Center - 333 South Green Street Aldermen’s Conference Room AGENDA 1. Call to Order 2. Roll Call 3. Public Input 4. Approve the October 8, 2019, and October 29, 2019, meeting minutes 5. Report of Investments and Accounts: a. Presentation and motion to approve the Treasurer’s Report b. LPL Financial Equities Report c. Capital Gains, Inc. Fixed Assets Report i. Presentation about the possibility of issuing bonds to pay off the unfunded liability for the Police Pension Fund. Possible action regarding recommendation to the Finance Committee or City Council 6. New Business: a. Department of Insurance Letter b. Consolidation of Funds c. Accept Applications of 2 New Officers i. Ashley O’Herron ii. Henri Krueger d. Approve Pension Increases e. Approve the purchase of service-time for unpaid leave for Officer Jill Foley f. Motion to approve a request from Bryan Wegner for a refund of all pension fund contributions in the amount of $19,651.16 g. Approve portability of time for Susan Ellis h. Approve portability of time for Ashley O’Herron 7. Unfinished Business: a. Motion to approve the payment of bills b. Public Pension Trustee Training Update 8. Semi-Annual Review of Executive Session Minutes 9. Additional Items for Discussion 10. Adjournment Police Pension Board of Trustees Special Meeting Minutes October 29, 2019 Call to Order The regular meeting of the City of McHenry Police Pension Board of Trustees was called to order at 8:30 a.m. in the City Council Chambers at 333 S. Green Street, McHenry, IL. Roll call: Members present: President Jeffery Foerster, Ann Buss, Cheryl Kranz. Officer Marc Fisher, Sergeant Nick Clesen. Others present: Monte Johnson Public Comments: No members of the public were present to offer comments. Review the Department of Insurance Audit and Motion to Submit a Response Members reviewed the response letter that was drafted by Jeffery Foerster. A motion was made by Sergeant Clesen and seconded by Cheryl Kranz. Vote: 5-ayes: Jeff Foerster, Ann Buss, Cheryl Kranz, Marc Fisher, Nick Clesen. 0-nays, o-abstained. Motion carried. Motion to Adjourn A motion was made by Sergeant Clesen and seconded by Officer Fisher to adjourn the meeting at 8:36 a.m. Vote: 5-ayes by unanimous voice vote. 0-nays, 0-abstained., 2-absent. Motion carried. Monte Johnson, Recording Secretary Jeff Foerster, President Police Pension Board of Trustees Regular Meeting Minutes October 8, 2019 Call to Order The regular meeting of the City of McHenry Police Pension Board of Trustees was called to order at 2:30 p.m. in the City Council Chambers at 333 S. Green Street, McHenry, IL. Roll call: Members present: President Jeffery Foerster, Ann Buss, Cheryl Kranz. Absent: Officer Marc Fisher, Sergeant Nick Clesen. Others present: Monte Johnson, Carolyn Lynch, Gary Karshna, James Schmidt, Kevin Cavanaugh Public Input: No members of the public were present to offer comments. Meeting Minutes A motion was made by Ann Buss and seconded by Cheryl Kranz to approve the minutes of the meeting on July 9, 2019. Vote: 3-ayes by unanimous voice vote. 0-nays, 0-abstained., 2-absent. Motion carried. Presentation of Actuarial Valuation Report and recommendation to forward Pension Fund Tax Levy request to McHenry City Council Mr. Cavanaugh presented and explained the Actuarial Funding Report. The recommended contribution for this year's tax levy will be $2,231,742. This is an increase of $149,321, which is about a 7.2% increase. The goal of Lauterbach & Amen is to be fully funded by 2040. The law states that we must be 90% funded by 2040. It is reported that our numbers have been based on an expected investment return of 7%, but we have been paying out 7 %%. Mr. Foerster questioned if it would be wise to look into purchasing bonds to pay off the shortfall and only paying 3% vs the 7%. Mr. Cavanaugh stated that many pension boards are looking into this option, and that it is definitely a discussion worth having. Treasurer's Report A motion was made by Cheryl Kranz and seconded by Ann Buss to approve the Treasurer's Report. Vote: 3-ayes by unanimous voice vote. 0-nays, 0-abstained., 2-absent. Motion carried. LPL Financial Equities Report Investment Advisor James Schmidt reviewed the Portfolio Performance Summary. Investments are up 14.6%. Capital Gains. Inc. Fixed Assets Report Investment Manager Gary Karshna reviewed the Fixed Assets Report. He explained that the 3 year bonds are down to 2%, but we have been fortunate enough this fiscal year to have a 4% bond rate. Political and economic issues were discussed as to how they are affecting the market. Europe may be purchasing American bonds, Hong Kong is causing issues, and a trade deal with China would help. Semi -Annual Review of Police Pension Fund Investment Policy The policy has recently been upgraded and everybody agreed that the policy looks fine. A motion was made by Cheryl Kranz and seconded by Ann Buss to leave the current Investment Policy as is. Vote: 3- ayes by unanimous voice vote. 0-nays, 0-abstained., 2-absent. Motion carried. Motion to Approve a Request from Bryan Wegner for a refund of all pension fund contributions in the amount of $19,651.16. Or. Foerster explained that an official letter has not yet been received, so this action will not take place until the next meeting. Motion to approve Office Sue Ellis Application Mr. Foerster stated that she was hired on September 23rd, and all of her paperwork has been submitted. A motion was made by Ann Buss and seconded by Cheryl Kranz to approve Officer Sue Ellis Application for Participation in the Police Pension Fund. Roll Call: Vote: Ayes: Ann Buss, Cheryl Kranz, Jeff Foerster. 0-nays, o-abstained. 2-absent. Motion carried. Approval of decision of Disability Pension for Sean Klechak A motion was made by Cheryl Kranz and seconded by Ann Buss to approve the decision of Disability Pension for Sean Klechak. Roll Call: Vote: Ayes: Ann Buss, Cheryl Kranz, Jeff Foerster. 0-nays, o- abstained. 2-absent. Motion carried. Approve the transfer of creditable service for Dinka Malik to Arlington Heights Police Pension Fund A motion was made by Ann Buss and seconded by Cheryl Kranz to approve the transfer of creditable service for Dinka Malik to Arlington Heights Police Pension Fund. Roll Call: Vote: Ayes: Ann Buss, Cheryl Kranz, Jeff Foerster. 0-nays, o-abstained. 2-absent. Motion carried. Pass a Resolution Regarding Consolidation of Pension Funds A motion was made by Cheryl Kranz and seconded by Ann Buss to pass a resolution regarding consolidation of pension funds.. Vote: 3-ayes by unanimous voice vote. 0-nays, 0-abstained., 2-absent. Motion carried. Motion to approve the payment of bills A motion was made by Ann Buss and seconded by Cheryl Kranz to approve the payment of bills. Vote: 3-ayes by unanimous voice vote. 0-nays, 0-abstained., 2-absent. Motion carried. Additional Items for Discussion Jeff Foerster began discussion of Pension Obligation Bonds. Mr. Foerster explained that there were a few issues with the Department of Insurance and the Police Pension Board. Many were small housekeeping items that were minor. There was also a discrepancy about converting Officer Porter, who is a retired officer. The Department of Insurance believes that we should not have converted Officer Porter, but our sources say that we did that appropriately. Motion to Adiourn A motion was made by Cheryl Kranz and seconded by Ann Buss to adjourn the meeting at 3:40 p.m. Vote: 3-ayes by unanimous voice vote. 0-nays, 0-abstained., 2-absent. Motion carried. Monte Johnson, Recording Secretary Jeff Foerster, President | 1| 11 Pension Obligation Bond Analysis Presented to: Baird Public Finance Stephan Roberts300 E. Fifth Avenue, Suite 200Naperville, IL 60563 630-778-9174 (direct)630-730-3415 (mobile) scroberts@rwbaird.com *See “Important Disclosures”on the inside front cover. Presented On: January 14, 2020 Dalena Welkomer300 E. Fifth Avenue, Suite 200Naperville, IL 60563 630-778-9857 (direct)630-664-3614 (mobile) dwelkomer@rwbaird.com | 2 Important Disclosures Robert W.Baird &Co.Incorporated (“Baird”)is not recommending that you take or not take any action.Baird is not acting as financial advisor ormunicipaladvisortoyouanddoesnotoweafiduciarydutypursuanttoSection15BoftheSecuritiesExchangeActof1934toyouwithrespecttotheinformationcontainedhereinand/or accompanying materials (collectively,the “Materials”).Baird is acting for its own interests.You should discuss theMaterialswithanyandallinternalorexternaladvisorsandexpertsthatyoudeemappropriatebeforeactingontheMaterials. Baird seeks to serve as underwriter in connection with a possible issuance of municipal securities you may be considering and not as financial advisor ormunicipaladvisor.Baird is providing the Materials for discussion purposes only,in anticipation of being engaged to serve as underwriter (or placementagent). The role of an underwriter includes the following:Municipal Securities Rulemaking Board Rule G-17 requires an underwriter to deal fairly at all timeswithbothmunicipalissuersandinvestors.An underwriter’s primary role is to purchase the proposed securities to be issued with a view to distributioninanarm’s length commercial transaction with the issuer.An underwriter has financial and other interests that differ from those of the issuer.Anunderwritermayprovideadvicetotheissuerconcerningthestructure,timing,terms,and other similar matters for an issuance of municipal securities.Any such advice,however,would be provided in the context of serving as an underwriter and not as municipal advisor,financial advisor or fiduciary.Unlike a municipal advisor,an underwriter does not have a fiduciary duty to the issuer under the federal securities laws and is therefore not required byfederallawtoactinthebestinterestsoftheissuerwithoutregardtoitsownfinancialorotherinterests.An underwriter has a duty to purchasesecuritiesfromtheissueratafairandreasonablepricebutmustbalancethatdutywithitsdutytosellthosesecuritiestoinvestorsatpricesthatarefairandreasonable.An underwriter will review the official statement (if any)applicable to the proposed issuance in accordance with,and as part of,itsresponsibilitiestoinvestorsunderthefederalsecuritieslaws,as applied to the facts and circumstances of the proposed issuance. The Materials do not include any proposals,recommendations or suggestions that you take or refrain from taking any action with regard to an issuanceofmunicipalsecuritiesandarenotintendedtobeandshouldnotbeconstruedas''advice''within the meaning of Section 15B of the SecuritiesExchangeActof1934orRule15Ba1-1 thereunder.The Materials are intended to provide information of a factual,objective or educational nature,aswellasgeneralinformationaboutBaird(including its Public Finance unit)and its experience,qualifications and capabilities. Any information or estimates contained in the Materials are based on publicly available data,including information about recent transactions believedtobecomparable,and Baird’s experience,and are subject to change without notice.Baird has not independently verified the accuracy of such data.Interested parties are advised to contact Baird for more information. If you have any questions or concerns about the above disclosures,please contact Baird Public Finance. IRS Circular 230 Disclosure:To ensure compliance with requirements imposed by the IRS,we inform you that the Materials do not constitute tax adviceandshallnotbeusedforthepurposeof(i)avoiding tax penalties or (ii)promoting,marketing or recommending to another party any transaction ormatteraddressedherein. | 3 Pension Funding Opportunity The City’s Police Pension Plan had the following characteristics as shown in the City’s Police Pension Fund Actuarial Valuation Report dated April 30,2019: The City is paying 7.0%on its unfunded Police pension liabilities. Baird estimates that the City could borrow at about 3.54%in the current taxable bond market. Should the City apply bond proceeds to retire its unfunded Police pension liabilities it could save over $8.6 million in interest cost over the next 20 years.* _____________________* Savings are estimated based on the City’s Police and Fire pension plan actuarial assumptions and Baird’s interest rate assumptions described herein. Police Total UAAL $22,532,960 Funded Ratio 54.65% Actuarial Rate 7.00% Payroll Growth Assumption 3.00% Amortization Period (Closed)22 Years | 4 What are Pension Obligation Bonds? The Unfunded Actuarial Accrued Liability (UAAL)of a pension system is the present value of the future pension costs that are not funded by existing assets. –The UAAL is amortized over a number of years as determined by the pension system. Pension Obligation Bonds (POBs)are issued to pay off all or a portion of the UAAL of the system. –Bond proceeds are deposited to be invested with other system assets. –Bonds are issued at taxable interest rates. –Bonds are typically amortized over the same term as the UAAL. POBs are attractive when the interest rate on the bonds is significantly less than the actuarial rate on the UAAL. –The actuarial rate (present value discount rate) is determined by the system and is usually the same as the assumed earnings rate of pension assets. Unlike a refunding bond issue,the expected savings is not fixed. –The actual earnings on invested bond proceeds over the life of the POBs will determine final economics. –Bond rate becomes the new hurdle rate for investment earnings. –Look at historical earnings the last ten years (to include 2008/2009 recession) to gauge the system’s ability to achieve its actuarial rate. | 5 Amortization of City’s Police Pension Plan UAAL (1) _____________________ (1)Total UAAL, 3.00% increase in payroll, 7.00% investment rate, 22 year repayment period and amounts are based on the actuarial assumptions detailed in the City's Police Pension Fund Actuarial Valuation Report as of April 30, 2019.(2)The UAAL payment is calculated as a constant percentage of payroll for covered employees. Tax Collection Year Ending December 31 Fiscal Year Ending April 30 - UAAL Payment & Valuation Total UAAL Annual Payment to Amortize UAAL (2) Interest on UAAL 2018 2019 $22,532,960 $1,484,297 $1,473,406 2019 2020 $22,522,070 $1,528,826 $1,469,527 2020 2021 $22,462,771 $1,574,691 $1,462,166 2021 2022 $22,350,246 $1,621,931 $1,450,982 2022 2023 $22,179,297 $1,670,589 $1,435,610 2023 2024 $21,944,317 $1,720,707 $1,415,653 2024 2025 $21,639,263 $1,772,328 $1,390,685 2025 2026 $21,257,621 $1,825,498 $1,360,249 2026 2027 $20,792,371 $1,880,263 $1,323,848 2027 2028 $20,235,956 $1,936,671 $1,280,950 2028 2029 $19,580,235 $1,994,771 $1,230,983 2029 2030 $18,816,447 $2,054,614 $1,173,328 2030 2031 $17,935,161 $2,116,252 $1,107,324 2031 2032 $16,926,233 $2,179,740 $1,032,254 2032 2033 $15,778,747 $2,245,132 $947,353 2033 2034 $14,480,968 $2,312,486 $851,794 2034 2035 $13,020,276 $2,381,861 $744,689 2035 2036 $11,383,104 $2,453,317 $625,085 2036 2037 $9,554,873 $2,526,916 $491,957 2037 2038 $7,519,914 $2,602,723 $344,203 2038 2039 $5,261,393 $2,680,805 $180,641 2039 2040 $2,761,229 $2,761,229 $0 2040 2041 $0 $0 | 6 Amortization of City’s Police Pension Plan UAAL (cont.) _____________________ (1) Assumes actuarially projected results are achieved. | 7 UAAL vs. POB Payments using Existing Payment Pattern This solution fully funds the UAAL and generates an estimated average annual cash savings of approximately $430,000 as illustrated below. _____________________(1) Assumes actuarially projected results are achieved and bonds are issued as described. | 8 UAAL vs. POB Payments using Existing Payment Pattern (cont.) ________________________(1)This illustration represents a mathematical calculation of potential interest cost savings,assuming hypothetical rates based on current rates for taxable general obligation bonds rated Aa2 as of December 31,2019.Actual rates may vary.If actual rates are higher than those assumed,the interest cost savings would be lower.This illustration provides information and is not intended to be a recommendation,proposal orsuggestionforarefinancingorotherwisebeconsideredasadvice.Assumes the bonds are dated as of February 1,2020 with principal due December 15 and a first interest payment on June 15,2020.Preliminary,subject to change.(2)Total UAAL,3.00%increase in payroll,7.00%investment rate and 22 year repayment period and amounts are based on the actuarial assumptions detailed in the City's Police Pension Fund Actuarial Valuation Report asofApril30,2019.The UAAL payment is calculated as a constant percentage of payroll for covered employees.Preliminary,subject to change.(3)Assumes actuarially projected results are achieved and bonds are issued as described. 4/30 Tax Collection Fiscal Year Year Ending of UAAL Annual Payment to Net Total Assumed December 31 Payment Amortize UAAL (2)Principal Interest Debt Service Savings (3) Avg= 3.54% 2019 2020 2020 2021 $1,574,691 $470,000 $669,625 $1,139,625 $435,065 2021 2022 $1,621,931 $430,000 $757,994 $1,187,994 $433,937 2022 2023 $1,670,589 $490,000 $748,878 $1,238,878 $431,711 2023 2024 $1,720,707 $550,000 $737,853 $1,287,853 $432,854 2024 2025 $1,772,328 $615,000 $724,928 $1,339,928 $432,400 2025 2026 $1,825,498 $685,000 $709,615 $1,394,615 $430,883 2026 2027 $1,880,263 $755,000 $691,531 $1,446,531 $433,732 2027 2028 $1,936,671 $835,000 $670,466 $1,505,466 $431,205 2028 2029 $1,994,771 $915,000 $646,335 $1,561,335 $433,436 2029 2030 $2,054,614 $1,005,000 $618,702 $1,623,702 $430,912 2030 2031 $2,116,252 $1,095,000 $587,346 $1,682,346 $433,907 2031 2032 $2,179,740 $1,195,000 $552,087 $1,747,087 $432,653 2032 2033 $2,245,132 $1,300,000 $512,413 $1,812,413 $432,720 2033 2034 $2,312,486 $1,410,000 $467,953 $1,877,953 $434,534 2034 2035 $2,381,861 $1,530,000 $418,321 $1,948,321 $433,540 2035 2036 $2,453,317 $1,655,000 $363,700 $2,018,700 $434,617 2036 2037 $2,526,916 $1,790,000 $303,458 $2,093,458 $433,459 2037 2038 $2,602,723 $1,935,000 $237,407 $2,172,407 $430,317 2038 2039 $2,680,805 $2,085,000 $165,038 $2,250,038 $430,768 2039 2040 $2,761,229 $2,240,000 $86,016 $2,326,016 $435,213 $42,312,524 $22,985,000 $10,669,660 $33,654,660 $8,657,864 Assumed Unfunded Actuarial Accrued Liability Funded by POBs ……………………$22,522,070 Assumed Present Value Savings @ Bond Rate………………………………...…………$6,381,533 Assumed PV Savings @ Bond Rate / UAAL………………..………………………………28.33% +10 basis points -10 basis points Potential Gross Savings $8,330,250 $8,985,842 Potential Present Value Savings $6,095,194 $6,671,635 Hypothetical Refunding Bond Yield (Discount Rate)3.616%3.414% Potential Percent Present Value Savings 27.06%29.62% Alternative Funding Method Level Savings Illustration (1) Interest Rate Sensitivity Analysis | 9 Alternative Amortization using More Level Debt Service POBs offer the benefit of allowing the City to structure bond repayments to better meet its needs. Because the current UAAL payments are based on an actuarially calculated constant percentage of payroll with payroll assumed to grow 3.0%annually,the UAAL Payments are designed to also grow annually as payroll grows. For the City,payments are expected to grow by nearly two times from $1.53 million in 2020 to $2.76 million in 2040. The City could structure its bonds with more level debt service. –By forgoing or reducing early year savings, the City can dramatically reduce future year payments by as much as approximately $1.16 million. –Generates approximately $1.66 million more in savings than the level savings scenario. | 10 UAAL vs. POB Payments using More Level Debt Service _____________________(1) Assumes actuarially projected results are achieved. | 11 UAAL vs. POB Payments using More Level Debt Service (cont.) ________________________(1)This illustration represents a mathematical calculation of potential interest cost savings,assuming hypothetical rates based on current rates for taxable general obligation bonds rated Aa2 as of December 31,2019.Actual rates may vary.If actual rates are higher than those assumed,the interest cost savings would be lower.This illustration provides information and is not intended to be a recommendation,proposal orsuggestionforarefinancingorotherwisebeconsideredasadvice.Assumes the bonds are dated as of February 1,2020 with principal due December 15 and a first interest payment on June 15,2020.Preliminary,subject to change.(2)Total UAAL,3.00%increase in payroll,7.00%investment rate and 22 year repayment period and amounts are based on the actuarial assumptions detailed in the City's Police Pension Fund Actuarial Valuation Report asofApril30,2019.The UAAL payment is calculated as a constant percentage of payroll for covered employees.Preliminary,subject to change.(3)Assumes actuarially projected results are achieved and bonds are issued as described. 4/30 Tax Collection Fiscal Year Year Ending of UAAL Annual Payment to Net Total Assumed December 31 Payment Amortize UAAL (2)Principal Interest Debt Service Savings (3) Avg= 3.45% 2019 2020 2020 2021 $1,574,691 $935,000 $635,353 $1,570,353 $4,337 2021 2022 $1,621,931 $890,000 $709,076 $1,599,076 $22,855 2022 2023 $1,670,589 $910,000 $690,208 $1,600,208 $70,381 2023 2024 $1,720,707 $930,000 $669,733 $1,599,733 $120,974 2024 2025 $1,772,328 $955,000 $647,878 $1,602,878 $169,450 2025 2026 $1,825,498 $980,000 $624,099 $1,604,099 $221,399 2026 2027 $1,880,263 $1,005,000 $598,227 $1,603,227 $277,036 2027 2028 $1,936,671 $1,030,000 $570,187 $1,600,187 $336,484 2028 2029 $1,994,771 $1,060,000 $540,420 $1,600,420 $394,351 2029 2030 $2,054,614 $1,095,000 $508,408 $1,603,408 $451,206 2030 2031 $2,116,252 $1,125,000 $474,244 $1,599,244 $517,008 2031 2032 $2,179,740 $1,165,000 $438,019 $1,603,019 $576,721 2032 2033 $2,245,132 $1,200,000 $399,341 $1,599,341 $645,791 2033 2034 $2,312,486 $1,245,000 $358,301 $1,603,301 $709,185 2034 2035 $2,381,861 $1,285,000 $314,477 $1,599,477 $782,384 2035 2036 $2,453,317 $1,335,000 $268,603 $1,603,603 $849,714 2036 2037 $2,526,916 $1,380,000 $220,009 $1,600,009 $926,908 2037 2038 $2,602,723 $1,435,000 $169,087 $1,604,087 $998,637 2038 2039 $2,680,805 $1,485,000 $115,418 $1,600,418 $1,080,388 2039 2040 $2,761,229 $1,540,000 $59,136 $1,599,136 $1,162,093 $42,312,524 $22,985,000 $9,010,221 $31,995,221 $10,317,302 Assumed Unfunded Actuarial Accrued Liability Funded by POBs ……………………$22,522,070 Assumed Present Value Savings @ Bond Rate………………………………...…………$6,645,146 Assumed PV Savings @ Bond Rate / UAAL………………..………………………………29.51% +10 basis points -10 basis points Potential Gross Savings $10,024,871 $10,613,964 Potential Present Value Savings $6,354,966 $6,939,710 Hypothetical Refunding Bond Yield (Discount Rate)3.524%3.322% Potential Percent Present Value Savings 28.22%30.81% Alternative Funding Method Level Debt Service Illustration (1) Interest Rate Sensitivity Analysis | 12 Potential Benefits to the City Could generate significant expected total gross savings (over $8.6 million),assuming the System’s investments realize the assumed 7.0%rate of return. Provides the City with flexibility to structure repayments to best meet its needs. Replaces one existing legal obligation with another,less costly liability. –No material net increase in the City’s obligations. Lowers the “hurdle rate”on investments from the historical average investment rate (7.0%) to the POB cost of funds (estimated to be 3.54%in today’s market). –If the return on investments achieved by the Pension Plans during the life of the POBs equals the bond cost of funds, the City would be at its point of indifference. Funds current UAAL obligations,assisting the City in complying with State funding requirements (90%funded by 2040)and potentially avoiding State aid diversion to the Pension Plan. Immediately reduces or eliminates the current UAAL of the Pension Plan. –Pension Plan receives upfront payment, instead of partial payments through 2040. | 13 Potential Risks to the City The principal risk is that earnings on POB proceeds will be less than the assumed 7.0%rate.The table shows the result of the various earnings scenarios: –Look at historical returns (including 2008/09 recession) to determine likelihood of achieving investment rate over the term of the POBs. Investing a large dollar amount all at once could result in adverse market timing. –Can be addressed through agreements with the pension plan. –This risk could be mitigated by Consolidation if the City will be buying a pro-rata portion of a larger pool of investments (consolidated Police Pension System), like IMRF. Actual Earnings Achieved Result Above Actuarial Rate Savings Greater Than Expected Actuarial Rate Expected Savings Received Below Actuarial Rate, but Above POB Rate Savings Less Than Expected POB Rate No Savings Below POB Rate Loss | 14 Potential Risks to the City (cont.) The City must turn over POB proceeds to the Pension Plan to be invested. –The City could ask to play a part in the selection of an investment manager. –For the City to maintain control over investments, a Trust could be created, but it will double count the liability. –Concerns of this could be mitigated by Pension Consolidation assuming there is a large pool of investments managed by a professional. The POBs are “hard”liabilities while pension payments can sometimes be considered “soft”liabilities. –Illinois’ Pension Protection clause contradicts this view as confirmed in recent Supreme Court rulings. –State aid could be diverted to the Pension Plan if the City does not meet State funding requirements. Additional UAALs may arise as a result of such things as mortality,payroll,asset valuationmethod,benefit levels,investment rate,etc. –This risk will be present whether the POBs are issued or not. City remains responsible for Normal Costs each year. | 15 Rating Agency Treatment of POBs Rating agency treatment is expected to be neutral overall assuming POBs are structured like the example herein. The City’s rating analysis would treat the POBs as bonds instead of pension liabilities. S&P has stated that it will have a negative view of POBs when one of the following conditions exist(1): Best to communicate the reasons for issuing POBs and to adopt a formal Pension Bond Policy to demonstrate this was a well-thought-out decision. _____________________ (1) Taken from S&P Credit FAQ: Quick Start Guide to S&P Global Ratings’ Approach to U.S. State and Local Government Pensions dated May 13, 2019. Conditions Response The bonds are used as a mechanism for short-term budget relief or poor funding structure.POBs, such as the example herein, are not used to fund normal costs and can be structured to lower the overall and annual cost to amortize the UAAL within the existing footprint. Issuance is not combined with plan-specific measures to address the long-term liability.POBs, such as the example herein, can be issued and structured to address the long-term funding of the UAAL. The bonds substantially reduce the government’s debt capacity. Home rule municipalities have no debt limit and if non home rule municipality issues alternate revenue bonds, not subject to debt limit. | 16 GFOA’s Recommendation on POBs The GFOA recommends against POBs for the following reasons. –If POBs are structured appropriately, four of the five reasons are not applicable. GFOA Reasons Response 1.The invested POB proceeds might fail to earn more than theinterestrateowedoverthetermofthebonds,leading toincreasedoverallliabilitiesforthegovernment. Agree –this is the primary risk of POBs. 2.POBs are complex instruments that carry considerable risk.POBstructuresmayincorporatetheuseofguaranteedinvestmentcontracts,swaps,or derivatives,which must be intensivelyscrutinizedastheseembeddedproductscanintroducecounterpartyrisk,credit risk and interest rate risk. POBs,such as the example herein,can be executed withoutcomplexinstruments/structures. 3.Issuing taxable debt to fund the pension liability increases thejurisdiction’s bonded debt burden and potentially uses up debtcapacitythatcouldbeusedforotherpurposes.In addition,taxable debt is typically issued without call options or with "make-whole"calls,which can make it more difficult and costly to refundorrestructurethantraditionaltax-exempt debt. Home rule municipalities are not subject to a debt limit andalternaterevenuesourcebondsissuedbynonhomerulemunicipalitiesarenotsubjecttoadebtlimit. Taxable bonds with par amounts less than $100 million cangenerallybepricedwithastandardoptionalparcallallowingforarefundingforsavingsinthefuture.Make-whole calls areonlyneededformuchlargertaxabletransactions. 4.POBs are frequently structured in a manner that defers theprincipalpaymentsorextendsrepaymentoveraperiodlongerthantheactuarialamortizationperiod,thereby increasing thesponsor’s overall costs. POBs,such as the example herein,can be structured over thesametermastheUAAL.The amortization can be acceleratedandleveledofftolowertheoverallcostandfutureyearpayments. 5.Rating agencies may not view the proposed issuance of POBs ascreditpositive,particularly if the issuance is not part of a morecomprehensiveplantoaddresspensionfundingshortfalls. Rating agency treatment is neutral so long as the POBs arestructuredasdescribedhereinandproceedsarenotusedtofundnormalcosts. | 17 Pension Consolidation Update November 14th,the Senate passed a bill that will consolidate downstate and suburban police and fire pension systems into two statewide funds. –House passed the bill on November 13th. –Governor is expected to sign. The goal of the bill is to increase investment returns,lower administrative costs and improve funding levels over time. –Could mitigate some of the risks associated with POBs identified earlier. –Is expected to function similar to the IMRF. –Investment restrictions lifted and “Prudent Person” investment policy is permitted. Many Illinois communities have expressed interest in POBs should consolidation occur. –Potentially higher returns makes a POB more attractive. | 18 Pension Consolidation Update (cont.) Transition period will be the next 30 months (by June 30,2022). –Transition Board has been established to appoint an executive director, hire professionals and establish rules. –Transition Board consists of three members representing municipalities, three members, two retirees and one member representing the IML. The transfer of assets will occur during the transition period. –The Transition Board’s rules will help determine when the actual transfer occurs. The Consolidated Plan will separately track the assets of each fund and prepare a unique contribution requirement for each fund. –The funded status of another fund should not affect the funded status of your fund. | 19 Recent POB Issuance in Illinois Relative to other states,there has been a dearth of POB transactions in Illinois. Some recent examples include:State of Illinois,Village of Milan,City of GraniteCity,Village of Round Lake Beach and Winnebago County. These examples provide an interesting perspective of how rating agencyreactionsarelargelydrivenbyhowthePOBisstructured. –Funding normal costs with proceeds vs. the unfunded liability. –Adopting a pension funding policy (handout). –Funding a budget stabilization reserve fund. –Amortizing the bonds over the same term as the unfunded liability. For illustrative purposes,we include in the Appendix rating reports for several Illinois POBs with highlights. –The rating agency will want to know that this has been well thought through, is part of a long-term financial initiative and has considered the risks and mitigation. | 20 Case Study: County of Winnebago The County sponsors three multiple-employer defined benefit pension plans administered by the Illinois Municipal Retirement Fund (“IMRF”).Baird reviewed the County’s unfunded actuarial accrued liabilities (“UAAL”)for each plan to determine if issuing pension obligation bonds (“POBs”)would be a more cost- effective method to amortize its UAAL than what was currently being employed by IMRF. The County had an estimated $29.3 million in combined UAAL and was paying 7.5%interest on these liabilities to IMRF.Baird estimated that the County could borrow at a lower rate in the bond market,generating significant expected savings through the amortization of the UAAL.In addition,the IMRF open amortization funding methodology results in payment on these UAALs for well over 100 years which would be much shorter with bonds. While our calculations demonstrated that the County had significant potential savings by using bond proceeds to retire its UAAL,it is important to Baird that issuers of POBs understand and become comfortable with the risks.Baird encouraged the County to evaluate the risks associated with issuing POBs and Baird and the deal team took the time to educate the County’s administration and Board on these risks.In addition,Baird drafted a pension funding policy for the County to adopt which set forth procedures to follow in order to mitigate the potential risks identified. Baird produced a detailed ratings presentation on the County’s plan of finance,which included the potential benefits,risks and mitigation strategies. Because the Bonds replaced one existing legal obligation with another and the County had clearly thought through the risks having adopted a policy and established a budget stabilization fund,the rating agency treatment was neutral.Moody’s affirmed the County’s Aa2 rating. As the County’s Bonds were preparing to price,Baird became aware that a comparable taxable Illinois general obligation bond issue rated AA+(one notch stronger than the County)was scheduled to price on the same day.Baird recommended that the County accelerate its pricing date by one day so as to not directly compete for investor orders.At the conclusion of the initial order period,over 40%of the Bonds remained unsold.Baird repriced and ran a second order period which generated a few additional orders.Rather than run a third order period,Baird offered to underwrite the balance of $8.5 million (27%of the offering)with upward adjustments in rates.Baird believes it is important to support our clients and,when appropriate,to transfer the risk of the unsold balances to our firm.The final interest rates achieved by Baird were as many as 23 basis points better than the other Illinois transaction which priced the next day.We believe this demonstrates our ability to use our understanding of the market to generate attractive rates for our clients. The County achieved a bond rate of 4.59%,well below the 7.50%it was paying to IMRF.Bond proceeds were paid to IMRF to retire the UAAL and to be invested in its $41 billion investment pool which has demonstrated historical returns greater than the actuarial rate of 7.5%.Assuming IMRF achieves 7.5%, as it has in the past,the County will achieve expected gross savings of $66.5 million.The present value of that amount is $29.3 million (34.6%of the UAAL funded).In addition,the County will shorten its amortization period for these liabilities from well over 100 years to 25 years. $31,005,000 Taxable General Obligation Bonds (Alternate Revenue Source), Series 2018Rated Aa2 by Moody’sNovember 2018Sole Underwriter | 212121 Recent Illinois POB Rating Reports Appendix Summary: Milan, Illinois; General Obligation Primary Credit Analyst: David H Smith, Chicago + (312) 233-7029; david.smith@spglobal.com Secondary Contact: Scott Nees, Chicago (1) 312-233-7064; scott.nees@spglobal.com Table Of Contents Rationale Outlook Related Research WWW.STANDARDANDPOORS.COM/RATINGSDIRECT APRIL 19, 2018 1 Summary: Milan, Illinois; General Obligation Credit Profile US$4.315 mil taxable GO bnds (alternate rev source) ser 2018A due 12/01/2038 Long Term Rating BBB+/Stable New Milan Vill GO rfdg bnds (alt rev source) Long Term Rating BBB+/Stable Downgraded Rationale S&P Global Ratings lowered its long-term rating and underlying rating (SPUR) on the village of Milan, Ill.'s general obligation (GO) debt two notches to 'BBB+' from 'A'. At the same time, we assigned our 'BBB+' rating to the village's series 2018A taxable GO bonds (alternate revenue source). The outlook is stable. The downgrade reflects, in our view, the village's structural imbalance, without a credible plan to adequately address it. The village has had three consecutive audited deficits and has underfunded its police pension plan during this period. The village intends to use the proceeds of the current issuance to improve its pension funding levels without addressing its underlying structural imbalance. In addition, we view the village's issuance of pension funding bonds in situations such as this one, where it serves as a mechanism for short-term budget relief, as a negative credit factor. Moreover, the village's plan to issue the bonds to increase its pension asset level to greater than $10 million in order to enhance its investment options may introduce greater risk, should the village's forecast investment returns not be met. The downgrade also reflects the continuing deterioration in the village's reserves following multiple years of general fund drawdowns. The series 2018A bonds are secured by the village's GO pledge and payable from the annual issuance of nonreferendum bonds and sales taxes. We rate to the village's GO pledge as we view it as the stronger pledge. The series 2018A bonds are structured with a covered abatement, requiring it to have pledged revenues deposited in the bond fund prior to abatement of the property tax levy securing the bonds. The remainder of the village's rated debt is secured by its GO pledge and by ad valorem taxes on all taxable property within its borders without limit as to rate or amount. Some of the village's debt that we rate is secured by multiple revenue streams, though in each case, we rate to the GO pledge, and the village's alternate revenue bonds have covered abatements. Proceeds from the series 2018A bonds will be used to finance a portion of the unfunded accrued actuarial liabilities of the police pension fund. The village indicates that the bond proceeds will improve its police pension asset levels to over $10 million, which will enable the village to invest a greater portion of its assets in equities pursuant to state law. The 'BBB+' ratings reflect our view of the village's: • Adequate economy, with projected per capita effective buying income at 78.0% and market value per capita of $63,631, that is gaining advantage from access to a broad and diverse metropolitan statistical area (MSA); WWW.STANDARDANDPOORS.COM/RATINGSDIRECT APRIL 19, 2018 2 • Weak management, with vulnerable financial policies and practices under our Financial Management Assessment (FMA) methodology; • Weak budgetary performance, with operating results that we expect could deteriorate in the near term relative to fiscal 2017, which closed with an operating deficit in the general fund but break-even operating results at the total governmental fund level; • Adequate budgetary flexibility, with an available fund balance in fiscal 2017 of 4.5% of operating expenditures but that is low on a nominal basis at $223,000; • Very strong liquidity, with total government available cash at 44.0% of total governmental fund expenditures and 2.9x governmental debt service, and access to external liquidity we consider strong; • Very weak debt and contingent liability profile, with debt service carrying charges at 15.1% of expenditures and net direct debt that is 116.6% of total governmental fund revenue, and a large pension and other postemployment benefit (OPEB) obligation and the lack of a plan to sufficiently address the obligation, but rapid amortization, with 73.0% of debt scheduled to be retired in 10 years; and • Adequate institutional framework score. Adequate economy We consider Milan's economy adequate. The village, with an estimated population of 5,314, is located in Rock Island County in the Davenport-Moline-Rock Island, Iowa-Ill., MSA, which we consider to be broad and diverse. The village has a projected per capita effective buying income of 78.0% of the national level and per capita market value of $63,631. Overall, the village's market value grew by 2.4% over the past year to $338.1 million in 2017. The county unemployment rate was 6.3% in 2016. Three midsize firms (Xpac, Deere & Co., and Group O Inc.) are the village's top employers, and residents also have access to employment throughout the MSA via a number of interstate and state highways that either pass through the village or are nearby. The Rock Island Arsenal, a federally owned weapons manufacturing arsenal that employs more than 6,000 military and civilian personnel, is also a major employer in the area and lies a few miles north. The village's equalized assessed valuation has grown by about 2.5% per year in each of the past two years. The village's top 10 taxpayer concentration is 29.1%. Should this percentage increase to greater than 35%, our view of village's economy will likely weaken. Overall, we expect the village to continue to see modest valuation growth over the next few years as it experiences steady commercial and industrial development. Weak management We view the village's management as weak, with vulnerable financial policies and practices under our FMA methodology, indicating the government lacks policies in many of the areas we believe are most critical to supporting credit quality. Key components of our FMA scoring include: • Revenue and expenditure forecasting that relies largely on three-year trend analysis, though with a mixed history of budget-to-actual results, suggesting that budget assumptions are not thoroughly validated; • Recent adoption monthly budget-to-actual updates to its board; WWW.STANDARDANDPOORS.COM/RATINGSDIRECT APRIL 19, 2018 3 Summary: Milan, Illinois; General Obligation • A formal investment policy, though without intrayear investment reporting. The village does not have a long-term capital or financial plan, nor does it have a debt or reserve policy. We understand that the village is working toward developing both a long-term capital and financial plan. Because we consider the village to have a structural imbalance without a plan to correct the imbalance, we consider the village's management weak for this additional reason as well. Weak budgetary performance Milan's budgetary performance is weak in our opinion. The village had deficit operating results in the general fund of 11.5% of expenditures, but a break-even result across all governmental funds in fiscal 2017. Weakening our view of Milan's budgetary performance is the village's deferral of significant expenditures, which we think inflates the budgetary result ratios. The village's audits show a payroll fund separate from the general fund that we have combined with the general fund for our analysis. Milan has also consistently underfunded its police pension actuarially determined contribution (ADC) for a number of years, and we have added the payment deficiency to general and total governmental fund expenditures to arrive at what we consider a more accurate portrayal of its structural budgetary performance. After reporting two consecutive audited deficits in fiscals 2015 and 2016 (fiscal year ended April 30), the village reported another unadjusted deficit in fiscal 2017 of $382,000, which was the result of weaker sales tax and income tax revenues. After adjusting a $176,000 police pension ADC payment deficiency into expenditures, we calculated the 2017 deficit at $565,000, or 11.5% of expenditures. For fiscal 2018, the village's budget shows a slight, $28,000 deficit, or 0.6% of expenditures, across the general and payroll funds. With respect to the village's police pension funding, we understand that it plans to use approximately $234,000 of the pension bond proceeds in fiscal 2018 to fund its required pension contribution of $495,577, with the remainder coming from property taxes. As a result, we view the village's improved unadjusted budgetary performance in the general fund in fiscal 2018 as illusory, as it does not include a significant pension contribution that the village is relying on borrowing to provide. For fiscal 2019, the village is planning to adopt a general fund budget that will include an additional revenue stream of corporate personal property tax revenue of approximately $250,000, money that has historically been allocated for the village's police pension contribution. The village anticipates an adjusted surplus of $250,000 because of the additional corporate personal property tax revenue. Filling the gap for the village's pension contributions in fiscal 2019 will be another $615,000 allocated from the pension bond proceeds. The village has raised its tax rate for fiscal 2019, which will result in approximately $135,000 in additional revenue. The village is not currently levying for its police pension fund in fiscal 2019 because of the receipt of the pension bond proceeds. We consider the village to be structurally imbalanced, without an adequate plan to correct the imbalance. Our criteria include a rating cap of 'BBB+' in these situations. We do not consider the use of borrowing to finance operations to be an adequate remedy to address the village's weakened budgetary performance. The village's use of pension funding bonds to address its chronically underfunded police pension plan does not address its continuing fiscal imbalance, as future pension contributions are expected to increase in the coming years. Moreover, while the village indicates that it is in discussions with its board regarding a formal funding plan for its police pension fund, a comprehensive and WWW.STANDARDANDPOORS.COM/RATINGSDIRECT APRIL 19, 2018 4 Summary: Milan, Illinois; General Obligation specific plan does not yet exist to address the village's pension shortfalls (despite the issuance of the bonds) through revenue increases in future years. Adequate budgetary flexibility Milan's budgetary flexibility is adequate, in our view, with an available fund balance in fiscal 2017 of 4.5% of operating expenditures. The village's reserves are low on a nominal basis at $223,000, which we view as vulnerably low and a negative credit factor. We have revised our view of the village's budgetary flexibility to adequate from strong, reflecting the significant decline in the village's reserves in fiscal 2017. The village's assigned and unassigned general fund reserves were close to $1 million as recently as fiscal 2014, though consecutive drawdowns in 2015 and 2016 left its available fund balance at only $608,000 at year-end 2016. The village's fiscal 2018 estimated result in indicates a 4.4% available fund balance, or $212,000, which we would still consider adequate. The village's reserves and, therefore, budgetary flexibility could continue to deteriorate if the village encounters unaddressed and unfavorable budget variances through the remainder of fiscal 2018 or in fiscal 2019, as it has seen with some frequency in recent years. We note as well that the village has no formal fund balance policy, though we understand it has a future target of 90 days of reserves in its general fund. Very strong liquidity In our opinion, Milan's liquidity is very strong, with total government available cash at 44.0% of total governmental fund expenditures and 2.9x governmental debt service in 2017. In our view, the village has strong access to external liquidity if necessary. Given the village's history of accessing capital markets to issue GO debt within the past 20 years, we believe its access to external liquidity is strong. The village's investments consist entirely of Illinois Funds, which we do not consider aggressive, and it has no exposure to alternative financing instruments or variable-rate debt. While the village's fund balance and operational flexibility have declined in recent years, its cash position and liquidity have remained very strong, and we expect them to remain so. Very weak debt and contingent liability profile In our view, Milan's debt and contingent liability profile is very weak. Total governmental fund debt service is 15.1% of total governmental fund expenditures, and net direct debt is 116.6% of total governmental fund revenue. Approximately 73.0% of the direct debt is scheduled to be repaid within 10 years, which is in our view a positive credit factor. Absent inclusion of the current pension bonds, the village's net direct would be 52.7% of total governmental fund revenue. Our direct debt calculation excludes $2.7 million in GO debt supported by enterprise funds that we consider self-supporting. We understand that the village may issue an additional $400,000 in new-money debt within the next two years for a new 911 emergency center, which it would share with three other jurisdictions. In our opinion, a credit weakness is Milan's large pension and OPEB obligation, without a plan in place that we think will sufficiently address the obligation. Milan's combined required pension and actual OPEB contributions totaled 10.6% of total governmental fund expenditures in 2017. Of that amount, 8.8% represented required contributions to pension obligations, and 1.8% represented OPEB payments. The village made 74% of its annual required pension WWW.STANDARDANDPOORS.COM/RATINGSDIRECT APRIL 19, 2018 5 Summary: Milan, Illinois; General Obligation contribution in 2017. The funded ratio of the largest pension plan is 45.8%. The village contributes to the Illinois Municipal Retirement Fund (IMRF), an agent, multiemployer defined-benefit pension plan administered by the IMRF board in accordance with the state pension code. It also contributes to its own single-employer, defined-benefit police pension plan. Current state law requires employees covered by the police plan to contribute a fixed percentage of their base salary and the village to contribute the remaining amounts necessary to fully fund the plan (as determined by an actuary) by 2040. The village's net pension liability for IMRF was $932,820 as of April 30, 2017, while its police plan had a net pension liability of $5.9 million and was only 46% funded. Milan also sponsors a single-employer retiree health plan that it funds on a pay-as-you-go basis. The plan was 0% funded as of April 30, 2017, with a $3 million unfunded liability. With the village's issuance of the pension funding bonds, we understand that the village anticipates initially reaching a 70.9% funded ratio after the bond proceeds are received in its police pension plan. In fiscal 2019, the village is not supplementing these pension bond proceeds with additional payments, essentially providing itself with a "pension holiday" that year, enabling itself to achieve better fiscal results than it would otherwise achieve were it fully funding its pension plan. The village is assuming investment earnings of 6.5% in its current projection and forecasts that it will achieve 100% funding by 2040. However, this assumption is based on increased contributions in later years, the sources of which are not identified. Given the village's historical lack of spending discipline and the absence of a significant, board-approved pension funding policy, we do not believe its current plan represents a credible plan to address its ongoing pension underfunding. Despite the expectation that the village's funding levels will improve after the pension bond issuance, we believe that absent a long-term funding solution, pension and debt service carrying charge costs will likely continue to increase and become less manageable over time. As a result, we expect the village's fixed cost burden to remain significant, and village's debt and contingent liability profile to remain very weak. Adequate institutional framework The institutional framework score for Illinois non-home rule cities and villages not subject to the Property Tax Extension Limitation Law is adequate. Outlook The stable outlook reflects S&P Global Ratings' opinion that Milan will likely maintain its very strong liquidity and continue to benefit from the broad and diverse Davenport-Moline-Rock Island, Iowa-Ill., MSA economy. We do not expect to change the ratings within the next two years, because of our view that the village will likely remain structurally imbalanced during that time period. Downside scenario We could lower the ratings if the village's financial performance were to continue to deteriorate, leading to weaker budgetary performance and budgetary flexibility. Upside scenario While unlikely over the next few years, we could raise the ratings if management were to make sufficient changes to its budget to correct its current structural imbalance. Most significantly, should the village develop an approach that WWW.STANDARDANDPOORS.COM/RATINGSDIRECT APRIL 19, 2018 6 Summary: Milan, Illinois; General Obligation would enable it to fully fund its pension ADC on an operational basis, we could revise our view of the village's budget as being structurally imbalanced and raise the ratings. Related Research • S&P Public Finance Local GO Criteria: How We Adjust Data For Analytic Consistency, Sept. 12, 2013 • Incorporating GASB 67 And 68: Evaluating Pension/OPEB Obligations Under Standard & Poor's U.S. Local Government GO Criteria, Sept. 2, 2015 • Local Government Pension And Other Postemployment Benefits Analysis: A Closer Look, Nov. 8, 2017 • Pension Obligation Bonds' Credit Impact On U.S. State And Local Government Issuers, Dec. 6, 2017 • 2017 Update Of Institutional Framework For U.S. Local Governments Ratings Detail (As Of April 19, 2018) Milan Vill GO (AGM) Unenhanced Rating BBB+(SPUR)/Stable Downgraded Milan Vill GO (ASSURED GTY) Unenhanced Rating BBB+(SPUR)/Stable Downgraded Many issues are enhanced by bond insurance. Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. Complete ratings information is available to subscribers of RatingsDirect at www.capitaliq.com. All ratings affected by this rating action can be found on the S&P Global Ratings' public website at www.standardandpoors.com. Use the Ratings search box located in the left column. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT APRIL 19, 2018 7 Summary: Milan, Illinois; General Obligation Summary: Granite City, Illinois; General Obligation Primary Credit Analyst: Andrew J Truckenmiller, Chicago (1) 312-233-7032; andrew.truckenmiller@spglobal.com Secondary Contact: Eric J Harper, Chicago (1) 312-233-7094; eric.harper@spglobal.com Table Of Contents Rationale Outlook Related Research WWW.STANDARDANDPOORS.COM/RATINGSDIRECT NOVEMBER 14, 2017 1 Summary: Granite City, Illinois; General Obligation Credit Profile US$40.0 mil taxable GO bnds ser 2017 due 04/30/2048 Long Term Rating BBB+/Stable New Rationale S&P Global Ratings assigned its 'BBB+' rating and stable outlook to Granite City, Ill.'s series 2017 general obligation (GO) bonds. The city's unlimited-ad valorem-tax pledge secures the series 2017 bonds. Officials intend to use series 2017 bond proceeds to fund a portion of the unfunded actuarial accrued liability of the city's police and firefighters' pension fund and pay continuing expenses related to the fund. The city expects to deposit $20 million of bond proceeds into the police and firefighters' pension fund ($10 million into each fund). Following the bonds issuance and the deposit of bond funds, management expects to fund the police pension fund at approximately 51.4% of the total actuarial liability, up from 33%, and the fire pension fund at roughly 44.4%, up from 27%. The city will deposit the remaining $20 million of bond proceeds into an ongoing pension costs fund, which it will use to help pay annual service costs and the actuarially determined contribution (ADC) of each pension fund. We have capped the rating at 'BBB+' due to our view that the city is structurally imbalanced, evidenced by it not fully funding the ADC and borrowing for ongoing operations through bond issuance. Granite estimates bond proceeds will be sufficient to pay annual service costs and fund the ADC for each plan for the next 10 years. Therefore, we believe Granite will likely remain structurally imbalanced because it will continue to use bond proceeds to finance ongoing operations for, what management estimates, the next 10 years. The rating reflects our opinion of the city's: ·Very weak economy, with a concentrated local tax base but access to a broad and diverse metropolitan statistical area (MSA); ·Weak management despite standard financial policies and practices under our Financial Management Assessment (FMA) methodology; ·Weak budgetary performance, with operating deficits in the general fund and at the total-governmental-fund level in fiscal 2017; ·Strong budgetary flexibility, with an available fund balance in fiscal 2017 of 17% of operating expenditures--It, however, has demonstrated a limited willingness to raise revenue to pay for ongoing pension obligations; ·Very strong liquidity, with total government available cash at 17.1% of total-governmental-fund expenditures and 1.8x governmental debt service, and access to external liquidity we consider strong; WWW.STANDARDANDPOORS.COM/RATINGSDIRECT NOVEMBER 14, 2017 2 ·Very weak debt-and-contingent-liability position, with debt service carrying charges at 9.5% of expenditures and net direct debt that is 134.1% of total-governmental-fund revenue, as well as a large pension and other-postemployment-benefit (OPEB) obligation and the lack of a plan to sufficiently address the obligation without using bond proceeds over the next few years--It is unclear how management will address the obligation over the long term; and ·Strong institutional framework score. Very weak economy We consider Granite's economy very weak. The city, with an estimated population of 29,421, is located in Madison County in the St. Louis MSA, which we consider broad and diverse. The city has a projected per capita effective buying income of 75.6% of the national level and per capita market value of $41,681. Overall, market value was stable over the past year at $1.2 billion in fiscal 2017. Weakening Granite's economy is a concentrated local tax base with the 10 leading taxpayers accounting for 41.4% of the total tax base. The county unemployment rate was 5.9% in 2016. Granite is in southwestern Illinois, approximately three miles northeast of St. Louis. Residents commute into and around the St. Louis MSA for employment. Granite's property tax base is primarily residential with a significant industrial presence. The city's residential valuation accounts for 46% of total equalized assessed value while industrial valuation accounts for 33%. Leading city employers include: ·Amsted Rail (1,400 employees), railcar manufacturing; ·Gateway Regional Medical Center (950); and ·United States Steel Corp.-Granite City Works (720). Prior to 2016, United States Steel Corp. employed approximately 2,200 until it laid off 1,500 in 2016. However, in February 2017, it called back approximately 220. While the city's tax base is concentrated, United States Steel Corp., its leading taxpayer, accounts for 16.5% of the total tax base. Company officials, however, report that the company is stable and that it has recently expanded. Weak management We view the city's management as weak despite standard financial policies and practices under our FMA methodology, indicating the finance department maintains adequate policies in some, but not all, key areas. Elements of the city's financial policies and practices include its: ·Use of historical data and outside sources in formulating the budget forecast--We, however, believe its budget assumptions are unrealistic because they do not adequately account for pension costs; ·Monthly budget-to-actual reports to all department heads and the mayor; ·Lack of formal long-term financial projections; ·Lack of formal long-term capital plans; ·Formal investment-management policy that mirrors state guidelines, coupled with monthly investment holdings reports--Investment earnings, however, are not presented; ·Lack of a debt-management policy--We note the city does not currently have GO debt outstanding prior to the series 2017 issuance; and ·Lack of a formal fund-balance policy. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT NOVEMBER 14, 2017 3 Summary: Granite City, Illinois; General Obligation Weak budgetary performance Granite's budgetary performance is weak, in our opinion. The city had operating deficits of 8.5% of expenditures in the general fund and 2.5% of expenditures across all governmental funds in fiscal 2017. While the audit shows a surplus in two of the past three fiscal years, the city has also underfunded the ADC for its police and firefighters' pension plan, inflating year-end budgetary results. In our analysis, we have adjusted general and total-governmental-fund expenditures to include the portion of the ADC the city did not fund to arrive at, what we consider, a more-accurate portrayal of structural budgetary performance. After adjustments, fiscal 2017 ended on April 30 with a 8.5% general fund deficit compared with the 1.5% surplus in unadjusted results and a 2.5% deficit across all governmental funds compared with an unadjusted surplus of 4.4%. We have also adjusted total-governmental-fund results to reflect one-time capital-outlay expenses. We understand Granite has struggled to keep pace with rising pension costs due to the decision to maintain its current services without raising taxes. Moreover, we believe it has little fiscal capacity to address these costs over the long term, especially without significant nontax revenue growth or other structural budget adjustments. Because of this, we understand the city will use bond proceeds, as described in the rationale, to help fund pension costs for the next 10 years; it, however, is unclear what type of funding strategy management will use beyond 10 years. The property tax levy accounted for about 30% of general fund revenue in fiscal 2017 while intergovernmental revenue generated 56% and charges for services accounted for 10%. Intergovernmental revenue, specifically sales-and-use and home-rule taxes, has been somewhat stable over the past five fiscal years; however, management expects it to increase modestly. The fiscal 2018 budget is operationally break even with no use of reserves. We, however, understand the city will use bond proceeds and the property tax levy to fund its ADC. Our local government GO criteria allows for a rating cap of 'BBB+' in situations where a local government has a structural imbalance in its budget and lacks a credible plan to correct it. We view the city's budget as structurally imbalanced due to its use of bond proceeds to pay for ongoing annual obligations, and we will likely consider the budget structurally imbalanced for as long as it uses bond proceeds to fund the ADC. Strong budgetary flexibility Granite's budgetary flexibility is very strong, in our view, with an available fund balance in fiscal 2017 of 17% of operating expenditures, or $4.8 million. Officials are currently projecting a slight surplus for fiscal 2018, but we believe this will not have a significant effect on reserves. We think that if Granite leaves rising pension costs unaddressed, the budget, and potentially reserves, could come under pressure over the next few fiscal years. However, we do not expect near-term available reserves to deteriorate because of Granite's use of bond proceeds to subsidize pension costs for approximately the next 10 years. Although the state permits the raising of tax revenue without approval, the city has self-imposed its own restrictions, preventing its revenue-raising capabilities in the past. Very strong liquidity In our opinion, Granite's liquidity is very strong, with total government available cash at 17.1% of total-governmental-fund expenditures and 1.8x governmental debt service in fiscal 2017. In our view, the city has strong access to external liquidity if necessary. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT NOVEMBER 14, 2017 4 Summary: Granite City, Illinois; General Obligation Granite had about $6.8 million in cash we consider available for liquidity at fiscal year-end 2017, including cash and cash equivalents, certificates of deposit, and other investments available within a year. Management expects total governmental cash to improve in fiscal 2018; therefore, we expect liquidity to remain very strong. In addition, Granite has demonstrated strong access to capital markets through its history of issuing GO debt. Very weak debt-and-contingent-liability profile In our view, Granite's debt-and-contingent-liability profile is very weak. Total-governmental-fund debt service is 9.5% of total-governmental-fund expenditures, and net direct debt is 134.1% of total-governmental-fund revenue. We understand the city does not currently have any additional debt plans. Granite amortizes debt slowly with pension bond debt service extending through fiscal 2047. In our opinion, Granite's large pension and OPEB obligation, without a plan in place we think will sufficiently address the obligation in the long-term, is a credit weakness. We note planned series 2017 bond proceeds will help with pension costs for 10 years; however, it is unclear how the city plans to fund its pension fully thereafter. The city made 56% of its ADC in fiscal 2017. The funded ratio of the largest pension plan is 26.2%. Aside from the police and firefighters' plan, Granite contributes to the Illinois Municipal Retirement Fund (IMRF), a multiemployer, defined-benefit pension plan that covers general employees with benefits and contribution rates set by state statute. For the single-employer, defined-benefit police and firefighters' plan, state statute governs benefit and contribution rates, under which the plan must be 90% funded by fiscal 2040. As reported in the city's fiscal 2017 audit, its IMRF plan was 89% funded with a $4.5 million net pension liability; in addition, its police pension plan was only 33% funded with a $36 million net pension liability and its firefighter pension plan was only 27% funded with a $43 million net pension liability based on Governmental Accounting Standards Board Statement No. 68. Granite's combined ADC totaled 15.9% of total-governmental-fund expenditures in fiscal 2017, but it only made 56.3% of the combined contribution; Granite has generally funded its pension at similar levels recently. We note funding levels will likely improve after the pension bond issuance. However, we believe that absent a long-term funding solution, pension costs will likely continue to escalate and become less manageable over time. Granite provides certain health-care-insurance benefits for retired and disabled employees who meet the eligibility requirements described in the personnel policy; the retired or disabled employees' pay the full premium. The city has not calculated or recorded the OPEB liability, and it believes OPEB is immaterial to financial statements. Granite continues to expense OPEB costs as incurred. Strong institutional framework The institutional framework score for Illinois home-rule cities and villages is strong. Outlook The stable outlook reflects S&P Global Ratings' opinion that Granite will likely maintain strong budgetary flexibility and very strong liquidity and that it will likely continue to benefit from the broad and diverse St. Louis MSA economy. We do not expect to change the rating within the next two years because of our view Granite will likely not fully fund WWW.STANDARDANDPOORS.COM/RATINGSDIRECT NOVEMBER 14, 2017 5 Summary: Granite City, Illinois; General Obligation its pension ADC without using pension bond proceeds, resulting in, what we consider, structural imbalance. Downside scenario We could lower the rating if economic indicators were to weaken further and if financial performance were to deteriorate, leading to weaker budgetary flexibility and liquidity, or if high debt were to put additional pressure on Granite's other credit characteristics. Upside scenario While unlikely over the next few years, we could raise the rating if management were to structurally balance budgetary performance, representing the city's ability to fund its pension ADC fully from operations rather than using bond proceeds to subsidize pension costs. Related Research ·S&P Public Finance Local GO Criteria: How We Adjust Data For Analytic Consistency, Sept. 12, 2013 ·Incorporating GASB 67 And 68: Evaluating Pension/OPEB Obligations Under Standard & Poor's U.S. Local Government GO Criteria, Sept. 2, 2015 ·2017 Update Of Institutional Framework For U.S. Local Governments Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. Complete ratings information is available to subscribers of RatingsDirect at www.capitaliq.com. All ratings affected by this rating action can be found on the S&P Global Ratings' public website at www.standardandpoors.com. Use the Ratings search box located in the left column. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT NOVEMBER 14, 2017 6 Summary: Granite City, Illinois; General Obligation Summary: Round Lake Park Village, Illinois; General Obligation Primary Credit Analyst: John A Kenward, Chicago (1) 312-233-7003; john.kenward@spglobal.com Secondary Contact: Jessica Akey, Chicago + 1 (312) 233 7068; jessica.akey@spglobal.com Table Of Contents Rationale Outlook Related Research WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 22, 2019 1 Summary: Round Lake Park Village, Illinois; General Obligation Credit Profile US$1.37 mil taxable GO bnds ser 2019 due 01/01/2037 Long Term Rating A+/Stable New Round Lake Pk Vill taxable GO (MAC) Unenhanced Rating A+(SPUR)/Stable Affirmed Round Lake Pk Vill GO (BAM) Unenhanced Rating A+(SPUR)/Stable Affirmed Many issues are enhanced by bond insurance. Rationale S&P Global Ratings assigned its 'A+' long-term rating and stable outlook to Round Lake Park Village, Ill.'s series 2019 taxable general obligation (GO) bonds and affirmed its 'A+' underlying rating (SPUR), with a stable outlook, on the village's existing GO debt. The electorate approved the bonds in November 2016. The village's unlimited-GO-property-tax pledge secures the bonds. Officials intend to use series 2019 bond proceeds, as with series 2017 bond proceeds, to increase the assets associated with the village's police pension. Credit summary Round Lake Park's location in Chicago's northern suburbs provides residents with economic opportunities throughout Lake County and northern Cook County. Despite not having home-rule powers, the village has been able to build and maintain very strong operating reserves thanks to a diverse revenue stream and conservative budgeting. Management's bold step in using voter-approved debt to increase its police-pension assets has led to a substantial increase in the plan's funding, which will benefit finances during the next few fiscal years. The rating reflects our opinion of the village's: • Weak economy, with a concentrated local property tax base, but access to a broad and diverse metropolitan statistical area (MSA); • Adequate management, with standard financial policies and practices under our Financial Management Assessment (FMA) methodology; • Adequate budgetary performance, with an operating surplus in the general fund but an operating deficit at the total governmental-fund level in fiscal 2018; • Very strong budgetary flexibility, with available fund balance in fiscal 2018 at 68% of operating expenditures; WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 22, 2019 2 • Very strong liquidity, with total government available cash at 69.9% of total governmental-fund expenditures and 11.1x governmental debt service, and access to external liquidity we consider strong; • Very weak debt-and-contingent-liability position, with debt service carrying charges at 6.3% of expenditures and net direct debt that is 179.9% of total governmental-fund revenue, as well as a large pension and other-postemployment-benefit (OPEB) obligation; and • Strong institutional framework score. Weak economy We consider Round Lake Park's economy weak. The village, with an estimated population of 8,755, is in northern Lake County, about 50 miles north of Chicago, in the Chicago-Naperville-Elgin MSA, which we consider broad and diverse. The village had a projected per capita effective buying income at 96.3% of the national level and a low per capita market value of $23,830 in fiscal 2019, which, in our view, indicates a limited tax base supporting debt and which we consider a negative credit factor. Overall, market value grew by 6% during the past year to $208.6 million in fiscal 2019. A concentrated local tax base, with the 10 leading taxpayers accounting for 36.3% of equalized assessed value (EAV), weakens Round Lake Park's economy. County unemployment was 4.5% in 2018. After decreasing for several years, EAV increased by 29% from levy years 2015-2018. The concentrated tax base's leading taxpayer, a senior-citizen community, accounted for 27% of levy year 2018 EAV while the next nine leading taxpayers accounted for 9%. Residents have access to jobs in the broad and diverse Chicago MSA, and they can commute into downtown Chicago via Metra train stations in neighboring communities. Leading county area employers include: • Great Lakes Naval Training Center in North Chicago on Lake Michigan (11,000 employees, including military personnel), • Walgreens Boots Alliance Inc. (6,500), • Aon Hewitt LLC (5,000), • Gurnee Mills Shopping Center (5,000), • Six Flags Great America (4,550), and • Baxter Healthcare Corp. (4,400). Based on the village's key economic indicators, which tend to move slowly, we expect the economy will likely remain weak during the next few years. Adequate management We view the village's financial management as adequate, with standard financial policies and practices under our FMA methodology, indicating the finance department maintains adequate policies in some, but not all, key areas. When developing the budget, management uses three years to five years of historical data, outside data sources, and line-item estimates. Management provides quarterly reports on budget-to-actual results to the village board, which can amend the budget as necessary throughout the year. The village does not maintain long-term capital or financial plans. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 22, 2019 3 Summary: Round Lake Park Village, Illinois; General Obligation While it does not have investment- or debt-management policies, management makes monthly reports on investment holdings to the board. Although the village does not have a formal reserve policy, management targets maintaining general fund cash at levels equal to, at least, six months' basic operating expenditures at fiscal year-end. Adequate budgetary performance Round Lake Park's budgetary performance is adequate, in our opinion. The village had surplus operating results in the general fund at 1.8% of expenditures but deficit results across all governmental funds at 3.8% in fiscal 2018. We adjusted audited fiscal 2018 general fund results for series 2017 GO bond proceeds, which the village used to increase police-pension assets. We no longer think it necessary to adjust general fund and total governmental-funds expenditures for underfunded pension payments because the village is now paying its police pension actuarially determined contributions (ADCs) at a higher level. As a non-home rule community in Lake County, the village is subject to the property tax extension limitation law's annual operating levy growth limit at the lesser of 5% or the rate of inflation, with additional levies allowed for new construction. State income taxes generated 23% of fiscal 2018 general fund revenue while licenses, permits, and fees generated 18%; property taxes generated 17%; and sales-and-use taxes generated 17%. For fiscal 2019, management reports a $294,000 general fund surplus. Officials conservatively structured the fiscal 2020 general fund budget with a $149,000 use of reserves; management now expects a small surplus. Based on management's expectations for fiscal years 2019 and 2020, we expect budgetary performance will likely remain, at least, adequate during the next few fiscal years. Very strong budgetary flexibility Round Lake Park's budgetary flexibility is very strong, in our view, with available fund balance in fiscal 2018 at 68% of operating expenditures, or $2 million. We expect available fund balance will likely remain above 30% of expenditures for the current and next fiscal years, which we view as a positive credit factor. Budgetary flexibility included unassigned general fund balance at fiscal year-end 2018. Due to management's expectations for fiscal years 2019 and 2020, we expect budgetary flexibility will likely remain very strong during the next few fiscal years. Very strong liquidity In our opinion, Round Lake Park's liquidity is very strong, with total government available cash at 69.9% of total governmental-fund expenditures and 11.1x governmental debt service in fiscal 2018. In our view, the village has strong access to external liquidity if necessary. The village reported $2.5 million of unrestricted cash at fiscal year-end 2018. In our opinion, the village's successful recent GO debt issuance demonstrates its strong access to external liquidity. The village does not have any exposure to contingent-liability risks resulting from private-placement or variable-rate debt that could pressure liquidity. Due to management's expectations for fiscal years 2019 and 2020, we expect liquidity will likely remain very strong during the next few fiscal years. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 22, 2019 4 Summary: Round Lake Park Village, Illinois; General Obligation Very weak debt-and-contingent-liability profile In our view, Round Lake Park's debt-and-contingent-liability profile is very weak. Total governmental-fund debt service is 6.3% of total governmental-fund expenditures, and net direct debt is 179.9% of total governmental-fund revenue. Including series 2019 GO bonds, the village has $6.15 million of direct debt. Officials do not currently have additional new-money debt plans. In our opinion, Round Lake Park's large pension and OPEB obligation is a credit weakness. Round Lake Park's pension contributions totaled 14.5% of total governmental-fund expenditures in fiscal 2018. The village participates in two agent, multiemployer pension plans under Illinois Municipal Retirement Fund (IMRF): the regular IMRF plan and the Illinois Sheriff's Law Enforcement Personnel Plan. At Dec. 31, 2017, the combined IMRF plans were 107% funded with a net pension asset of $247,000. The village has a history of paying 100% of its ADC annually. A single-employer, defined-benefit pension plan covers police employees. Following the deposit of series 2017 bond proceeds, the police plan's funding increased to 64% at April 30, 2018, from 15% at fiscal year-end 2016. Management is projecting funding will increase to 75% with series 2019 bond proceeds. The village paid the police pension's full ADC in fiscal 2018, which is now calculated to reach 100% funding by 2040. The village's ADC for its police pension is higher than the Illinois statutory ADC, calculated to reach a 90% funded level by 2040. Management expects to pay its full ADC during the next few fiscal years. The IMRF's statewide discount rate is currently 7.25%, which is consistent with the national trend for defined-benefit pension plans but below the 6.5% we consider more prudent due to market conditions. Given the high funded level for the village's IMRF plan, and the increased funded level for the police plan, which is the village's largest pension plan, we do not view pension liabilities as an immediate source of credit pressure. The village does not subsidize retiree health care, so it only has an implicit rate subsidy. Strong institutional framework The institutional framework score for Illinois non-home rule cities and villages subject to the property tax extension limitation law is strong. Outlook The stable outlook reflects S&P Global Ratings opinion Round Lake Park's management will likely take the steps necessary to maintain balanced operations, coupled with very strong budgetary flexibility and liquidity. It also reflects the village's access to employment opportunities in the broad and diverse Chicago MSA economy, which has a stabilizing effect on income. Therefore, we do not expect to change the rating within the two-year outlook period. Upside scenario We could raise the rating if key economic indicators were to improve substantially, if management were to maintain very strong budgetary flexibility and liquidity, and if management were to show additional progress in strengthening police pension funding. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 22, 2019 5 Summary: Round Lake Park Village, Illinois; General Obligation Downside scenario We could lower the rating if, due to budgetary imbalance, available reserves were to decrease significantly. Related Research • S&P Public Finance Local GO Criteria: How We Adjust Data For Analytic Consistency, Sept. 12, 2013 • Incorporating GASB 67 And 68: Evaluating Pension/OPEB Obligations Under Standard & Poor's U.S. Local Government GO Criteria, Sept. 2, 2015 • 2019 Update Of Institutional Framework For U.S. Local Governments Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. Complete ratings information is available to subscribers of RatingsDirect at www.capitaliq.com. All ratings affected by this rating action can be found on S&P Global Ratings' public website at www.standardandpoors.com. Use the Ratings search box located in the left column. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT OCTOBER 22, 2019 6 Summary: Round Lake Park Village, Illinois; General Obligation U.S. PUBLIC FINANCE CREDIT OPINION 9 November 2018 Contacts Eric Harper +1.312.706.9972 VP-Senior Analyst eric.harper@moodys.com Coley J Anderson +1.312.706.9961 AVP-Analyst coley.anderson@moodys.com CLIENT SERVICES Americas 1-212-553-1653 Asia Pacific 852-3551-3077 Japan 81-3-5408-4100 EMEA 44-20-7772-5454 Winnebago (County of) IL Update to credit analysis Summary Winnebago County (Aa2) benefits from its sizable tax base, which we expect will moderately expand over the next few years. The county has maintained strong available reserves and liquidity over a prolonged period, despite economically sensitive sales tax revenue making up a large share of its operating revenue. Its debt and pension burdens are moderate, which we expect will continue based on its limited additional debt plans and gradual tax base appreciation. Full value per capita is low and median family income is somewhat below the US. Credit strengths »Strong operating reserves and liquidity »Sizable tax base experiencing recovery in the manufacturing sector »Moderate long-term liabilities Credit challenges »Dependence on economically sensitive sales tax revenue »Weak full value per capita Rating outlook Outlook are usually not assigned to local governments with this amount of debt. Factors that could lead to an upgrade »Economic diversification and increase in wealth and income indicators »Significant and sustained growth in reserves and liquidity Factors that could lead to a downgrade »Decrease in reserves and liquidity »Increase in the debt or pension burden »Negative financial performance in the River Bluff Nursing Home fund that affected the county's financial position MOODY'S INVESTORS SERVICE U.S. PUBLIC FINANCE Key indicators Exhibit 1 Winnebago (County of) IL 2013 2014 2015 2016 2017 Economy/Tax Base Total Full Value ($000)$12,413,331 $11,507,880 $10,946,013 $10,675,239 $10,836,537 Population 293,384 292,026 290,439 288,896 295,266 Full Value Per Capita $42,311 $39,407 $37,688 $36,952 $36,701 Median Family Income (% of US Median)90.4%88.8%89.2% 89.0% 89.0% Finances Operating Revenue ($000)$109,420 $113,816 $114,749 $111,812 $112,954 Fund Balance ($000)$51,314 $51,282 $51,218 $47,504 $45,384 Cash Balance ($000)$42,444 $40,357 $42,533 $35,403 $33,293 Fund Balance as a % of Revenues 46.9% 45.1%44.6%42.5% 40.2% Cash Balance as a % of Revenues 38.8% 35.5% 37.1% 31.7% 29.5% Debt/Pensions Net Direct Debt ($000)$147,365 $143,086 $135,842 $123,406 $115,799 3-Year Average of Moody's ANPL ($000)$109,610 $118,803 $154,659 $190,578 $240,883 Net Direct Debt / Full Value (%)1.2% 1.2% 1.2% 1.2% 1.1% Net Direct Debt / Operating Revenues (x)1.3x 1.3x 1.2x 1.1x 1.0x Moody's - adjusted Net Pension Liability (3-yr average) to Full Value (%) 0.9% 1.0% 1.4% 1.8%2.2% Moody's - adjusted Net Pension Liability (3-yr average) to Revenues (x) 1.0x 1.0x 1.3x 1.7x 2.1x Source: Winnebago County, IL audited financial statements, US Census Bureau, Moody's Investors Service Profile Winnebago County is located 90 miles north of Chicago (Ba1 stable) and has a population of approximately 288,896. The county seat is Rockford (A2 negative). Detailed credit considerations Economy and tax base: large tax base with manufacturing concentration The regional economy remains heavily dependent on the volatile manufacturing sector, which we expect to continue its pace of gradual recovery. Manufacturing jobs make up 22.4% of total employment in the county. The economic profile of the county is satisfactory, though is relatively weak in comparison to Aa2 medians. Its tax base size is strong at $11.1 billion, but low on a per capita basis at $37,533. Median family income equates to 89% of the US level. Management expects 4-5% tax base growth in the next two years. The county’s economy and tax base are closely tied with the City of Rockford (A2 negative), which is the county seat. The manufacturing sector has added thousands of factory jobs since the economic recovery began, primarily within the automobile manufacturing industry. Chrysler Group LLC (FCA US LLC, Baa2 positive) is the largest employer in the area with 5,152 employees followed by the Rockford School District (4,700), and the Swedish American Health System (2,600). The county reports several commercial developments underway, including a $12.4 million distribution center that is expected to create 200 new jobs, expansion at the Chicago-Rockford International Airport, and new health care clinics. Financial operations and reserves: strong financial position despite somewhat volatile sales tax revenue We expect the county to maintain positive general fund operations over the next two years. Management projects a $1.5 million surplus in fiscal 2018 and the county has adopted a balanced general fund budget for fiscal 2019. General fund performance over the last few years has been somewhat mixed, but positive overall trending between minor surpluses and deficits. It has maintained strong This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history. 2 9 November 2018 Winnebago (County of) IL: Update to credit analysis MOODY'S INVESTORS SERVICE U.S. PUBLIC FINANCE general fund reserves over a prolonged period, which in fiscal 2017 totaled $13 million, or 24.8% of revenue. Inclusive of all operating funds1, available reserves totaled a strong $45.7 million, or 40.2% of operating revenue. The county's largest sources of operating revenue include sales taxes (32.5%), property taxes (24.3%), and intergovernmental revenue (21.5%). We expect major revenues to remain stable over the next two years, although its sales taxes are more sensitive to economic fluctuations. Management reports that sales tax revenue is trending with a positive variance relative to the budget in fiscal 2018. The county is also evaluating a possible referendum to increase the rate of its public safety sales tax, which could offset future public safety cost increases that have remained a budgetary challenge for the county. The county has not historically increased its property tax levy by the inflationary increase allowed under the property tax extension limitation law (PTELL), although the county indicates it may begin doing so in the near future. The county owns the River Bluff Nursing Home, which has operated with deficits and narrow liquidity in recent years. At $14 million in annual operating revenue, the nursing home's operations are relatively small compared to the county's general fund, which totaled $51.7 million. We expect the nursing home's operations to remain a relatively minor pressure for the county, but do not expect it to significantly affect the county's financial position. River Bluff Nursing Home fund cash declined to $793,000 in fiscal 2017, from $1.6 million the prior year, or a low 17 days cash on hand. In response to the poor financial operations of the nursing home, the county hired a new administrator and management company. The county expects the nursing home to run a $500,000 to $1 million deficit in fiscal 2018, and is working on eliminating the deficit in fiscal 2019. It is also studying options to sell the nursing home, which would eliminate future county liabilities. LIQUIDITY Liquidity is strong at $33.3 million, or 29.5% of operating revenue in fiscal 2017. Inclusive of government wide cash and equivalents, total liquidity was $62.5 million. Debt and pensions: moderate debt burden and manageable pension liabilities We expect the county's debt burden to remain moderate given its limited additional debt plans and expected growth in the tax base. Net direct debt is a moderate 1.2% of full value and 1.2x operating revenue. Total fixed costs, inclusive of debt service and pension and other post employment benefit (OPEB) contributions, were a moderate 20.8% of revenue (net of refunding debt service). The county reports that it may issue up to $25 million in new general obligation debt in fiscal 2019 for deferred maintenance projects. DEBT STRUCTURE All of the county's debt is fixed-rate and long-term. Debt amortization is below average with 69.4% scheduled to be repaid within 10 years. DEBT-RELATED DERIVATIVES The county is not a party to any derivative agreements. PENSIONS AND OPEB The county participates in the Illinois Municipal Retirement Fund (IMRF), which is a multiple-employer cost-sharing pension plan. The Moody's adjusted net pension liability (ANPL) for the county, under our methodology for adjusting reported pension data was $259 million, or a moderate 2.4% of full value and 2.3x operating revenue. With the issuance of its 2018 bonds, we expect its ANPL to decline in exchange for a higher direct debt burden. The county's contributions to IMRF are based on actuarially determined rates, and have been above our “tread water” indicator in the last several years. Our tread water analysis measures whether or not annual pension contributions are sufficient to maintain reported pension liabilities at the current level. Contributions above tread water make progress towards paying down the reported unfunded liability. The county provides OPEBs although its liabilities are limited to the implicit rate subsidy. As of September 30, 2016, the unfunded actuarial accrued liability was $6.3 million. Management and governance: moderate institutional framework Illinois counties have an Institutional Framework score of A, which is moderate compared to the nation. Institutional Framework scores measure a sector's legal ability to increase revenues and decrease expenditures. Winnebago County is non-home rule and is subject to PTELL, which caps property tax revenue growth to the lesser of 5% or CPI growth, plus new construction. Revenue predictability 3 9 November 2018 Winnebago (County of) IL: Update to credit analysis MOODY'S INVESTORS SERVICE U.S. PUBLIC FINANCE is moderate, with varying dependence on property, sales, and state-distributed income taxes. Expenditures, which are primarily for criminal justice, are moderately predictable. Counties have limited ability to reduce expenditures given strong public sector unions and pension benefits that enjoy strong constitutional protections. The county has a fund balance policy to maintain 25% of expenditures in the general fund. While not yet adopted, it is developing a multiyear capital improvement plan, which it expects will be finalized in 2019. Endnotes 1 General, public safety sales tax, Illinois municipal retirement, county detention home, historical museum, children's advocacy project, health, veteran's assistance, social security, and debt service funds. 4 9 November 2018 Winnebago (County of) IL: Update to credit analysis 29 1 Pl �-0 V c O .U) W CL a N 3 m f` d 0 0 0 N m 0 IL 3 O N r d d O E «O. N r O N O f�4 N N C O C i d m N N d L .3 m m 0 ro N c U :c rn 0) E C N C 0 E N ci 0 a 0 U C A .O N N E CD O m N 21 O c cC0 m E r O O 2 15 Z 0 Q 0 Z w 0 0 w x .0. T a c v° m � C C ' U O o E j R o y E 01 L eN C9 U U E ro 2 E N c m >_ a c 'o a. 01 `o 0 Y o 0 N uj c o a o E v_ m Q c c N O N fa V Ul N 15 c YO Itl tv O O > U o Av O O U U L L O N m N C N E m N E N N O U N N N G1 C 7 > U CO U .O C 0 O N U 0(L O m C a)c m [0 ,N 0 c E C d NO U m C O N C d 0 E �N N N E C m 0 o'o E H`oa0 0 E r N N 01 � E Q! 1 Ir N U m N O N O C O a N 2012 U.S. PUBLIC FINANCE SPECIAL COMMENT US State and Local Governments Face Risks with Pension Funding Bonds Table of Contents: Summary Opinion SUMMARY Oril VON 1 I : IIFR n-Ic ;TIVATIONS FOR FFNSiON Pension funding bonds provide a source of funding for US state and local governments FUNDING BONDS VARY seeking to bolster the assets of their pension plans. Pension funding bonds (also commonly CREDIT IMPLICATIONS OF PENSION referred to as pension obligation bonds, although they are typically not an obligation of P g g y FUNDING BONDS 3 Balance sheet and default risk pension systems) may be neutral or negative for an issuer's credit rating. The degree of credit Budgetary Risk 3 impact depends on the use of proceeds, the relative size of the bond issue and associated debt Loss of Flexibility 5 service, the level of future budget savings assumed, and the assumptions on which such Management quality 5 savings are based. MOODY'S RELATED RESEARCH 6 If pension bonds merely shifted an issuer's long term obligations from one similar form to Analyst Contacts: another, in this case from an unfunded pension liability to bonded debt, they would tend to have a neutral credit impact. However, issuance of pension bonds changes the nature of the NEW YORK 1.212.553.1653 liability and typically creates additional risks, including: Marcia Van Wa"ner .1.212,553.2 ,-? Budgetary risk - stemming from the government's anticipation of future savings on annual pension funding contributions which may not materialize; Timothy Bkkr, 0 212,553.0949 Default risk - a missed payment on bonded debt constitutes a default, while a missed rin,nti,y.I IaI ri_;n radys.ccrr: pension contribution payment generally does not; CHICAGO +1.212.553.1653 » Loss of flexibility - under -payment of pension contributions is a budgeting option for I hornas Aaron Y1-312.706.99467 financially stressed governments which may reduce default risk on bonded debt. Issuance of pension bonds may also reflect poorly on the quality of management. If bond proceeds substitute for annual contributions to pension plans or are used to pay pensioners, we consider it a deficit borrowing and would view the financing as credit negative, particularly if it is large relative to the budget (e.g. over 5%), is part of a continuous pattern of reliance on one-time resources, or is used in the absence of a plan to restore budget stability over the medium term. In general, we consider credit -positive management strategies to be those directed toward sustained improvement in net funded status of the pension plan, in contrast to credit -negative management strategies that primarily seek near - term budget savings without improvement in pension funded status. MOODY'S INVESTORS SERVICE Is M Governments contemplating pension bonds must sift through a number of factors influencing their decisions, including the idiosyncrasies of their pension plans and the structure of the bonds. We recognize that these particulars can vary among issuers and take these factors into account when evaluating the impact of a particular pension bond issuance on credit. However, pension bonds are often a red flag associated with greater rigidity of long term obligations, failure to find sustainable solutions to pension funding and a pattern of pushing costs off into the future. For this reason, most pension bonds have, at best, a neutral impact on our overall assessment of an issuer's credit quality. ' Issuer motivations for pension funding bonds vary Issuers may turn to pension bonds for a variety of reasons, for example: to adequately fund a closed pension plan; to attempt to benefit from the spread between their borrowing costs and a greater long - run assumed investment return on assets invested in their pension funds; or to achieve short-term budget relief and substitute borrowed funds for budgeted annual pension contributions. With unfunded pension liabilities rising to high levels while borrowing costs remain at historic lows, the current environment supports interest in pension funding bonds. The following transactions demonstrate these diverse motivations for issuance of pension bonds. Short-term budget relief » The State of Illinois has issued $17.2 billion in pension bonds since 2003, and has used more than half of the bond proceeds to make annual contributions to the fund and half to fund previously accrued liabilities. Despite the sizable infusion of borrowed funds, the two main state pension plans reported funded ratios of 35.5% and 46.5% in 2011, among the lowest in the country. » The Village of Rosemont, IL issued $35 million of pension bonds to benefit its public safety plan in 2007, but has subsequently failed to make its annual required contributions, thus negating any long-term benefits from the bond sale. Interest rate arbitrage » In September 2012, the City of Fort Lauderdale, FL issued $340 million of pension bonds to cover a significant portion of the unfunded pension liability associated with its two pension plans. The city sold the bonds at a reported true interest cost of 4.168% and expects to achieve savings of $5.5 million in the first year and $84 million in present value savings over 20 years if the invested bond proceeds achieve a compound annual investment return of 7.5%. Funding closed pension plans » A number of local governments in Wisconsin have used pension bonds to shorten the amortization period of their unfunded liabilities and reduce total interest costs. » In 2008, the very low -funded Puerto Rico Employees Retirement System issued $3 billion of long-dated (up to 50-year) bonds to increase its minimal asset base relative to liabilities. Despite the bond sale and the closing of the system to new members in 2000, it is still projected to rapidly The impact of the issuance of pension bonds on a government's credit profile is a separate topic from the credit evaluation of the pension bonds themselves. We rate individual pension bonds based on the security, which may be a general obligation of the issuing government, an appropriation obligation, or debt backed by a special revenue stream such as the sales tax. A pledge of pension assets to the bonds and eligibility for tax -exemption are prohibited by the IRS. Regardless of the specific security pledge and rating, the issuance of such debt also becomes a consideration in our assessment of the issuer's general credit profile and G.O. rating. C�FCEM3ER I', RJ'Z SPLCIAL COMM':NT: US STATE AND LOCAL GOVERNMENTS FACE RISKS WITH PLNS:ON FUNDING BONDS MOODY'S INVESTORS SERVICE L U.S. PUBLIC FINANCE deplete its remaining assets in the coming years, exposing the Commonwealth to increased budgetary requirements to pay benefits and pension bond debt service. Credit implications of pension funding bonds Pension bonds have direct implications for an issuer's balance sheet as well as its credit risk profile and perceptions of its management quality. In most aspects, at the time of issuance, pension bonds have negative implications for the government's general credit quality, though often not material enough to result in a rating downgrade. Balance sheet and default risk The issuance of bonds to fund previously accrued pension liabilities would have a neutral effect on comprehensive debt measures that include bonded debt and unfunded pension liability, as the new bonds merely substitute one form of long-term obligation for another. However, the resulting increase in an issuer's debt metrics, such as debt -to -revenue ratios, would indicate increased leverage. Although neutral from the perspective of an issuer's overall fixed liabilities, transforming unfunded pension liabilities into bonded indebtedness introduces default risk on obligations where there once was none, since non-payment of pension contributions does not constitute a default.2 A recent case in point is Woonsocket, Rhode Island which was downgraded to B2 with a negative outlook, largely because outstanding debt stemming from pension bonds issued in 2002 has led to payments of nearly 17% of its operating revenues for debt service. In issuing pension bonds, which were used partly to substitute for an adequate annual contribution schedule, the city has reduced the range of options it has to address its pressing financial problems while satisfying its bonded debt obligations. Budgetary Risk Savings based on any "expected" return on pension investments involve significant risk. Realized returns on pension investments, which are largely allocated to different types of equities, are uncertain, and have become more volatile in the past decade. The risk of volatile and negative returns does not go away with time and may increase in future years if pension funds become especially focused on generating high returns to restore better funding status. If investment return assumptions are borne out, pension bonds can reduce operating costs by lowering the amortization component of annual required contributions (ARC) to the pension plan by more than the bond debt service cost. Given the prevalence of relatively high assumed pension returns and discount rates in the public sector, projected budgetary savings stemming from issuance of pension bonds are often incorporated into an issuer's financial plans. Such savings are certainly not guaranteed, and a financial plan based on large assumed pension financing savings carries additional credit risk. Figure 1 illustrates the high variability of historic pension investment returns. 2 This is being tested in California, where CalPERS is challenging the ability of the cities of San Bernardino and Compton to forgo payments to the pension system. See our November 2, 2012 special comment, "Status of Pension Obligations in California Tested by San Bernardino and Compton." :.FT'. V.! COM.'IENI: J�- SWE AND LOCA_ GOVERNMEN IS FACE WSY.S WI IHPENS! ON FUNDING BONDS MOODY'S INVESTORS SERVICE U.S. PUBLIC FINANCE FIGURE 1 Median investment returns for period ended 12/31/2011 Period 1 year 3 years 5 years 10 years 20 years 25 years Source: NASRA, Callan Associates, Inc. Median average annual return 0.8% 11.4% 2.0% 5.7% 7.7% 8.3% Once deposited with plan assets, pension bond proceeds are subject to market volatility associated with the pension plan's investment strategy. If return assumptions aren't met, the anticipated savings will be eroded by new or additional pension UAAL amortization payments. Taxpayers and recipients of government services must ultimately make up the difference with increased revenues or offsetting spending reductions. This budget risk is present even if investment returns consistently exceed borrowing costs as long as the issuer has budgeted ARC savings based on the assumed investment rate of return. Figure 2 illustrates the potential savings and risks for three hypothetical pension bond scenarios compared to a baseline where no pension bonds have been issued but assets returns meet the plan's assumptions. In the baseline scenario, a pension system has $1 million of unfunded liability that is being amortized over 30 years on a level percent of payroll basis. The plan's assets achieve the assumed investment rate of return of 7.5%. In the two alternate scenarios, the government issues pension bonds with a 5.0% coupon and 30 year maturity, investing the proceeds with the corpus of the pension fund assets. The graph charts the annual costs of amortizing the initial unfunded liability in comparison with the costs experienced in alternate scenarios where: 1) pension bonds are issued and the proceeds achieve the expected investment return of 7.5%; and 2) pension bond proceeds return 4%, less than the 5% bond rate. When pension fund asset returns meet or exceed the assumed rate of return, a pension bond can generate long-term budgetary savings. This is illustrated by the distance between the lowest line in the chart and the baseline case of no pension bond. In addition, because bond principal is amortized more rapidly than unfunded liabilities (as it is in a typical level -dollar amortizing debt structure) combined debt outstanding and unfunded liabilities amortize more rapidly than in the case of no pension bonds. However, if assets underperform, annual costs increase relative to the no pension bond case as illustrated by the line above the baseline. In this case, where asset returns are 4% -- less than the government's borrowing costs — annual expenses exceed the baseline case by a significant margin, illustrating total cost risk. The magnitude of budgetary risk is measured by the size of the issuer's projected ARC savings, less pension bond debt service, relative to operating revenues. We would view projected savings in the range of 5% or more of revenues as representing a material risk of future budgetary imbalance. SPECIAL COMMEN iJ5 ,PATE AND LOCAL . WI [H cNSiCjN rUN iDltl 5CNL?S i OODY'S INVESTORS SERVICE FIGURE 2 Budget risk from assumed pension bond savings No pension bond, assets earn assumed rate • • • • • • • • Pension bond proceeds earn assumed rate -- Pension bond proceeds earn less than bond rate $300,000- - -- - - - $2S0,000 $200,000 — - - - - - - - - --- �� --- - - -- Budgetaryrisk $150,000 - - - — $100,000 - — ��--- ........ $50,000 --- --___ — - Budgetary savings $- 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Source Moody's Investors Service Loss of Flexibility Converting unfunded pension liabilities to bonded debt reduces budgetary flexibility, a factor in our assessment of credit quality. Actions that may be considered to have negative credit implications if pursued frequently, such as reliance on non -recurring revenues or deficit borrowing, can also be viewed as last -resort options that provide flexibility when sudden credit pressures arise. Pension amortization schedules can be changed, typically by enactment of statutes that reduce liabilities, to the extent allowed by each state's legal environment. In some cases, governments can reduce or even eliminate their contributions, either by taking pension holidays or by shifting payment onto other parties, such as employees or lower levels of government. While governments have various debt management tools, they cannot adjust their outstanding bonded liabilities short of bankruptcy or other insolvency proceedings. The contrast between Woonsocket and Central Falls, Rhode Island illustrates this issue. The two cities have similar socioeconomic profiles, with low wealth levels and a narrow economic base. As noted above, Woonsocket's outstanding pension obligation debt has removed the option of restructuring of pension liabilities and impaired its credit profile. In contrast, Central Falls (B2/positive) recently emerged from bankruptcy, which the city used to significantly decrease its unfunded pension liabilities through reductions to current employee and retiree pension benefits. The city has relatively low debt levels and has never issued pension bonds. Management quality Pension borrowing may also focus more of the credit risk assessment on expected management decision -making on key issues. These issues center on funding history and the ability or willingness to close the gap between pension assets and liabilities through sustained commitment to making adequate contributions or taking difficult political actions to constrain benefits. •��UEi_EMSE(: 11, COMMENT: 4!- S1ATE AND LOCAL COVERNMEN'15 FACE RISKS WITH PENSION FUNDING 3ON6S -MOODY':S INVESTORS SERVICE Is WMIN01-14 Ability to achieve program reforms: a significant reduction of unfunded liability through bond financing could reduce a government's incentive and political leverage to subsequently achieve meaningful modification of pension benefits, which may be weak to begin with for governments choosing to shift their unfunded liabilities to bonded indebtedness. Deficit financing: if proceeds of pension bonds directly substitute for the issuer's contribution requirements, we would view the transaction as deficit financing. Such transactions could have a material result on credit quality if the deficit financing accounts is sizable relative to operating revenues, or if it is part of a pattern of reliance on non -recurring budgetary balancing actions. Positive when part of structural reform: issuance of pension bonds could be part of a broader credit - positive effort aimed at restoring a balance between the pension's actuarial liabilities and asset values and achieving affordability. Moody's Related Research Special Comment: » Status of Pension Obligations in California Tested by San Bernardino and Compton, November 2012 046999) Sector Comments: >> Michigan Pension Reforms Reduce Expenses for School Districts, August 2012114.50031 » Maryland Shifts Teacher Pension Costs to Local Governments; Positive for State. Negative for Affected Localities Mgy 2012 142 2 » Public Sector Pension Plans' Reduced Investment Return Assumptions Are Credit Positive. February 2012 (139781) Issuer Comments: » San Diego Pension Reform Measure's LegaliKy To Be Tested, a Credit Negative. J ulv 2012 14 80 » Illinois 2012 Budget Ends Deficit Financings, But Leaves Pension and Payment Backlog Issues Unaddressed, August 2011 (135024) Request For Comment: » Adjustments to US State and Local Government Reported Pension Data, Iuly 2012 1143254) To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients. _'6: ! ".51;; 1 20':2 ., i:_i r.1 c^ • .! JS 5'1 ATE AND LOCAL COVERNI":NTS FACE R SKS W1 i H PENS ON rIJNCNNG 60?10S Six Years Into The Recovery, Pensions Are A Big Divider Of U.S. State Credit may not generate material fiscal benefits until long after their terms end, we perceive a bit of reform fatigue may be setting in which could slow the pace. However, the growth in unfunded liability due to GASB 67 and 68 could give pension reform efforts a second wind, at least for those that need it most. Illinois continues to litigate the merits of SB 1, which is the pension reform effort the state put forward under its previous administration but which is currently being litigated in the state's Supreme Court. Oral arguments began on March 11. Although the pension reform litigation is ongoing, Gov. Bruce Rauner's administration has proposed its own version of pension reform as the centerpiece of its budget proposal. The budget assumes $2.2 billion in savings from pension reform, accounting for more than a third of the gap -closing measures. Even if this version of pension reform is passed by the legislature, it will face implementation risk with significant financial ramifications. New Jersey's pension reform efforts are still being litigated in court, but the administration has already built in the savings from a second round of pension reforms into its fiscal 2016 budget proposal based on the recommendations of the New Jersey Pension and Health Benefit study commission. The budget proposal funds only 30% of the actuarially determined contribution, with pension reforms expected to bridge the gap to full funding. In 2011 the state passed pension reform that included increased future pension contributions. The slow pace of economic recovery and lower than forecasted revenues in fiscal 2014 and 2015 led the governor to roll back those increases ($2.5 billion in total). A Superior Court judge ruled that the reduction of the payment in 2015 violated pensioner's constitutionally guaranteed contractual rights. While this is likely to be appealed by the state, it could further pressure the state's budget if the ruling stands. Even prior to exhausting its all of its options through legal venues, the state could go to its voters for a constitutional amendment that, if passed, could provide the state the ability to modify current benefits, which is one of the commission's proposed reforms. However, this too could be a lengthy process. Pension Obligation Bond Proposals Gain Momentum The acceleration of liabilities, a weak funded ratio for certain states, poor contribution histories, and low interest rates have increased interest in pension obligation bonds (POBs) recently. There are several proposals pending during the 2015 state legislative session which will affect pension funding performance and associated budget requirements. While POBs have been a consistent feature of the municipal bond market for the past 25 years, their performance has been uneven. From a credit perspective, governments that turn to POBs generally have large unfunded liabilities and the decision to utilize debt for this purpose is tantamount to deficit financing --funding an operating expenditure with bonds. Specifically, if actuarial contributions had been regularly funded there would be no liability to address with bond proceeds. POB mechanics Issuing a POB increases leverage and fixed costs. It essentially creates a fixed debt service obligation in place of a potentially variable annual payment to fund a long-term liability. Once the POB is issued, the net proceeds are placed in the pension trust fund to be commingled with the other funds, and usually invested according to existing asset allocation guidelines. Thus, the pension fund experiences a rapid increase in assets resulting in a higher funded ratio. For the POB to generate savings for the employer, the investment return rate on the invested POB proceeds must be greater than the interest cost of the bonds. The employer, as POB issuer and obligor, would then be able to achieve lower total pension contributions than it would have if it had not sold the POB. Timing obviously plays a role in the overall success of a POB plan and we note that the bull market for equities just reached its six -year anniversary. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT MARCH 24, 2015 5 1393883 1300098050 Six Years Into The Recovery, Pensions Are A Big Divider Of U.S. State Credit It is important to understand the overall financing plan in place, as well as the timing of the POB's issuance, which potentially introduce risk to a state's debt and liability profile from a credit standpoint. Specifically some of the issues we are focused on include: • How will the financing affect current contributions (is it being issued for budget relief?) • Will any front -loading of savings lead to higher, unsustainable contribution rates in later years? • What is the statutory relationship between the issuer/employer and the pension fund? How have the laws and precedents for contributing affected funding progress, and how do they play into the POB strategy? • What are the funding goals and how will the POB affect these objectives? Current proposals • Pennsylvania has a $3 billion proposed POB issue that would be secured by wine and liquor enterprise profits with increased contributions funded by dedicating the sales tax into a restricted account. • Kentucky had a $3.3 billion POB proposal in the legislature for KTRS, but that has recently been delayed pending further study. One of the claimed benefits is the potential to reduce its required contribution to a more affordable level, and potentially avoid the application of a blended rate. • In Kansas, the governor proposed a $1.5 billion POB, while a lower $1.0 billion authorization bill passed the state senate. The proposed 2016 budget has some minor pension "savings" in it, which includes lengthening the period to amortize the unfunded pension liability by 10 years and lower contributions due to a higher retirement system funded rate following the POB. However, the governor has proposed funding less than the full pension ARC in 2016 regardless of whether there is a pension bond or not. There is also a debate about whether there should be capitalized interest for a one-time lower state contribution in the coming fiscal year. More Of The Same Is On The Horizon It is clear that the issues surrounding public pensions are in a period of transition based on accounting and actuarial changes and funding commitments. As a result, we expect pensions to remain a significant public policy and funding challenge for many state governments, and a continuing source of expanding liabilities for most. Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook WWW.STANDARDANDPOORS.COM/RATINGSDIRECT MARCH 24, 2015 6 1393883 1300098050 MICHIGAN STATE U N I V E R S I T Y Extension Center for Local Government Finance and Policy seasons and Risks: � �ension Obligation Bonding in AA-ichigan Policy Brief Samantha Zinnes, Law Fellow Mary Schulz, Associate Director Center for Local Government Finance and Policy Michigan State University Extension November 2017 Introduction Per Article IX § 24 of the Michigan Constitution, past accrued pension benefits are protected and the state and local governments are contractually obligated to provide these benefits.' Once an employee becomes vested in her employer's defined benefit pension plan ("DB"), the employer cannot take those benefits away. DB pension plans are funded by both employer and employee contributions that are then invested. Pension plan investment portfolios have traditionally tended to be heavily weighted in lower risk and lower return assets. Because traditional investments are not yielding desired returns, in recent years, pension portfolios have taken on more risk with investments that have greater potential returns. Pension fund managers, employers, and employees want to know there will be enough assets in the fund to cover accrued pension benefit payments. Michigan's municipal governments (i.e. townships, cities, and villages) and counties have a limited number of revenue raising tools to use to meet their contribution obligations. One tool recently made available to Michigan local units is the ability to issue pension obligation bonds. Pension obligation bonds (POBs) "may offer cost savings if the bond proceeds are invested, through the pension fund, in assets that realize a return higher than the cost of the bond"' However, if the return is not higher than the cost of the bond, the municipality or county will need to decide how to pay back bondholders in addition to pension payments. Additionally, POBs are issued to finance pension systems and financing is not the same as funding.' The underlying issues leading to large unfunded pension li- abilities still exist and the local governments will need to address them at some point. Pension obligation bonding impacts more than just public sector employees and employers. It also impacts taxpayers because bonding directly influences the rest of the local unit's operating budget. Consequently, issuing POBs to finance unfunded pension liability can effect taxes as well as public services.¢ This policy brief will explore pension obligation bonding in the United States as well as in Michigan spe- cifically and will discuss: Michigan law regulating local government pension obligation bonding, including Act 34 of 2001, the Revised Municipal Finance Act. The reasons Michigan local governments issue pension obligation bonds, including to save money, increase fiscal responsibility, and provide short-term budget relief. • Various risks associated with pension obligation bonding, such as investment risk, political risk, and flexibility risk, and the way these risks manifest in Michigan. Policy considerations to make pension obligation bonding less risky and more likely to produce positive results for all parties involved. Michigan Law —Pension Obligation. Bonds Since the 1980s, states and local governments have used POBs to finance pension and retiree health care benefits. In October 2012, Public Act 329 added section 518 to Michigan Act 34 of 2001, the Revised Municipal Finance Act ("Act"), permitting municipalities and counties to issue general obligation bonds to pay for unfunded pension or retiree health care costs.' Section 518 also lays out conditions a municipality 1 MI Const. art. IX, § 24: "The accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions shall be a contractual obligation thereof which shall not be diminished or impaired thereby." 2 Alicia H. Munnell, "An Update on Pension Obligation Bonds;' Number 40 Center for Retirement Research at Boston College July 2014, 3 There is a difference between a fully funded pension system and a fully funded pension system financed by POB proceeds. "Borrowing to invest in financial assets is a distinctly different type of financial operation from investing free cash flows, or borrowing for capital improve- ments. James B. Burnham, Risky Business? Evaluating the Use of Pension Obligation Bonds, Government Finance Review June 2003, at 14. 4 "The oft -stated intent of POBs is to reduce the burden of annual pension system payments and avoid diverting resources from core service areas." Thad D. Calabrese & Todd L. Ely, Pension Obligation Bonds and Government Spending, 33 Public Budgeting & Finance 43-65 (2013). 5 MCL § 141.2518 (2017). or county must meet in order to issue a POW The local government must have a credit rating of AA- or higher. The pension system for which the municipality or county wishes to bond must be a closed sys- tem, meaning no new employees can be added to that pension! While the bond is outstanding, benefits cannot be increased; still, local governments "may reduce benefits of the defined benefit plan for years of service that accrue after the issuance of municipal securities under [Section 518]" 8 The most recent legislative action regarding POBs occurred earlier this year. In February 2017, Bill 4275 was introduced in the Michigan House of Representatives to amend Section 518. This amendment would allow more local governments to bond by lowering the credit rating requirement to bond from AA- to A. The bill has been referred to the Committee on Local Government and no further action has taken place. However, considering the current focus on pension reform and state and local government unfunded pension liability, legislators will likely introduce more POB legislation in the near future. Reasons to Bond Local governments issue POBs for various reasons, including to save money, provide budget relief, and increase fiscal responsibility.9 The Center for Retirement Research found that a local government is more likely to issue a POB if a large portion of the local unit's budget goes toward pension obligations and there is a lack of revenue.10 One needs to keep in mind, bonding changes the nature of the pension liability debt. Generally, this change turns a relatively "flexible" pension obligation into a more "inflexible" type of debt obligation, ensuring the debt "will be paid in a timely fashion strengthening the fiscal health of the pension system"11 For revenue constrained local governments, this option could provide short-term fiscal clarity. Michigan local units are required to make their annual pension payments. They are also responsible for paying down their unfunded pension liability. For many local units, these payments take up a significant and growing portion of their general fund budgets. To meet these fiscal demands, some local units are increasing employee contributions, which can negatively impact employee morale, and others are in- creasing taxes, which may make the municipality less competitive and encourage taxpayers to leave the area. Even more constraining is that some municipalities and counties have raised taxes to the legal limit. Instead of cutting public services in order to pay promised retirement benefits, bonding can be an attrac- tive option. At a minimum, POBs provide short term fiscal relief by financing some or all of a local unit's unfunded pension liability. POB bonding can lessen the burden on the local unit's general fund and, thus, its cur- rent taxpayers, without significant increases in employee contributions or taxes. For the decision to bond to be fiscally beneficial in the long term, the local unit's pension liability and its annual required contribu- tion (ARC)12 would need to be reduced more than is paid in principal and interest on the POB. 6 MCL § 141.2518(1) (2017): "In connection with the partial or complete cessation of accruals to a defined benefit plan or the closure of the defined benefit plan to new or existing employees, and the implementation of a defined contribution plan ... a county, city, village, or township 'may by ordinance or resolu- tion of its governing body, and without a vote of its electors, issue a municipal security under this section to pay all or part of the costs of the unfunded pension liability for that retirement program provided that the amount of taxes necessary to pay the principal and interest on that municipal security, together with the taxes levied for the same year, shall not exceed the limit authorized by law." 7 Leon Hank, "To Bond or Not to Bond: Is That Your Question," presentation, at https://www.mersofmich.com/Portals/O/Assets/PageRe- sources/Events/AnnualMeeting/2016/To%20Bond%20or%20Not%20to %20Bond.pdf. 8 MCL § 141.2518(9) (2017). 9 See Alicia H. Munnell, An Update on Pension Obligation Bonds; Number 40 Center for Retirement Research at Boston College July 2014; see also Allan Beckmann, "Pension Obligation Bonds: Are States and Localities Behaving Themselves or Do the Feds Need to Get Involved?" Spring 2010. 10 Alicia H. Munnell, "An Update on Pension Obligation Bonds; Number 40 Center for Retirement Research at Boston College July 2014. 11 Allan Beckmann, "Pension Obligation Bonds: Are States and Localities Behaving Themselves or Do the Feds Need to Get Involved?" Spring 2010. 12 A local unit's annual required contribution (ARC) is the unit's normal cost plus the unit's unfunded actuarial accrued liabilities (UAAL). Risks, In General and. In Michigan Pension obligation bonding is not risk -free. In general, there is political risk, flexibility risk, and invest- ment risk. In addition, there exists an "intergenerational risk and cost transfer imposed by POBs by cur- rent taxpayers on future taxpayers;' with the risk transferred from the government and current taxpayers to future taxpayers.13 Some of these risks are not as pronounced in Michigan as they are in other states due to legal constraints dictating the conditions under which a government can issue POBs. Generally, changing the nature of pension liability into debt payments creates a flexibility risk. Pension liabilities need to be paid; even so, "while debt payments are a non-negotiable portion of a government's budget, some people will advocate deferring pension payments into the future because the penalty for not making pension payments is vague and distant.' " By changing the nature of the pension liability into a less "flexible" debt, a local unit must be fiscally responsible in order to pay the "inflexible" obligation. On the other hand, changing the nature of the pension liability debt to a less "flexible" debt reduces the gov- ernment's financial flexibility, especially during times of fiscal stress. In Michigan, local governments are constitutionally required to make ARC payments to fund pension sys- tems, making these payments fairly "inflexible" By law, there is no "deferring pension payments into the future. uture "" Even so, ARC payments are possibly more "flexible" than fixed POB annual payments. Failure to make an annual POB payment will trigger bondholders to sue the local government. Most Michigan pension systems are part of the Municipal Employees' Retirement System (MERS). While MERS can apply a penalty to a local government for failing to make its ARC payment, MERS works with the local govern- ment to try to prevent that from happening in the first place; a bondholder may not have this same kind of relationship with the municipality. Also, local units are blocked from refunding (i.e. refinancing) for 10 years. Local governments are locked in, which hamstrings their ability to "call a bond" and, should rates fall, refinance at a lower interest rate and benefit from a more advantageous deal. Under the right circumstances, bonding can produce good re- sults; however, one of those conditions is that "the issue should be callable, since in an environment of low inflation, low pension fund returns are likely to be correlated with low interest rates, and the opportunity to refinance a higher cost pension bond should not be forfeited.' By restricting the ability to call bonds, Michigan local units are deprived of an opportunity to achieve positive results. Generally, there are political risks to issuing POBs. A pension system fully funded by POB proceeds can "create the political risk that unions and other interest groups will call for benefit increases."" Michigan local governments can only issue POBs for closed pension systems and are prohibited from increasing benefits while the bond is outstanding, eliminating the political risk. Be that as it may, a Michigan municipality could lessen its political risk without closing the system. Per the Act, "[i]f a county, city, village, or township has issued a municipal security under this section, that county, city, village, or township shall not change the benefit structure of the defined benefit plan if the defined benefit plan is undergoing the partial cessation of accruals"" The law is written such that the elimination of political risk is tied to whether or not the system is closed. It does not appear as though there is much preventing the legislature from revisiting the law and changing it to state "[i]f a county, city, village, or township has issued a municipal security under this section, that county, city, village, or township shall 13 Thad Calabrese, Public Pensions, Public Budgets, and the Risks of Pension Obligation Bonds, Society of Actuaries (2010). 14 Allan Beckmann, Pension Obligation Bonds: Are States and Localities Behaving Themselves or Do the Feds Need to Get Involved?, Stu- dent Paper, University of North Carolina at Chapel Hill (2010). 15 Id. 16 James B. Burnham, Risky Business? Evaluating the Use of Pension Obligation Bonds, Government Finance Review June 2003, at 16. 17 Alicia H. Munnell, An Update on Pension Obligation Bonds;' Number 40 Center for Retirement Research at Boston College July 2014. 18 MCL 4 141.2518(9) (2017). not change the benefit structure of the defined benefit plan'" The law acts as a shield against political risk by prohibiting an increase in benefits; prohibiting an increase in benefits need not be conditional on the closure of the DB system. One of the strongest argument for this view is there is not a similar rule for Other Post -Employment Benefit (OPEB) bonding. Another political risk stems from the negative consequences that can result from closing a pension system. A local government may not have the political will to accept the negative reaction to closing a pension plan. If so, issuing POBs may not be a viable option. Investment risk comes with POB issuance. The goal of issuing a POB is to invest the bond proceeds and the pension assets in order to earn more than the cost (principal and interest payments) of the bond.20 If bonding does not produce a high enough investment return, future taxpayers may face increased taxes or decreased public services, whereas current taxpayers may see increased public services or lower taxes resulting from less annual municipal revenue being paid to pension funding.21 According to Beckmann, governments arguing in favor of POBs state they are "cost effective because the expected return on the investments bought with the bond proceeds will exceed the cost of the debt."I However, because governments tend to budget on an annual basis, "current accounting practices do not create a mindset that encourages the investment risk to be properly reflected in long-term budgeting projec- tions of the impact of a POB issue. Instead, due to the short-term nature of government budgeting, there is a tendency to "shift risk to future generations" even without bonding.24 In a similar vein, the Society of Actuaries is not supportive of POBs and states "the current state of public budgeting dis- counts the future by definition since it focuses only on the short-term... [which] leads governments to engage in fiscally damaging behavior, such as the issuance of pension obligation bonds that transfer risk to future generations with no compensation for this risk transfer." Pension Obligation Bonding in Michigan As of October 27, 2017, 14 local government in Michigan have issued POBs for unfunded pension li- ability: six counties, three townships, and five cities (see Chart 1). One Michigan municipality that has bonded is Bloomfield Hills, one of Michigan's wealthiest communities. The decision to bond was based on the promised amount of benefits to employees in the municipality's DB pension plan, potential cost savings from bonding, as well as "predictability of annual payments for budget purposes" Bloomfield Hills' 2016 Financial Audit Report states that issuing POBs for pension liabilities "stabilized an annual expenditure that used to fluctuate year to year based upon an actuarial report" The people involved in this bonding process were bond attorneys, department heads, as well as Union leaders. The role of the taxpayer in pension obligation bonding is limited, however there is an opportunity for taxpayers to comment on the decision to issue POBs. One of the first steps in issuing a POB is to pub- lish and to circulate a Notice of Intent to issue the bonds and, at that point, taxpayers may make their opinions known to local government officials. Chart 1 shows a pattern for bonded pension funds. A year before a POB was issued, the funding ratio was below the recommended minimum rate of 80% for all but two local units. After the bond is is- sued, the funding ratio increases due to the additional assets. However, shortly afterward, the pension 19 Id. 20 "Spotlight on Governmental Plan Pension Obligation Bonds;' BuckConsultants, Vol 38 Issue 105 (2015). 21 "Critics see [POBs] as an investment gamble, and complain that the approach saddles future taxpayers with bond repayment obliga- tions to cover past liabilities.' "Spotlight on Governmental Plan Pension Obligation Bonds;' BuckConsultants, Vol 38 Issue 105 (July 22, 2015). 22 Allan Beckmann, Pension Obligation Bonds: Are States and Localities Behaving Themselves or Do the Feds Need to Get Involved?, Student Paper, University of North Carolina at Chapel Hill (2010). 23 Id. 24 Thad Calabrese, Public Pensions, Public Budgets, and the Risks of Pension Obligation Bonds, Society of Actuaries (2010). funding ratio goes down again. This may be due to lower than projected pension fund investment returns or changes to the pension fund system assumptions (e.g., adoption of new mortality tables, life expectancy). Be- cause the pension systems are closed, as workers retire new employee payroll contributions decline, therefore decreasing the funding level. This limitation applies to pension systems that require employee payroll contri- butions; some pension systems do not require employee contributions. While the investment returns on the pension assets may increase the fund ratio in the long term, the fund may continue to drop in the short term. A low funded ratio can negatively impact a local unit's credit rating and will be a flag for credit rating agen- cies. Moreover, pension system fiduciaries may require accelerated payment schedules in order to invest more funds, which, in turn, may result in greater returns, making pension fund systems healthier. The accelerated payment schedules apply to open and closed systems. C ndusion Nationally, "evidence to date suggests that the jurisdictions that issue POBs tend to be the financially most vulnerable with little control over the timing;' according the Munnell. On the other hand, the Michigan De- partment of Treasury has to review and approve municipal POB issuance. This Treasury oversight may help Michigan municipalities and counties make a sound fiscal decision. Generally, Munnell found that the gov- ernments most likely to consider bonding for unfunded pension liabilities are governments under financial stress. In other words, "the governments that could issue a POB generally have not, while those that should not issue a POB have done so" Consequently, even though the overall market is attractive for bonding, the governments bonding across the country may be the ones least able to pay bondholders in the future. In the face of increasing legacy costs, some of Michigan's revenue constrained local governments issue POBs hoping for the potential rewards of bonding despite the long term risks. eD 5 0 0 0 0 o a o � o o o0 0O N ' I'll O M M M N q CO to 0� M N 4 O p 4 N 4 I� �6 00 00 co C. �a ID 00 a. w y O� 00 Ln rn n a0 ON N M U) O N O M 00 W 001 O CDd' 1� 00 N O N M D\ 00 O 00 C+ N w y C7, N � M 10 M ..p 0 N .~-i N M 10 N 00 N M T M - N N QS i» � *fl 69 te 'Al v3 ie ile iq ON �o cl N d' N O, v O Ln N N LLr)nON O a\ I n Nam. n a� l� � 00 ..-i _ C o�0 M N r [� 00 4 �-+ NO N O W n O d' 00 a, v .r N ti V^ to N C F M %C O W O N N O ra �o 469 V3 cli64 69 6g M 64 d0' 64 b4 69 PV 69 a� a Ln oo oo N 10 W 1 01 O1 Ol 10 O oo v N i` O 1-1i` 10 N 10 w n O O y n N O O �0 n r W C, oo n v1 M O lr, O Noo oo oo .M. ry o0 � ,N., 10 .N. EA 69 � EA fA 64 69 � yy to :A EA 69 O M Obi m n N O\ O O �D 1� N n n n T o7 M oo �. ti O �O O T �D N M �O 10 O A t+N'� M !` M d' l� O V' to i+Ni n O ul M CI N GO oo CD OD t+m'i V�1 N Q n W O .0 V1 V ra 10 N N „may .Nr 00 Na, 69 lA 4N9 d4 fA fR 4.):A Ey �j M .4 [A oD C. p CG 00 � t+i o, ^l oo In r, oo M \0 �O oo M r.,i\ a' O � C e N n 00 o0 W O O '� O N O y O M � O t�l1 Mi 10 Ol N Noq W n W OD n N M M tMfl 69 619 ONO 4Y 69 69 69 O� b9 t�A Mi fA .M-� 69 Ol ti M 10 N O r, n 00 O\ M N � M N d' O m dam^ v O W ^ N O O N 1O M in O O o0 N b O d^ N a T M n H a N O N D\ m N oo N N T 0� 1, N \0 O a0 N yi bq N to yt �Oo s .6 M b9 d9 6pp4 tBl pp ,4pA o� ' O o0 co O' M h. �p _ N N ��(7� �n ' efi rla lam: 69 T E3 .!r A * aCF Q N +13 �$ 6H ENA tAl 5�3j yy v? R7 �` 10 tl _ � C' O v c O oo O C G O O" G. ❑ '.J' O 4 - u p O 6 �'.�' •G td Gs I o a o a ae of e o aE o tiO° �e O+ � 00 m 00 eD CD p .~-i O 00 00 D+ N If; tb "r I';0 (71 m O 00 M 0� u1 W o0 Ol M 0o O N 00 m N ao M o `c N oo d! -- d' oo O rn oo D h n O M N �p 0� l� M b •--i U y m o v a0 N n cool O DD N � ol •� D V' M M t\ d, ID o0 m 0• n O P &4 �i eq d9 69 efl 69 fR N.N-� yj fA fJ (A v w y9 In Q` N N N N y W M l M N [, O o0 ll�o .4 li �O C d' O c; O M ll�Q O, F p a d; � oo w � o) m N N oo ol o0D0 t, N oo o o <a 4» *fl v3 M f» w v3 us o ds o in `� � O M W c0 N N C a a0 o0 0o m e» oo a,lD O eD a, oo a, \o � ec O w rn t\ W O O N N W O N � M oO0 N N '+ N n N co a0 O N m .. b T OD O 00 a N M lf1 7 ya\ N b rl G lo d lo E9 N to N 69 ^+ u9 M m N V3 oo N !A ^� T &9 '"' EA N 69 yi � O N Di cl1tv V1 vl rl a,d' NO ncD o\ O\ h n 00 aTi mom+ ^ t� ^ mO o o M N � l� ON N o0 H oo te N .a N3 :A bN9 49 Hi Vi 69 d9 M tH N N o 69 Ow O Cl 4 g In p©p pO O A 0. , O aOf7 h: a�0 N p�O C:,` O �.. v1 b .gpCp N C � M n. n pWR A M N mo Q 40 d?` 'CI to ID mlp 'N - N N N fV N N N (V a y tl zf A O O CCQQJJ q 0 bee y�p.pp 3 ci 4nv u u u �I ICH IGAN STATE U N I V E R S I T Y Extension Center for Local Government Finance and Policy thrivelocaLmsue.msu.edu COMMENTARY Pension Obligation Bonds Add Risk When Pension Funds Should be Decreasing Risk States Consider Pension Obligation Bonds Despite Risk By Brian Fojtik October 27, 2016 There's an old joke about banks making loans: when you have money and don't need it, banks are eager to lend, but when you don't have money and need it, theyre nowhere to be found. If only lenders were as reserved when purchasing pension obligation bonds (POBs) from state and local governments that play with fire by borrowing to cover the costs of their pension systems. Pension systems that find themselves in a fiscal hole generally have four options to increase their assets on hand: increase contribution rates, make a lump sum payment into the fund, invest in higher -yielding assets and hope the return matches expectations, or issue POBs and add those funds to the plan's portfolio. The first option, though it would constitute a meaningful improvement to plan solvency if done properly, is usually unattractive to policymakers. Near -term focused legislators or governors often want to avoid the political downside of increased contributions —increasing employer contributions means less money to spend on current public services. Most states typically don't have the revenue for the second option, since year-to-year budgets tend to be tight and the resources scarce for lump sum payments in to plans. The more common approach for plans is to chase higher returns by investing in assets with higher potential yields — but also with more risk. A survey of public -sector pension systems conducted by Pensions & Investments found that in 2012 states allocated about 27% of assets to fixed -income instruments (generally considered the safest asset class), 52% to equities (riskier, but relatively safe), and nearly 20%to "alternatives" between 2008 and 2011. Compare this to 50% invested in fixed -income, 38% in bonds, and only 5% in alternatives between 1984 and 1994. But this U.S. Public Pension Fund Asset Allocation, 1994 to 2011 is no free lunch. Higher expected returns means increased risk, as many pension funds have found out the hard way. And that brings us to pension obligation bonds. These are bonds issued by a state, county, or municipal government specifically to finance its pension system. Oakland, California issued the first POB in 1985, trying to leverage borrowed money and make higher returns than otherwise possible using contributions alone. Higher investment returns means reduced future contributions. This is referred to as "actuarial arbitrage." In finance, arbitrage is simply making a trade in one part of the market with the intention of making some simultaneous trade in another part of the market in order to take advantage of special knowledge held by the investor. In the case of POBs, the debt -issuing government is implying it can do more with the money it collects from the private sector than the investors handing over the money could do with it. Why should anyone be worried about this common practice from the private sector being used by the public sector? When comparing private and public sector operations, what's good for the goose is not good for the gander. Though POBs are uncommon across the country (only 0.2% of governments issued POBs according to the Center for Retirement Research at Boston College) for those that have tried the practice, it has not worked out well. CRR calculated the internal rate of return (IRR) for POBs issued over various time intervals, and the results tracked the general performance of the market, as one would expect. The average IRR from 1992 to 2007 was 0.8%, from 1992 to 2009 was negative 2.6%, and from 1992 to 2014 was about 1.5%. This tells us that the success of POBs largely depends on the market. This does not bode well for issuers, as future returns will likely be much lower than in the recent past. The Government Finance Officers Association has come out against states and municipalities issuing POBs because the risk associated with POBs is higher than that of private debt. In practice, there is a very real possibility that public sector investments will turn into a net loss for the POB issuer, and this has to be weighed carefully when future taxpayer money is on the line. To date, most of the POBs issued have not matured, so more data are needed to fully determine the efficacy of current investments. Connecticuts Teachers Retirement System issued a $2 billion POB in 2008 that matures in 2032. The Center for Retirement Research found that, to date, this POB has returned negative 0.3% per year. But none of this has stopped states from considering POBs. The boards of the Oregon Public Employees Retirement System (OPERS) and Oregon Investment Council (OIC) recently announced they were considering a POB to deal with the State's $22 billion unfunded liability. Similarly, Alaska's governor announced his intention to issue $3.3 billion in POBs, until being rebuffed by legislative leadership. The State risked a credit downgrade if it proceeded with the POB. Both Oregon and Alaska face large unfunded liabilities due to previous poor investment returns and funding policies. And this follows a trend where states that consider or issue POBs tend to have very poorly funded pension systems. As CRR's report concluded, "governments are more likely to issue POBs if the plan represents a substantial obligation to the government, they have substantial debt outstanding, and they are short of cash... financial pressures play a major role." Or as Nobel Laureate William Sharpe said a bit more pointedly (on, yes, his personal youtube channel), issuing POBs is "borrowing money to gamble." Even if it were possible to use POBs responsibly, the data show otherwise. POBs are not a tool used by prudent pension funds to increase returns. Rather, they are straws that struggling funds grasp at when theyre already underwater. COMMENTARY Governments Issuing Pension Obligation Bonds Risk Worsening, Not Improving, Their Financial Shape POBs bring long-term risks that can worsen a government's fiscal health. By Anil Niraula August 15, 2018 Concerned over rising pension contributions, policymakers in Chicago are contemplating borrowing millions in the form of pension obligation bonds (POBs). However, city leaders may ultimately reject the idea as many other state and local governments with underfunded public pensions have found POBs bring long-term risks that can in fact worsen —not improve —a government's fiscal health over time. To say that Chicago's pension systems for public employees have solvency concerns would be an understatement. Last year, for example, the Chicago's two largest pension funds: Municipal Employees' Annuity & Benefit Fund of Chicago (MEABF) and Chicago Teachers Pension Fund (CTPF), were just 28.0 percent and 46.6 percent funded, respectively (as reported under current GASB accounting rules). The same year, the city funneled more than $1 billion, or approximately 10.5 percent of its 2017 budget, into four of its six pension funds, more than doubling the citys contribution a decade ago. And the city officials hope that POBs would save future taxpayers hundreds of millions of dollars. Chicago is hardly the only jurisdiction considering this idea, however. Omaha Public Schools —which was less than 60 percent funded last year —was seeking $300 million in POBs this April. And the state of Illinois was seriously considering a whopping $107 bilkun POD borrowing earlier this year, despite 3ireadv ;hooting itself in the foot with bad POD deals in the past. However, "there is no free lunch" in the public pension realm. Despite the pension funding boost, POBs do not make the issuer any healthier. Rather, they shift the financial risks away from within the pension fund to the municipal authority (city, state, school district, etc.) itself. In a sense, POBs trade "hidden" pension debt buried within pension accounting for formal, bonded debt. If not accompanied by systemic reform, this can leave pension funds exposed to the same types of long-term risks in the future that have produced the kinds of pension underfunding seen today in many plans by burying the problems with a dump truck of money. That, in turn, yields an environment of long-term budgetary uncertainty for government employers. At an operational level, a POB is created when a municipal government issues a series of bonds, collects the revenue, and transfers that revenue to the pension fund(s) like any other contribution. The pension fund then invests it and manages those contributions as if they came from the government employer as an overpayment using dollars from a budget surplus. From the perspective of the pension fund, it doesn't matter where the dollars come from—POBs simply create a one-time pool of funds that can be used to increase the overall asset base of the pension system, and —on paper, at least —improving a plan's funded ratio However, the source of the funds matters a great deal to the state or municipality who needs to cover the debt service on issued bonds and navigate a range of factors all of a sudden in play, including market conditions, credit ratings (which shape bond rates), and flexibility to raise taxes if budgetary hurdles arise. In extreme cases when a state or municipality can't possibly keep up with required annual pension contributions due to enormous claims they have on government finances, POB issuance might perhaps be justified as part of a larger pension reform effort designed to lower or eliminate long-term financial risks, similar to the approach taken by Houston last year. In that case, taking out a loan in the form of POBs can serve as a bridge to prevent any further degradation in pension solvency while "buying time" for the long-term reforms to work at de -risking the pension system. But that is not what often happens. Instead, time and time again these bonds are used as a stand-alone tool by the governments failing to make good on their annual pension contributions and wanting to put a quick Band-Aid on growing pension debt. Ironically, these often tend to be states and municipalities poorly equipped to shoulder the long -run risks packaged with POBs, exacerbating the problem. A 2014 study by the Boston College Center for Retirement Research (CRR) found that the top three POB issuers since 1985—when the city of Oakland, California, made history issuing the first POB—have been Illinois, New Jersey, and California, states with some of the worst -funded retirement systems in the nation. One of the key risks that POBs pose comes from the implied pursuit of so- called "actuarial arbitrage" This is when a government bets on the proceeds —which are invested by the struggling public pension plan(s) as part of its overall asset portfolio —to generate investment returns higher than the rate of debt service payments on the issued POBs. Such a bet is essentially a gamble with public money. With the "new normal" lower yield environment there is a considerable chance to generate a net loss and increase the budgetary burden in the long -run if pension investments underperform relative to the POB borrowing rate. Additional long -run risks associated with POBs include: 1. Moving liability risks away from public pension plans to states and municipalities; 2. Undermines intergenerational equity, where future taxpayers are required to continuously foot the POS bills; 3. Sharp increases in public debt because of POBs that can trigger credit rating downgrades, Increasing future borrowing costs; 4. Instead of somewhat flexible pension debt (amortization of which could theoretically be smoothed out), governments face a stream of inflexible annual debt payments; 5. Provides no incentive to de -risk pension portfolio allocations, leading to continual chase for higher yields, thereby risking more volatile returns. Examples abound of risky POB bets. "we achieved a favorable borrowing cost of 5.88 percent, which is well below the 8.5 percent assumed long- term return on assets of the Teachers' Retirement Fund (TRS)," said former Connecticut Treasurer Denise L. Nappier back in 2008 when the state issued a $2 billion POB. Since then, however, the Connecticut TRS's actual returns have averaged out to just 4.08 Percent, far below the POB rate and the plan's return assumption. The pension plan is now more than $14 billion in the red (market value). Connecticut TRS: Historical Analysis of Plan's Solvency loose 90% Sags 70% 60w .2 s 50w Tf, 9 40% 1 sass tow 10% 0% 2002 2004 2006 200E 2010 2012 2024 2016 Sourc¢Raawn GouMali"n Malyah el CunnKtl[ut wluaWnnp[rt[and C.aFRG In a similar vein, the aforementioned CRR study shows that as of 2009, POBs nationally had lost 2.6 percent in earnings for its issuers. That is not to say that reinvested funds can't generate net positive results, given that most such bonds have yet to mature. However, there is no guarantee that the gamble will pay off in the long -run, as growing evidence suggests that much lower investment returns are likely over the next 10-15 years, relative to the past few decades. And, with uncanny timing, this year's "favorable" borrowing rate might turn out particularly ugly during the next market downturn - if the steadily flattening yield curve actually inverts. Cities like New Orleans, Detroit and Stockton have already been negatively affected by bad POB deals during previous market downturns, the last two cities seeing POBs as one factor among those leading to Chapter 9 bankruptcy proceedings. And New Orleans —which in 2000 sold $171 million in bonds with a fluctuating coupon rate —ended up paying 11.2 percent instead of 10.7 percent interest, refinancing the debt a decade later. There can be occasional silver linings. Connecticut's state and locai (e.g. town of Hamden) POB shows, for example, that POBs can be designed with covenants to bondholders that include a promise to pay 100 percent of actuarially determined employer pension contributions until the bond matures, a move that could nudge otherwise fiscally imprudent policymakers toward some degree of pension funding discipline. Even that, however, should be taken with a grain of salt because annual actuarially determined pension contributions tend to be undercalculated whenever a public pension plan sets an over -optimistic investment return assumption, and in some cases continuously re -amortizes its unfunded liability. Thus, even a pension plan that receives every dollar of pension contributions as calculated by the plan actuaries may still fall short of fully funding its liabilities. Still, even if one succeeds in garnishing positive net returns on a POB, the Government Finance Officers Association rightly point: out that continuously failing to achieve the targeted rate of return alone would bur den the issuer with both inflexible (i.e. alrrrost impossible to renegotiate) POB debt service requirements, as well as rising unfunded pension liability payments —a "double whammy" from a fiscal perspective. There is no one -size -fits -all approach to public pension underfunding. And state and local governments often have to strike a delicate balance between short-term budgeting and long -run pension solvency. But, more often than not, POBs serve as a poor substitute to meaningful pension reforms and should be avoided when possible. Anil Niraula is a policy analyst at Reason Foundation. Pension Obligation Bonds: Risky Gimmick or Smart Investment? POBs have bankrupted cities, including Stockton, yet some are still big players. by Eric Schulzke I January 2013 Stockton photo: calwest/Flickr CC calwest/Flickr CC "It's the dumbest idea I ever heard," Jon Corzine told Bloomberg.com in 2008 when he was still governor of New Jersey. "It's speculating the way I would have speculated in my bond position at Goldman Sachs." Corzine, who followed up his tenure as governor with a $1.6 billion investment debacle as chairman of MF Global, seemed to know a thing or two about risky ventures. In this case, he was speaking of pension obligation bonds. POBs are a financing maneuver that allows state and local governments to 'wipe out" unfunded pension liabilities by borrowing against future tax revenue, then investing the proceeds in equities or other high -yield investments. The idea is that the investments will produce a higher return than the interest rate on the bond, earning money for the pension fund. It's a gamble, but one that a lot of governments are willing to take when pension portfolio returns plummet, causing unfunded liabilities to run dark and deep. Almost every fund has faced such liabilities from time to time, though current times have been more treacherous than others. As Paul Cleary, executive director of the Oregon Public Employees Retirement System (PERS) points out, since 1970 his state's pension fund has suffered annual losses only four times. But three of those losses were in the last decade, and one, in 2008, was a catastrophic 27 percent decline. Faced with such losses -- and with a dearth of state and local revenue to make up for the shortfalls — POBs have become a favored tool to fix pension woes. Oregon is a big player in the POB market, along with scores of its cities, counties and school districts. Other major POB issuers include California, Connecticut, Illinois and New Jersey. The bonds took on some notoriety this past summer when two California cities, Stockton and San Bernardino, went bankrupt. Generous pensions awkwardly propped up with ill-timed POBs contributed to both debacles. Over the years, returns on POBs have often fallen below the interest rate the stale or locality paid to borrow the money, digging the liability hole even deeper. Nonetheless, they remain popular with politicians in a revenue pinch. Politically, it is easier to borrow money to pay for pension costs than it is to squeeze an already -stressed budget. While many economists and policy analysts view them as risky gimmicks and question the high market growth assumptions that make them seem viable, POBs have defenders who believe that with careful timing they can pay off. When Oakland, Calif., launched the first pension obligation bond in 1985, it appeared to be a reasonable strategy. It qualified as a tax- free bond that could be issued at the lower municipal bond rates. A state or city could then pivot and invest the funds in safe securities - - a corporate bond, for instance -- at a slightly higher rate. "That was classic arbitrage," Cleary says. "You were locking down the difference between nontaxable bonds and taxable bonds." The Tax Reform Act of 1986 ended that strategy by prohibiting stale and local governments from reinvesting for profit the money from tax-free bonds. When the concept resurfaced, the strategy called for states or localities to issue a taxable bond and leverage the higher interest rate of that bond against higher return but riskier equity market plays. So long as markets boomed, the new tactic seemed savvy. "Some people call this arbitrage, but it's not," Cleary says of post-1986 POBs. "It's really an investment gamble.' Arbitrage occurs when prices for the same product differ between two markets, allowing a nimble player to exploit the difference. "Real arbitrage is free money," says Andrew Biggs, a scholar at the American Enterprise Institute. "But it doesn't hang around very long.' Safe bonds and risky equities are not the same product, but public pension accounting currently permits state and localities to treat them as if they were. "They are counting the return on the stocks before the return is there," Biggs says. "If you borrowed money to invest in the real world, you would factor the current value of the debt with the current real value of the stocks." Given the inherent risks and possible rewards, how have POBs fared? In 2010, a research team led by Alicia Munnell, director of the Center for Retirement Research at Boston College, ran some numbers to find out. The team took 2,931 POBs issued by 236 governments through 2009. They used each bond's repayment schedule to calculate interest and principal, and then clustered them into cohorts based on the year issued. They assumed a 65135 investment split between equities and bonds and tracked the results with standard indexes. They then produced two composite graphs — one at the height of the market in 2007 and the second in 2009, after a crash and before recovery, In general, bonds issued in the early stages of a stock boom performed well prior to the crash. Thus, POBs issued in the early 1990s were healthy, ranging from 2 to 5 percent net growth. Borrowings in 2002 or 2003 also looked good - Those issued in the latter years of the 1990s or 2000, however, were in negative territory even before the 2008 crash, having suffered serious losses to their principal in the 2001-2002 downturn. After 2008, all POBs were under water — except those issued in the trough of the collapse, which by 2009 were already pushing 25 percent gains. Oregon's numbers mirror Munnell's findings. Local govemment POBs issued in 2002 al the depth,of,that market collapse and managed by Oregon PERS gained ! % Pond. Less lucky were bonds issued in 2005. Thi INDUSTRY aond carried 4.65 percent interest, it likely earned ro. INSIDER rs earned just 2 percent on their investments throe n. The same fate befell Stod pillion POB in 1997 — on the wrong side of another. "The whole thing is the tin Stay up to date! med out and when interest rates are reasonable, because really what you are doing is making an investment bet. If people thought when they did POBs that they were refinancing a Rg41¢�ijii�a�����li�a��1�e investment play, I'm sure they have been very surprised head Ines an analysis of breaking ews. ree signup by the results." takes less than one minute. And yet that is exactly how th NOT RIGHT NOW 1j .:v Riw-. lew POBs in 2009, the voter education pamphlet argument in favor of issuance explicitly framed the choice as a "refinance and cas rye projected returns as money "saved." "Just like many homeowners are refinancing their home mortgages; the pamphlet read, "the State should take advantage of these historically low rates, which can save Oregon more than $1 billion over the next 25 years. The money saved will help reduce cuts and protect services that all Oregonians rely on." Because POBs demand headroom between the interest an issuer pays to borrow and the high returns promised on resulting Investments, their investment strategies tend to chafe against safer portfolios. Without a hefty "discount rate" — as the projected annual gain assumed by a pension fund is known — the pension bonds would not be possible. In a 2012 paper, Andrew Biggs argues that the aggressive 8 percent discount used by many states overstates likely earnings and understates risks. A fund that required $100 million in 20 years and employed an 8 percent discount rate would be "fully funded" with $21 million, Biggs notes. But if that same fund were to gain only 5 percent annually, it would need $38 million today to be fully funded in 20 years. Many experts argue that because public pension obligations are legally binding, pension funds should be discounted at close to zero risk on the front end -- at or near the rates offered by government bonds. "While economists are famous for disagreeing with each other on virtually every conceivable issue," wrote then -Federal Reserve Board Vice Chairman Donald Kohn in 2008, "when it comes to this one there is no professional disagreement: The only appropriate way to calculate the present value of a very -low -risk liability is to use a very -low -risk discount rate" In point of fact, the 8 percent discount rate may be on its way out. The Governmental Accounting Standards Board (GASB) is launching a complex hybrid discount standard in 2014, which will affect the assumptions stales make with their funds. Some fear the GASB rule will only create more confusion. Bond rater Moody's is taking a simpler tack In weighing government pension plans, having recently proposed to shift its pension discount rate down to the level of AA taxable bonds, which are now at 5.5 percent. "Currently, discount rates used by state and local governments are all over the place," says Tim Blake, Moody's managing director of publicfinance. "Most are in the range of 7.5 to 8 percent. We need a uniform rate Not surprisingly, 5.5 percent is very close to the rate at which many POBs are sold to investors With aggressive 8 percent discount rates now under attack by economists, oversight boards and rating agencies, issuers who counted on rosier outcomes have learned some hard lessons. Five years ago, when Connecticut State Treasurer Denise L. Nappier announced a new $2.28 billion pension bond, she noted that the state had "achieved a favorable borrowing cost of 5.88 percent, which is well below the 6.5 percent assumed tong -term return on assets of the Teachers' Retirement Fund. This will provide significant cash flow savings over the long term and a potential savings to taxpayers of billions of dollars." When the bond was issued in April, the Dow Jones average stood just shy of 13,000. By November, the market was in free fall. It bottomed out the following March at just over 6,600, Connecticut's timing could hardly have been worse. As the market plunged, Pensions & Investments lit into POBs, singling out Connecticut. The editors argued that POBs shove obligations "that should have been paid as earned" onto future generations, along with the risk of the debt. By 2010, with the market still emerging from the trough, Connecticut's finances were as messy as ever. But now there was little appetite for more bonds. POBs "are certainly a risky proposition," Michael J. Cicchet i, chairman of Connecticut's Post Employment Benefits Commission, told the CT Minor. "Things are different now than they were then." Even as Connecticut licked its wounds, Boulder, Colo., was launching its own new POB, designed to clean up some tangled threads from pension programs long since closed to new employees. With the market down, Boulder's CFO Bob Eichem was ready to take a chance "POF3s arc not for the faint of heart." Eichem says. "You have to understand them," Boulder's bond, for a tame $9 million, was issued into a recovering market, and the city got a low 4.29 percent interest rate. Boulder also ran worst -case scenarios and decided it could absorb any likely loss. "You've got to pay that debt every year," Eichem says. "So if the market goes against you, you will have to decrease your other expenditures to make up for what the market did to you." With the bond money in hand, Boulder staged its investment. "There was great uncertainty in the market, as there still is," Eichem says. The city put the funds in a holding account and "income averaged" them into the market over a year. "That would hold you down if the market really rose in that year, but it would also protect you if the market really dropped," Eichem says of the gradual strategy. After stringing out three quarters of the fund through the year, Eichem put the remainder in when the market bottomed in early 2011. "Issuing a POB may allow well heeled governments to gamble on the spread between interest rate costs and asset returns or to avoid raising taxes during a recession," Alicia Munnell and her team wrote in 2010, warning that "most often POB issuers are fiscally stressed and in a poor position to shoulder the investment risk." ISSUER IN-DEPTH State of Kansas 11 AUGUST2015 Kansas' $1 B Pension Obligation Bonds Do Little to Solve Pension Challenges Kansas's (Aa2 stable) planned $1 billion sale of pension obligation bonds later this month will RATINGS do little to solve the challenges surrounding its poorly funded state -administered pension State of Kansas plans. Even if the state's pension bonds work as designed, contributions must rise in order ^ % to address growing unfunded liabilities; contribution requirements (in dollars) will still rise S; an F A;:propriation deg by 4% annually, if all assumptions hold, due to the increasing payment structure used by (KansasDeveiopn-e.ntfinanceAwmi,! stars:: the pension plan. The state reduced its pension contributions for the next few years in conjunction with this bond sale, signaling that the state is using POBS, and taking on some ANALYST CONTACTS additional long-term risk, to achieve near -term budgetary relief. Dan Seymour, CFA 212-553-4871 D Kansas is using Pension Obligation Bonds to achieve budgetary relief. Although Assi5tantl/cePre; dear-A;>a(,st: the bond sale fits into a plan to achieve full pension funding by 2033, the reduction in Jan.;rymou ra:r,^r,cdys.ccm pension contributions for the next few years in conjunction with the bond deal indicates I h0rnas Aaron :312-706-9967 its use as a modest form of budgetary relief. VP-A,,&lysi. hornaS.tiiR'vl(:%fiUJO:I`JS Cv;'T7 » The Pension Obligation Bonds exchange a "soft" liability (unfunded pensions) for Nicholas Samuelf,, 212-553-7121 a "hard" one (appropriation debt). Debt represents an inflexible fixed cost that cannot be renegotiated or modified without defaulting. By contrast, an unfunded pension liability can sometimes be modified through benefit reforms or funded over a longer Emily Raines 212-553-7203 vn- , cre<.ire once: timeline without defaulting. enay,rairne<<,moorlys.ccm The state's pension plans remain poorly funded, even with this bond deal. The state's practice of capping pension contributions below actuarially determined rates remains in place, and these bonds will rectify the problem only if market returns meet optimistic return assumptions and the state adheres to an escalating future schedule of budgetary contributions. Meanwhile, the state's net pension liability is very high relative to peers, and a $1 billion increase to pension assets has only a modest impact on pension funding levels. Additionally, due to the use of a back -loaded amortization structure by the pension plan, the state's reported unfunded liabilities could continue to grow for several years, after an initial decline due to the pension bond issuance. a correction to ;he a-nount transferred to the general fund frc n the state MOODY'S INVESTORS SERVICE U.S. PUBLIC FINANCE Background on Kansas's Pension Obligation Bonds p!Ice < ter' iJllllf;3tiOn G;:l'a''P :jr'ri riy i•�I csf' i2..•"••Y •t:a: .I - I .:1 - - • • I !. I•. ,. v'.'_ •ur:�� 1,1n n:';_;s :rnt .12 ;' :ov'- r •ts'n?13t st:ita'. �cs,e-i c,:3n �,r:, -, aim nt 0f,_ ieaslne n. ijntunncfc Ihk;��lit! 53r_;V=A*wir a.1atl6It, v:'. i l 1,: r1 j ryt_in•.• :-41IraiJ?06, ]'. 4%per yea-. Kansas POBs provide budgetary relief Kansas has reduced contributions to its pension plan in conjunction with this bond sale, indicating its use as a form of budgetary relief. Although the POBs fit into a plan to achieve full pension funding by 2033, adding $1 billion of debt to do it represents a riskier strategy than the simpler alternative of making larger annual pension contributions. Kansas's Pension Conundrum The foundation of Kansas's pension conundrum is that state statute caps its own annual pension contributions. Legislation passed in 1993 limits growth in pension contributions to about 1.2% of payroll annually. Actuarially required contributions, or the contributions that would result in full pension funding over time, frequently grow by more than 1% of payroll. As a result, the state's statutorily permitted contributions have been lower than actuarially determined contributions for years (see Exhibit 1). Since 2001, the state on average has made 72% of its actuarially determined contributions. Exhibit 1 The Foundation of Kansas' Pension Conundrum Actuarial vs. Statutory Pension Contributions for the State/School Pension Group Actuarially determined contribution rate 16% 14% 12% 010% ip _ d 8% - O 6% 4% 2% 0% — 2000 2001 2002 2003 2004 2005 Source: KPERS 2074 valuation report Statutory cap on contribution rate 2006 2007 2008 2009 2010 2011 2012 2013 2014 Valuation year The predictable consequence of a law that prohibits fully funding pensions is a growing unfunded pension liability (see Exhibit 2). tris ,., rating action in'orc atk an, 11 ALIGUST 2015 S1A1"E Of KANSAS: KAIJSAS' S1B PENSION OBLIGATION BONDS DO LITTLE TO SOLVE PENSION CHALLENGES MOODY'S INVESTORS SERVICE U.S. PUBLIC FINANCE Exhibit Z Capping Pension Contributions Has Predictable Consequences for Unfunded Liability � Unfunded pension liabilities (actuarial) $12,000 „ $10,000 $8,000 �~ $6,000 m d $4,000 v $2,000 $0 1_.—..... Source: KGERS 2014 valuation report Funded ratio (right axis) 2003 2004 200S 2006 2007 200E 2009 2010 2011 2012 2013 2014 100% 90% 80% 70% 60% 50% 40% LL 30% 20% 10% 0% The state's goal is to achieve full funding by 2033, which would ordinarily be impossible as long as state law prevents growth in pension contributions at actuarially determined rates. This is where the POBs come in. by depositing $1 billion into the pension plan, the unfunded liabilities would decrease, and as a result the actuarially determined contribution would decrease. The state expects the statutory rate to converge with the actuarial rate in 2020, at 13.55% of payroll. In comparison, the state contributed 12% of payroll in fiscal 2014. Once the actuarially determined contribution is within the statutorily permitted range, the state will be on a path to full funding if its assumptions hold and it adheres to actuarial contribution requirements, which it historically has not. Adhering to actuarial payment requirements may prove challenging because once contributions reach the actuarial rate as a level percentage of payroll, the state's pension payments in dollars will continue to rise at 4% annually, equal to the salary increase assumption used by the state's pension plan. Since the state amortizes its unfunded pension liabilities using a steeply increasing payment schedule, actuarial requirements under the plan's assumptions will not be sufficient to prevent unfunded liabilities from growing each year until the fiscal 2018 payment. At that point, the state's amortization payments will cover all of the annual interest on its unfunded liabilities, plus some principal. Unlike the annually escalating pension amortization payments, debt service payments for the POBs will be level each year. The use of POBs in this way would not necessarily be negative, except that in the legislation authorizing the POBs (SB 228) the state reduced its contribution rates in anticipation of the bonds (see Exhibit 3). 11 AUGUST 2015 STATE OF KANSAS' KANSAS91n PENSION OBLIGATION BONDS DO LITTLF TO SOLVE PENSION CHALLENC,FS OF MOODY'S INVESTORS SERVICE U.S PUBLIC FINANCE Exhibit 3 POBs Provide Budgetary Relief M Actuarial contribution rate Original statutory rate ■ Recertified rate under SB 228 16 15.0 14.9 14 13.6 12.4 i 12 10.9 0 10 T a 8 `o 6 4 2 0 — 2016 2017 ' This shows contribution rates for the KPERS state/school group Source: KPERS 2074 valuation report 10.8 The reduced pension contributions indicate that this plan is, at least in part, a form of budgetary relief enabling the state to contribute less to its pension plans the next few years. To be clear, the budgetary relief is modest: $45.1 million in 2016 and $97.8 million in 2017, a small share of a $6.4 billion operating budget. Cash -flow borrowing from other funds ($675 million in 2015) and the state general fund's transfers from its transportation fund ($174 million in 2015) are both more dramatic indicators of budgetary stress than these reductions in pension contributions. Nonetheless, the reduction of contributions adds risk in this context because of uncertainty whether the bonds will be able to be sold (see sidebar below). The 5% Cap s a;e cannot resumption Ii-e bonus wou,d sell. i hese lover I i I I 2045 terra a5 the yie.ded sarle POBs exchange a soft liability for a hard one By effectively converting some of its liabilities from a softer, more flexible form (unfunded pensions) to a harder, less flexible form (appropriation debt), Kansas is increasing the risks of its portfolio of liabilities. Pension liabilities are generally a "softer" liability than debt. Pension benefits can be renegotiated, litigated, spread out, reduced or reformed. Employers can negotiate contributions from employees. In the case of states, issuers can choose the schedule at which they fund pension liabilities. 11 AUGUST 2015 STATE or CAMAS: KAN SAS' SIB PENSION OBLIGATION BONDS DO LITTLE TO SOLVE PENSION CHALLENGES MOODY'S INVESTORS SERVICE U.S. PUBLIC FINANCE Debt, by contrast, is inflexible. Debt service payments cannot be restructured without triggering a default except when market conditions allow for a refinancing and the timing of debt service is not negotiable. The two liabilities are not equal, even if they are the same size: pension liabilities are easier to remold, underfund or maneuver around. Kansas's debt burden is modest, and has capacity to take on an additional $1 billion. Assuming these bonds sell at a 5% yield, General Fund debt service will go to 3.1% of revenues from about 1.9% of revenues, which is still moderate. Pension Obligation Bonds post -sale will represent two-thirds of the state's non -transportation debt (see Exhibits 4 and 5). The state sold SSOO million of POBs in 2004, most of which is still outstanding. Exhibit 4 Kansas' Debt Profile, Pre -sale Appropriation (POBs) 14% Appropriation _ (non-POBs) 23% Special tax I 8% Source: State of Kansas, Moody's Investors Service Exhibit 5 Kansas' Debt Profile, Post -sale Special taxi 6% Highway Revenue Appropriation _ (POBs) Highway Highway 36% Revenue ss% Appropriation (non-POBs) 17% Source: State of Kansas, Moody's Investors Service Kansas's pension plans remain poorly funded, even with this bond deal These bonds do little to change Kansas's fundamental pension condition: its plans are poorly funded and its unfunded liabilities are big. The KPERS system encompasses three plans covering substantially all public employees in the state. The state is responsible for a majority of the funding. In Exhibit 6 below, the state and school contributor groups (both of which the state is fully responsible for) represent 77% of the plans' $9.5 billion of total unfunded liabilities. Exhibit 6 Kansas' Reported Pension Liabilities Are Big Group Actuarial Liability Actuarial Value of Assets Unfunded Liability Funded Ratio State $4,161 $3,122 $1,039 75% School $13,437 $7,232 $6,205 54% Local $4,569 $3,081 $1,488 67% Police and Fire $2,801 $2,075 $726 74% judges $163 $153 $10 94% Total $25,131 $1S,663 $9,468 62% Source: KPERS 2074 valuation report The state isn't responsible for the full $9.5 billion of unfunded liabilities because local governments contribute to some of the smaller groups within the plans. However, the $7.2 billion of unfunded liabilities in the state and school groups already exceeds the state's budget and is high for the sector. 5 1.1 AUCUST 2015 STATE •]i KANSAS- KAN SAS' S1a PENSION OBLIGATION BONDS DO LITTLE TO SOLVE PENSION CHALLENGES MOODY'S INVESTORS SERVICE U.S. PUBLIC FINANCE We adjust reported pension figures to achieve greater comparability among issuers utilizing different assumptions, such as the discount rate used to bring future liabilities to present value. After making these adjustments', we estimate the state and school groups' adjusted net pension liability at $18.6 billion, or 1.5 times governmental revenues. A $1 billion reduction to $18.6 billion of net pension liabilities is clearly not a game -changer. The effect it would have on our adjusted pension metrics would be minor. The 8% Return Assumption A key aspect of the goal to bring the funded ratio to 100% by 2033 is an assumption that pension assets will deliver returns of 8% annually. If actual returns are less than this, pension assets will be lower than projected and actuarially determined contributions may remain above the statutory limit, foiling the state's plan. This is the essential wager of a POB: Kansas is hoping that returns on invested assets will exceed interest costs on the bonds. If they do, the returns will help to fund the plans' liabilities and ease the path toward full funding. However, if returns fall short of the assumption, the plan could work not as well or not at all. 1f returnsare below 8%, then pension assets will not grow as fast as projected. As a result, the unfunded liability will be higher than projected, as will the actuarially determined contribution. The risk in this case is that the actuarially determined contribution will exceed the statutory contribution limit, putting the state once again in a position where it is unable to fully fund its pension liabilities within its self-imposed limits and is in a structurally unbalanced budget condition. if returns are below 5%2 , then not only will pension assets not grow as fast, this deal will represent a net cost on the general fund. If the returns don't exceed the interest on the bonds, then total funding costs will be higher than if the bonds were never issued. Even if the 8% return assumption is met, the state's future pension contributions, apart from the comparatively modest bond payments, will need to rise by 4% per year for the state to achieve its planned full funding objective by 2033. The payroll growth assumption is one actuarial factor, and several others could lessen the need for higher contributions, such as mortality rates. 11 AUGLJST2015 STATE OF K.ANSAS: KA.NSA.S' SIB P[r"ION OBLIGATION BONDS DO LITTLE TO SOLVE PENSION CHALLENGES