The confusion and concern over Denver Public Schools’ finances has shifted from a Wall Street transaction that went badly wrong in its first year to longer-term worries about the district’s funding of its employee pension plan.
Yet a handful of board members and outside critics who are now raising concerns about the district getting caught off guard in 2015 by a special “true-up” payment to Colorado PERA, the administrator of the district’s pension, are worried about the wrong thing.
DPS’ problem is not a potential surprise payment in five years. Instead, it’s what DPS has knowingly committed itself to, and what PERA is forecasting today: an ever-escalating schedule of pension expenses that will likely see the district paying more than $100 million annually by 2013, more than $200 million annually by 2021, and nearly $400 million per year just over two decades from now.
The payments are twofold: One, the district must pay roughly $70 million per year until 2037 to retire a set of bonds it issued last year in order to boost the assets in the pension fund. And two, the district must make up in the future for pension payments it’s skipping right now.
The Denver school board’s finance and audit committee will meet publicly at 4:30 p.m. today at 900 Grant St. to talk about pension financing.
It is, in a way, what was planned all along by Superintendent Tom Boasberg and his predecessor, Michael Bennet. They sought a way to relieve DPS of a crushing annual pension expense and put the money back into the classroom.
As a bonus, funding the Denver Public Schools Retirement System, or DPSRS, would ease a merger with the Colorado Public Employees’ Retirement Association, which would both get DPS out of the pension-administration business and make it easier for DPS to hire teachers from other school districts, all of which use PERA.
Their plan, however, was to fully fund the DPS pension, turn it over to PERA, and then cut the district’s annual contributions to save expenses. The DPS pension’s funding level would then deteriorate to the level of PERA’s own school division, which was 70.1 per cent at the end of 2008.
(This reporter, when with the Rocky Mountain News, interviewed Boasberg in February 2009 about the plan. When he said, “We’d like to be like the other 177 school districts in Colorado,” this reporter asked, “Underfunded?”)
An arrangement goes spectacularly wrong, at first
DPS issued what are called Pension Certificates of Participation, which pledged a number of the district’s buildings as collateral, and used the $750 million in proceeds to pump about $400 million into the pension plan and pay off a past pension-debt issue.
The district decided 30-year interest rates were unattractively high because of market tumult at the time. It instead chose to issue variable-rate debt, then fixed the rate with an offsetting transaction with a group of investment banks that “swapped” interest payments with DPS. That arrangement went spectacularly wrong in its first year when credit markets seized up, but has since moved back in the district’s favor.
Read Milstead’s April 2010 take on the pension transaction, “Analysis: Both sides right in the DPS pension debate.”
Injecting money into a pension plan by issuing bonds was a no-brainer to Bennet and Boasberg, who said the district would effectively make money by borrowing at roughly 5.5 per cent interest, then investing it with an expected return of 8.5 per cent.
Critics of “pension obligation bonds” and similar vehicles point out that an 8.5 percent return is an assumption, and a long-term one at that. No one gets a smooth 8.5 percent every year from a portfolio; there are ups and downs, sometimes big ones. And what you experience after you put the money in matters a great a deal.
If the timing of the interest-rate swap was poor, the timing of the bonds, in retrospect, was worse. The DPSRS annual report for 2008 shows that the district put in nearly $435 million, including its annual contributions, compared with just over $40 million in 2007.
But 2008’s investment losses sucked almost $804 million out of the fund. And, as a result, a pension that was 87.7 percent funded at Dec. 31, 2007, was 84.3 percent funded at the end of 2008. Any “full funding” of the DPS pension was fleeting.
Those statistics understate the problem, because DPS, like most public pensions, employs a technique called “smoothing” that delays the recognition of both gains and losses. It takes four years for the funding ratio to fully reflect any given year’s gains or losses.
A 30-year bond to pay off, and higher-than-expected payments
To see what happened to a pension that didn’t pump in money during the period, look at PERA: Its funding ratio dropped from 75 percent at year-end 2007 to 69 percent at Dec. 31, 2008. And if you take away the smoothing effect, the funding ratio was just 52 percent at year-end 2008. (Numbers taken from the 2008 PERA annual report.)
All pensions had a much better year in 2009, but it was not nearly enough to make up for the previous year’s carnage. And this is where DPS stands now: With a 30-year bond issue to pay off, coupled with higher-than expected payments over the next three decades.
A subset of DPS board members, previously questioning and critical of the interest-rate swap deal, has now turned their attention to the funding level of the DPS pension, with particular worries about a series of “true-ups” included in the legislation that authorized the DPSRS/PERA merger.
The “true-ups,” the first of which comes in 2015, are designed to ensure that the funding of the DPS pension does not fall behind PERA’s Schools division due to DPS’ under-funding of the plan. Every five years, a measure is taken, and the legislature is empowered to ask DPS for money to end any imbalance.
Their concern is based in large part on DPS’ current under-funding of its ongoing PERA obligations. Per the merger legislation, DPS gets a credit against its PERA contributions for the amounts it’s paying on its debt – quite a bit so in these first years after the bond offering.
For 2010, the statutory PERA contribution is $80.4 million; after a $74 million debt credit, DPS is putting just $6.8 million into PERA. In 2011, the contribution of $89.1 million is reduced to $20.6 million.
(Boasberg takes issue with the term “underfunding,” given DPS’ injection of cash last year. “It’s important when you start the clock. If you start it right after the $400 million funding, you’re right. If you start the clock one day before, it’s overfunding.”)
The calculation, however, is misunderstood. Board member Jeannie Kaplan, in a June 30 special meeting, expressed worry that all of those credits come payable five years from now:
“One of the questions I have is by the year 2015, when the first true-up from Senate Bill 09-282 occurs, we will be, according to our figures, $369 million short,” she said. “So my question is, is this not a debt that we’re building up and that we’re going to have to pay at some time?”
A 2015 “true-up,” but based on estimates for 2045
Not in 2015, however, because of the way the “true-up” is calculated. The primary statistic that will be used to compare the funding of the two plans is their unfunded actuarial liability – the excess of benefits owed, over the plans’ assets – as a percentage of payroll.
And the numbers will not be the then-current figures, but will be estimates for 30 years down the road. That means the 2015 true-up will be based on estimates of the plans’ health in 2045.
And even then, the legislation calls for the General Assembly to consider whether to adjust DPS’ contribution rates, which means any gap will be paid off incrementally over the following 30 years – not in one giant lump.
Use sliders at bottom and right to see growth in DPS’ pension expenses through 2040.
Even if DPS owed anything in 2015, predictions of a sudden, lump-sum payment in the tens of millions of dollars – or, as some hyperbolic anonymous commenters on The Denver Post website suggested, a billion dollars – are wrong.
And it seems unlikely that DPS will be found lacking in the first true-up, thanks to its massive lead in funding on the PERA schools division.
At Dec. 31, 2009, PERA’s School division had a 69.2 percent funding ratio and an unfunded liability of nearly $9.36 billion. The unfunded liability was 238.6 percent of the $3.92 billion in payroll.
While the DPSRS annual report has not yet been released, PERA reveals some of its numbers in its own documents: DPSRS has a funding ratio of 88.3 percent, and the unfunded liability is about $387 million, just 92 percent of a $420 million payroll.
It’s not the “true-up,” it’s the annual cash outlay
Again: In the key statistic used for the true-up, PERA’s schools division has more than twice the underfunding DPS does, giving DPS plenty of room to cut its contributions without worrying about a true-up.
Instead, the big problem for DPS is simply the annual cash outlay. Annual pension expense – the debt payments plus PERA contributions – are projected by PERA to increase 10 per cent annually for the next six years, at a rate of 8 percent for the next two, and 6 percent annually until 2032. By the time the growth in pension expense flattens, DPS will be paying nearly $400 million per year.
(The PERA statistics were provided to Education News Colorado by DPS as part of a document that showed DPS’ relative funding strength. When questioned, Boasberg agreed they were the best available long-term projections of DPS’ pension costs.)
The raw numbers are shocking, but they are also reflect many years of inflation – as we all know, a dollar today is worth more than a dollar in 2040. If DPS’ payroll grows by 4.5 percent per year, it will quadruple by 2040 to more than $1.6 billion.
Still, the pension expense as a percentage of payroll will also rise, from a level below 20 percent today to more than 30 percent by 2026. It will fall again by 2033, but remains above today’s levels in every year of the PERA projections.
In short, DPS’ pension costs are likely going nowhere but up. What, exactly, will make DPS able to meet pension payments tomorrow that it didn’t want to pay today?
“All school districts in Colorado are facing the exact same issues over the next several years,” Boasberg said, attempting to minimize concerns. “For all of us, the payments are going to be challenging.”
David Milstead wrote about corporate finance at the Rocky Mountain News for eight years until it closed in February 2009. He previously worked at the Wall Street Journal, among other publications. He now writes for the Report On Business section of The Globe and Mail, Canada’s national newspaper. He passed the Level I exam in the Chartered Financial Analyst program in December 2007.