States Turn to Financial Engineering to Ease Pension Burdens

(Bloomberg) -- It's no secret that states and cities across the country are grappling with a growing pension crisis. Now some are resorting to an unconventional tool to help: financial engineering.

California, New Jersey and other governments are moving around resources on their balance sheets lessen the burden of their underfunded pensions as more traditional reforms have failed to fix ailing systems, according to a report by Fitch Ratings. Strategies have included everything from transferring lottery money to public pensions to recognizing future revenues to lower current funding ratios, the report stated.

"States are starting to think strategically about what they have in internal assets and internal cash flow that they can redirect to get their pensions on a steadier footing," Douglas Offerman, a senior director at Fitch who authored the report, said in a telephone interview. "In the context of legal protections for benefits and steadily rising contributions, states are looking for additional ways to steady their pensions."

Public retirement funds across the country have long struggled to balance their books as the cost of benefit packages promised in the past have outpaced sluggish investment returns and government contributions. Though badly needed in many places, traditional pension reforms such as cutting benefits or increasing annual contributions are often difficult issues for state and local politicians to address, both politically and because of legal protections. As a result, reforms are rare and often too tepid to reverse yawning funding gaps.

The political difficulties of passing traditional reforms have led officials to seek alternatives. For instance, California will borrow $6 billion from internal surplus state cash balances to infuse into the California Public Employees' Retirement System. State officials estimated that the transaction, approved as a part of the state's 2018 fiscal year budget, will save $11 billion over the next 20 years. Fitch stated in the report that California is well positioned to realize the plan's goals.

"For California to do this, it's a very unique idea," Offerman said. "It's different than a pension obligation bond or over-contributing because they had a really good year. They are looking internally at their own balance sheet to see what they have available to put into the fund temporarily and they've set up a mechanism to repay it with tax revenues."

While financial engineering may help states in the near-term, the credit rating company warned that it's not a substitute for more traditional reforms that address the underlying issues.

New Jersey, for instance, experimented with alternative methods when Governor Chris Christie signed a law in July that pledged about $1 billion of the state's lottery revenue to some of its public retirement systems, which have long been a drain on the Garden State's finances. While Fitch said it improves the pension's finances, it only raises the system's funding ratio to 58.9 percent from 44.7 percent.

"They cannot go back and make up for all the years when they didn't contribute enough, except at great cost," Offerman said. "It's not surprising that they would be looking at creative ways to address it."

To contact the reporter on this story: Rebecca Spalding in New York at rspalding@bloomberg.net.

To contact the editors responsible for this story: Christopher Maloney at cmaloney16@bloomberg.net, Brian Chappatta