STUMP » Articles » Public Pensions Watch: UC System Borrows Money Long-Term to Cover Operational Expenses » 21 July 2014, 17:39

Where Stu & MP spout off about everything.

Public Pensions Watch: UC System Borrows Money Long-Term to Cover Operational Expenses  


21 July 2014, 17:39

…which is what the annual “required” pension contributions are.

There are several reasons to be skeptical if one were a bond investor.

Let’s look at the details of the borrowing:

UC regents last week approved borrowing another $700 million internally to help close a pension funding gap, bringing the total borrowed to $2.7 billion in a pension bond-like strategy with risks or rewards, depending on investment earnings.

Five years ago University of California employers and employees were paying nothing into the pension system. In a remarkable contribution “holiday” that began in 1990, payments into the system dropped to zero and stayed there for two decades.

After restarting in 2010, the employer contribution to the UC Retirement Plan increased from 12 to 14 percent of pay this month and most employee contributions increased from 6.5 to 8 percent of pay, a total of nearly $2 billion a year.

But the steady increase of contributions that were once zero still falls short of closing the pension funding gap. Last year UC Retirement had only 76 percent of the actuarially projected assets needed to pay pension obligations over the next three decades.

To help close the funding gap, UC borrowed $1.1 billion from its own Short-Term Investment Pool in 2011 and $937 million from external sources. The $700 million loan approved last week is from the short-term pool.

The UC Retirement fund, with assets valued at about $50 billion, expects to earn an average of 7.5 percent a year, the same as the California Public Employees Retirement System. Critics say the earnings forecast is too optimistic and conceals massive debt.

In what some call arbitrage, money borrowed at a low interest rate from the UC short-term pool (which earned 1.7 percent last year) and invested in the pension fund earns a profit if the return is the expected 7.5 percent or even a little less.

There are so many things wrong with this little scheme, I don’t know where to begin.

First, I don’t quite understand the nature of the $1.8 billion in total borrowed from the short-term pool. Do they have to pay that back short-term? (as in, in under a year) Or is this a longer-term loan, like most pension obligation bonds?

There are problems with either one.

I will explain this later in greater detail, but required annual pension contributions based on that year’s service is an operational expense. You pay for it when service is rendered.

Compare to a 401(k) contribution: say your employer promises a 4% contribution. But then they say they’ll make that contribution ten years from now, but don’t worry, they’ll accrue what is owed to you.

Would you believe them?

(btw, such a move is illegal. I know of some criminal cases based on 401(k) contributions not being made or just outright stolen from employees)

So, for two decades, no contributions were being made. The operating expenses were not being covered, because the balance sheet looked good… right up until it didn’t look good. FFS, they should have locked in gains, but no, they were greedy and stayed way too much in equities.

One should always match one’s borrowing to one’s accrual of expenses. It’s okay to finance the acquisition of an asset (such as a car or a house) with a loan that amortizes over the life of the asset. It’s not okay to take out a 30-year-loan to pay for a trip to Disney. The first is based on good financial principles, the second indicates you are living way beyond your means.

Short-term financing for operational expenses is fine if one has “lumpy” cash flows (which the UC system may have, depending on how they pay their staff. I get paid for my adjunct teaching only during the semester.) But even though they’re calling it a short-term pool, it sounds to me like what they’re doing is borrowing under short-term limits, but keeping rolling over the debt, as if it were a longer-term loan.

I really don’t like the sound of that.

That is something that could escalate rapidly should interest rates start to rise.

Bottom-line: borrowing money for a fake arbitrage is bad finance. The 7.5% return is just an assumption, not a sure thing. Real life returns vary a lot the way they invest it — and the loan interest is a sure thing, just as the pension benefits are a (supposed) sure thing.

So while you wait for my post explaining why PENSION OBLIGATION BONDS ARE OF THE DEVIL, why not read something a bit more measured on the disaster that is borrowing long-term to make pension contributions.

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