Proposed Bond Issuance: FAQs
Below are some common questions that people have asked about the bonding proposal.
1. What is the annual funding obligation to retiree pension and health care?
Last year, Washtenaw County’s required annual contribution for retiree pension and health care coverage exceeded $20 million. These dollars directly fund obligations to:
- The Washtenaw County Employees' Retirement System (WCERS), a defined benefit retirement program, provides accrued monthly pension benefits to retired members and beneficiaries.
- The Voluntary Employees Beneficiary Association (VEBA) provides, through insurance contracts, medical benefits for retired employees of the County, their spouses and dependents.
2. How does the County determine the annual funding obligations to WCERS and VEBA?
Washtenaw County receives an actuarial report on an annual basis that defines how much funding the County needs to set aside to cover funding obligations to retirees for the next year. The actuarial report takes into account many variables – including the participant demographic (age, projected lifespan, salary, increase in fringe benefit costs) of employees in the plan, as well as past and expected future market performance of investments. These factors assist in determining the level of funding needed to meet these obligations. Given the number and complexity of variables involved, as well as their unpredictability from year to year, this situation causes significant uncertainty in the County’s budget process. It is nearly impossible to know with any degree of confidence what the County’s retirement obligations will be from year to year under the current system.
3. What is a bond?
A bond is essentially an “IOU.” A bond serves the same purpose for an organization that a mortgage note serves for someone who is purchasing a house. An organization issues – or sells – bonds to one or more investors in order to generate a certain sum of liquid – or readily accessible – funding from one or more investors, just like a homebuyer borrows money from a bank to pay for a house. Then this debt is repaid over time according to a predetermined schedule that specifies the amount of principal and interest the borrower owes each year, just like the amortization schedule for a household mortgage.
4. How does bonding work?
The County has carefully calculated the amount sufficient to fulfill the current total unfunded liability created by the County’s retiree pension and health care obligations as reported in the most recent valuations on file (December 31, 2011), and this sum – up to $350 million – is the amount for which the County is proposing to issue bonds.
In order to issue these bonds, the County would put together a prospectus, which describes the amount of money that the organization wishes to borrow, the purpose for borrowing the money, and assurances about the County’s ability to repay the debt. After considering the prospectus, along with all other information available about the County, one or more investors (usually a large investment bank) will make an offer to purchase the bonds. The County would then enter into an agreement with the investor offering the most favorable terms (chiefly, the lowest repayment interest rate).
That investor provides the bond proceeds in a lump sum amount, which will be directed into an Intermediate Trust, created for the sole purpose of receiving these funds. This Trust is restricted; the money in the Trust cannot be used for any purpose other than paying for retiree pensions and health care (or to retire the bond debt early), providing protection against the temptation to redeploy these resources elsewhere. The Trust will fund retiree benefits by directing the appropriate amount of funding to WCERS and VEBA every year.
It is important to note that the County retains the ability to invest the money held within the Intermediate Trust. The goal is to invest the proceeds such that the returns on investment modestly outpace the bond repayment rate, providing the ability to fund current retiree pension and health care obligations, stability for the organization, and security that future obligations will be met.
The County would still direct the annual required contribution to retiree pension and health care benefits to the WCERS and VEBA funds, respectively, but these would no longer come out of the General Fund. Rather, these contributions would be paid from the Intermediate Fund, and the bond repayment obligations would be paid from the General Fund. (See flow chart here)
5. Does a bond issuance create exposure to stock market volatility? Is the County concerned about this risk?
The County is very concerned about the investment of all of the money for the WCERS and the VEBA. This includes the money already in the WCERS and the VEBA and the rest of the money which will come from the bond issuance.
The three methods by which the new money will be managed to reduce the risk include:
Selecting a professional investment firm to manage the investment, with watchful oversight by an appointed Board of Directors. The Board of Commissioners has already emphasized their intent to invest the bond proceeds cautiously, with an eye toward preserving the principal rather than growing the funds. This intent will translate into a directive for the investment firm to manage the funds with discipline and impartiality.
Taking the long view. The Intermediate Trust will be invested over the 25-year term of the bond. The length of the investment’s time horizon helps smooth market volatility, as the fund has time to recover from any short-term swings in the market.
Selling bonds at the lowest possible interest rate (currently hovering around 4%, and expected to rise soon), so the annual bond repayment obligation is as modest as possible. The lower the interest rate the County can achieve the better chance that the bond proceeds’ investments will outpace the repayment rate. View the presentation that Professor Jens Stephan delivered on this concept at the June 6, 2013 Working Session. Put simply, if the County borrows $350 million at a repayment rate of 4%, and then invests that sum in the market, the return need only be greater than or equal to 4% over the life of the investment in order for the bonding experience to be positive. For reference purposes, over the past eight years – a time of significant market volatility – the WCERS has grown an average of 6.30%, and the VEBA has grown an average of 7.45%.
Finally, it is important to remember that the County’s retirement (WCERS) and health care (VEBA) funds are currently invested in the market. Regardless of whether the County proceeds with the bond issuance, this exposure will exist. For this reason, it is equally important for the WCERS and VEBA funds’ investments are managed well, as the performance of these funds will influence the annual required contribution from the Intermediate Trust.
6. What’s a bond rating?
An organization’s bond rating is much like an individual’s credit score; it communicates information about the person or organization’s likelihood to be able to repay the debt according to the specified terms. Washtenaw County’s bond rating is currently AA+, meaning the County is considered a very low-risk borrower. Just like with personal finance, the better your bond or credit rating, the more favorable terms one can expect to receive on debt.
7. Why is now a good time to issue these bonds?
The County is proposing to take advantage of a handful of circumstances that, together, provide a uniquely favorable window of opportunity for a bond issuance:
- Interest rates are at historic lows. Borrowing money has not been this inexpensive since the 1950s. The County anticipates the ability to sell bonds at a repayment interest rate of around 4%, which is significantly lower than the rate of funding increases required to meet the County’s obligations to retiree pensions and health care. Further, the County plans to invest the proceeds from the bond issuance. It is important to note that the County is not proposing bonding as a means of making a profit. The magnitude of the bond is deliberately conservative: $350 million is a high water mark sufficient to fulfill the current total unfunded liability created by the County’s retiree pension and health care obligations as reported in the most recent valuations on file (December 31, 2011). With the closure of the pension and health care plans, these legacy costs have been contained. Therefore, the Intermediate Trust need only earn an average of 4% – commensurate with the bond repayment interest rate – over the course of the 25-year term of the bond to remain solvent. Considering the long time horizon, this rate of return can fairly be described as modest. With that said, the Intermediate Trust only represents one piece (i.e., the unfunded liability) of the funding puzzle for retiree pension and health care costs. Careful management of the dollars already set aside to fund pension and health care obligations (in the WCERS and VEBA trusts, respectively) is imperative, to ensure that these funds maintain healthy balances as well.
- New accounting regulations, promulgated by the Governmental Accounting Standards Board (GASB 67 & 68), will require the recording of the unfunded pension liabilities to be shown as “debt” on an organization’s balance sheet effective for year ending December 31, 2015. It is anticipated that this same recording will be required for retiree medical benefits beginning with the year ending December 31, 2017. If this level of debt is not addressed – either by restructuring the pension/health care obligations through a bond issuance (Alternative A), or making structural/staffing reductions within the organization (Alternative B) – in advance of the new rules’ taking effect, the County’s bond rating could be downgraded, which makes future borrowing more expensive and difficult.
- In October 2012, the Michigan legislature enacted a law to allow counties to issue bonds for retiree health care obligations. The law specifies that this opportunity will expire on December 31, 2014.
- Washtenaw County recently completed a collective bargaining process that resulted in 10-year contracts with the majority of the County’s employees. The contracts specify that the existing defined benefit (pension) plan will be closed. Therefore, employees hired on or after January 1, 2014, will be enrolled in a defined contribution (similar to a 401(k)) plan. The new collective bargaining agreements also closed the County’s Voluntary Employee Benefit Association (“VEBA”) to new employees beginning on January 1, 2014. VEBA is the vehicle for funding retiree health care costs. The closing of the defined benefit plan and the VEBA trust to new employees triggers a change in the method used to calculate the employer’s annual contribution to the accounts that fund these obligations; this change is a significant factor in determining the annual required contribution. Issuing bonds effectively restructures this debt, helping to resolve the approximately $7 million structural deficit projected for 2014-2017.
8. What will happen to any remaining proceeds if the County’s Intermediate Trust does, indeed, outperform the bond repayment schedule?
First, the County could choose to retire, or pre-pay, the bond debt earlier that originally projected. If any proceeds remain after the bonds are fully repaid after 25 years, a future Board of Commissioners will have the opportunity to determine how to apply these funds.
9. Will the County raise taxes to generate funds for the bond repayment?
No. If the bond issuance is approved and finalized, the County will redirect General Fund dollars that would otherwise funded retiree benefits to repay the bond issuance instead. Retiree benefits would be drawn from the Intermediate Trust, in which the bond proceeds (and any returns generated through the proceeds’ investment) would be held.
10. What is the alternative to a bond issuance?
Per State law, the County must produce a balanced budget every year – and per the State constitution, the County must also meet the pension obligations that have been promised to retirees. Similarly, retiree healthcare is a contractual obligation for the County. If the County does not issue bonds to pay for retiree benefits, these funds would need to be allocated from existing General Fund dollars. The County is currently projecting a nearly $7 million deficit for 2014-2017, taking into account all known variables; of this amount, the increased required annual contribution for pension and health care costs represents just over $5 million. The County is already planning to reduce annual operating costs (through organizational downsizing and reduced contributions to outside agencies) in the amount of nearly $2 million. Resolving the entire projected $7 million deficit solely through organizational restructuring would demand the elimination of 80-100 positions. In order to achieve the necessary impact, most of these positions would need to be clustered in departments that rely most heavily on General Fund dollars, such as Public Safety and Justice. (See more detail on the implications of these reductions here)
11. Other communities – like Detroit – have issued bonds for retiree benefits and ended up in worse shape than before. What is different about Washtenaw County’s proposal?
The City of Detroit made two critical errors in issuing bonds for retiree benefits:
- They underestimated the actual unfunded liability, meaning the bond issuance was not large enough to cover all the costs they wished to cover; and
- They continued to enroll new employees in the defined benefit plan, meaning the City continued to incur more and more retiree obligations, rapidly outpacing the amount of funding generated by the bond issuance.
Washtenaw County is using a conservative estimate of total unfunded liability, and has already identified the date of closure for the defined benefit plan. As of January 1, 2014, all new employees will be enrolled in the defined contribution plan (similar to a 401(k)) instead of the defined benefit plan. These obligations, therefore, have been contained.
12. How will the County fund retiree health care obligations now that the VEBA is closed?
Beginning on January 1, 2014, new employees will be provided Health Reimbursement Arrangement (“HRA”) accounts for their use upon retirement. Under the HRA, the County establishes an individual retiree health care account for each new employee and contributes a set amount to that account every pay period. Each employee covered by the HRA has the power to determine how those funds are invested. These funds can only be used for qualified medical expenses upon retirement.
13. Has the actuarial report been completed?
An actuarial report as of 12-31-13 is in process. It will be presented to the WCERS & VEBA Boards on July 30, 2013 and available to the public shortly thereafter.
14. Has the financial report been completed?
The Comprehensive Annual Financial Report Year Ended December 31, 2012, has been completed (link provided).