Pension bonds draw debt-laden governmentsNews added by Benefits Pro on July 8, 2014

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By Nick Thornton

Pension Obligation Bonds tend to be issued by governments with high debt levels, a shortage of cash and a pension plan that represents a big chunk of their liabilities, according to a study by the Center for Retirement Research.

The examination, a look at how POBs have fared since the financial crisis, acknowledges there’s a time and place for POBs but that, too often, the issuers are financially vulnerable and can ill-afford the risk.

“POBs could potentially be used responsibly by fiscally sound governments who understand the risks involved or could play a role as part of a broader pension reform package for fiscally stressed governments,” the paper’s authors wrote.

But the study – produced for the Center for State and Local Government Excellence – found POBs are not being used in that way, and that often they're issued by cash-strapped governments.

“Think Detroit,” warn the authors, “which issued POBs in 2005 and 2006, just as the market was approaching a peak.”

For a brief period in their existence, POBs were a seemingly ideal instrument for state and local governments to raise cash to fund annual pension obligations. First issued by the City of Oakland, California, in 1985, POBs allowed local governments to issue debt, and then take the proceeds from that debt issuance and invest it directly into the assets of pension funds.

Governments would, of course, be on the hook for paying the interest on that debt, but the guaranteed return on higher-yielding U.S. Treasuries held in pension funds would more than cover the obligation, as well as adding immediate cash infusions into pension funds.

And the interest on POBs was tax-free, as it was with other municipal bonds, making them attractive to institutional and retail investors alike, and cheaper than interest on Treasuries, which all but assured a positive return on investment.

They were almost an ideal form of arbitrage for pension sponsors, a way to pump quick infusions of cash into funds while spreading the risk in doing so over a protracted period — 30 years in many cases.

Perhaps too ideal for Uncle Sam’s taste.
The Tax Reform Act of 1986, the high-water mark for proponents of Reganomics, lowered the top marginal tax rate to 28 percent, and the top corporate tax rate to 34 percent.

Yet the federal government was engaged in massive deficit spending, fueled by the Cold War. Tax revenue had to be made up elsewhere, so Congress forbade local governments from issuing tax-exempt bonds that existed solely to reinvest proceeds into higher-yielding securities.

Despite the utility they offered public fund sponsors, POBs, now stripped of their tax-exemption status, were expected to fade into irrelevance.

For a brief time they did, only to re-emerge in the 1990s.

The Center for Retirement Research identified two factors that accounted for the resurgence of POBs in spite of their being stripped of tax-exempt status.

For one, interest rates had been in systemic decline since a peak in the 1980s, making the debt obligations carried with POBs cheaper.

And secondly, pension funds had been reaping the benefits of allocating more cash to equities. Statutory changes in the 1970s and 1980s allowed public funds, which were once almost exclusively comprised of fixed-income investments, to more resemble allocation patterns of private corporate pension funds. Allocation in stocks increased steadily through the 1990s, peaking at about 63 percent between 2005 and 2007.

That meant richer returns, which encouraged governments to re-examine POBs.

With average annual returns on pensions in the 8-percent range, the paper notes POBs offer an attractive option to governments that, because of unfunded liabilities, have higher borrowing costs.

But their risk lies in the possibility of their reward: in order for POBs to not only add value, while not increasing liabilities, they would have to meet those projected returns of 8 percent.

Those assumptions don’t always turn out to be correct.

Then there is the question of market timing. The return on cash raised from POBs is highly susceptible to significant market swings relative to when proceeds are invested in a pension fund’s riskier assets, and when the bonds mature.

The study looked at data available for 4,538 bond issuances since the passage of the Tax Reform Act of 1986. Bonds that matured at the end of 2007, when the stock market was doing well, fared fine. For those that came to maturity in the middle of 2009, the story was much different.

All told, as of February 2014, the majority of POBs were in the black, beneficiaries of the market run-up since the financial crisis. Only those bonds that were issued at the end of the market run-up in the late 1990s, and those issued before the market began to slide in 2007, have produced negative returns.

Notably, states with the highest levels of unfunded pension obligations seem to be the most attracted to juggling the risk of POBs.

Almost all POB activity has been in centered in about 10 states. Illinois has issued more than $10 billion in POBs since the market lows in 2009. California has issued about $26 billion since 1986, most of that coming before 2009.

New Jersey, Oregon, Pennsylvania and Connecticut are the next biggest players in the POB market.

Originally published on
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