Underfunded pensions are a simmering problem in the U.S., with state and local governments having $1.3 trillion less than is necessary to cover pension benefits owed going forward, according to the Federal Reserve. With the pressure escalating, some governments are looking for solutions in the form of pension obligation bonds (POBs), in which the proceeds of a taxable bond issue are deposited into a pension fund.
In today’s low interest rate environment, POBs appeal to issuers who estimate they can earn more from investments than they will have to pay to borrow. For example, a top-rated, 30-year taxable municipal bond yields on average 3.65%, according to Bloomberg, and many pension fund managers assume their investments will yield twice that figure.
$340 million worth of pension obligation bonds have been sold so far in 2015, according to Bloomberg, compared to just $368 million in all of 2014. And there are billions more on the radar. The Kansas Legislature recently approved a $1 billion pension obligation bond deal, and Pennsylvania is considering billions in pension bonds as well.
However, it’s important to note two categories of these securities. In what is thought of as a true POB, the sponsoring government continues to make actuarially determined annual contributions to the pension fund, with the bond proceeds providing an extra boost to the pension system’s health.
“There are many good reasons why a government might choose to issue a POB, but perhaps the best one is to create a visible and fixed repayment plan to tackle the unfunded pension liability monster that is stealthily growing underneath the budget table of many state and local governments.”
– Kemp Lewis, Senior Managing Director
The other category is a form of deficit financing. The sponsoring distressed government uses the POB proceeds as a replacement, instead of a supplement, for its annual contributions to the pension fund, which doesn’t improve the status of the pension fund over the long term. This type of arrangement has helped contribute to the checkered view of these debt instruments by the public and investors.
The potential public relations liability that comes along with POBs is another thing for issuers to consider. Because distressed governments have issued POBs in the past, the public and media often consider them to be a red flag. Issuing a POB is not for those with a weak stomach. However, they can be a useful tool for addressing the “real debt” of underfunded pensions, especially when paired with reform.
If an issuer is using POBs to manage pension debt while at the same time making adjustments to employee contributions or creating a more transparent system, there is likely to be more support. “Unless you’re fixing the leaks, more money isn’t necessarily a long-term solution,” said Kemp Lewis, senior managing director and head of Raymond James’ public finance office in New York. His office served as senior manager on the $125 million general obligation bond issue for the Town of Hamden, Connecticut. The bond proceeds will be used to partially fund the town’s unfunded pension liability, representing just one facet of a comprehensive strategy developed by the town’s financing team, including Raymond James, to address the mounting issue.
“There are many good reasons why a government might choose to issue a POB,” Mr. Lewis wrote in a commentary for The Bond Buyer in March. “But perhaps the best one is to create a visible and fixed repayment plan to tackle the unfunded pension liability monster that is stealthily growing underneath the budget table of many state and local governments.”