WASHINGTON — State and local governments are more likely to issue pension obligation bonds if they face financial pressures, according to researchers at the Center for Retirement Research at Boston College.
The finding is similar to the result of a study CRR published in 2010.
"While POBs could potentially be a useful tool under the right circumstances, evidence to date suggests that the jurisdictions that issue POBs tend to be the financially most vulnerable with little control over the timing," the researchers wrote in the new paper.
POBs are taxable bonds whose proceeds are invested with the issuers' pension plan assets. The bulk of POB issuance from 1985 to 2013 has been in about 10 states, notably Illinois and California, CRR said.
There are two main reasons why issuers may find POBs to be an attractive policy tool. One is that they can provide governments with budget relief during times of economic stress. The other is that they can reduce the cost of pension obligations by being invested in assets that have a higher rate of return than the interest rates of the bonds, the researchers said.
However, there are also risks to issuing POBs: their returns may not average more than the cost of financing the debt, they involve a good deal of timing risk, and they are "inflexible debt with required annual payments," the paper said. Additionally, governments could end up with pension systems that have more assets than liabilities, which could lead unions and others to call for benefit increases even though the underfunding was just moved from the pension plans' balance sheets to the governments' balance sheets.
In order to see if governments are earning more on the proceeds of their POBs than they have to pay in interest, CRR researchers assessed the internal rates of return for POBs at three points in time: 2007, 2009 and 2014. The researchers found that the economic recovery following the Great Recession has improved POBs' rates.
In the middle of 2009, after the stock market crashed, most POBs appear to have been "a net drain on government revenues." As of February 2014, most POBs have produced positive returns because there were large gains in financial markets following the financial crisis. The only POBs that have produced negative returns were those issued at the end of the 1990s market boom and those issued right before the crash in 2007, CRR said.
From 1992 to 2007, the average internal rate of return on POBs was 0.8%, while from 1992 to 2009, it was -2.6% and from 1992 to 2014, it was1.5%, according to the paper.
The study's authors also conducted an analysis to see what factors contribute to governments' issuing POBs.
They found that "governments are more likely to issue POBs if the plan represents a substantial obligation to the government, they have substantial debt outstanding, and they are short of cash," the researchers wrote in the report. Governments also are more likely to issue POBs if they are in a state with relatively high unemployment, if they administer their own pension plans, and if the spread is greater between their retirement systems' investment returns in the past three years and the 10-year Treasury rate, the researchers found.
The paper suggests that POBs could be used responsibly by fiscally sound governments that can take on the risks of the bonds. POBs also can be issued "as part of a larger pension reform plan in which the POB helps provide immediate relief while other reforms put the plan on the path to long-term sustainability," the researchers said.
However, these aren't the ways that the bonds are being used. For example, Detroit issued POBs in 2005 and 2006 as the stock market was approaching a peak, the paper said.
