This commentary challenges two common criticisms of pension obligation bonds that have been repeated so often their truth may appear to be self-evident. Before addressing the criticisms, I would like to propose new labels for two very different types of bonds that unfortunately both carry the title POB. In both, the proceeds of a taxable bond issue are deposited into a pension fund.
After the issuance of a "True POB," the sponsoring government continues to make actuarially determined annual contributions to the pension fund so the deposited bond proceeds improve the pension system's long-term funded balance.
After the issuance of a "Faux POB," the sponsoring government takes a pension funding holiday. The bond proceeds are used to offset what otherwise would have been annual contributions to the pension fund.
A Faux POB does not improve the long-term funded status of the pension fund. It is a deficit financing for the sponsoring government. A Faux POB is often dressed up as pension reform providing a political and false message that something has been done to improve long-term pension funding. Considerable taxpayer dollars have been wasted for the wilted fig leaf of respectability provided by a POB title. Many Faux POBs could have been issued as working capital bonds at materially lower tax-exempt interest rates if the bond proceeds had been deposited directly into the government's general fund.
The rest of this commentary addresses the criticisms of True POBs.
Criticism #1: POBs are nothing more than a way for governments to create a leveraged, speculative investment.
All state and local government pension funds are fully funded.
Pension funds that do not have investment assets on their balance sheets equal to the actuarially determined present value of the projected benefits own a fixed income asset that is a debt of the sponsoring government. I'll call it a "Sponsor Bond."
A Sponsor Bond is:
- Secured by a super priority general obligation pledge;
- Structured to a have a fixed rate of interest that can be reset by changing the actuarially assumed earnings rate;
- Much like a payment-in-kind bond in that the obligor has the right to either pay interest or let the interest accrete into a higher par value; and
- Prepayable at par at any time.
The issuance of a POB by the government is the functional equivalent of the pension fund selling its Sponsor Bonds and using the proceeds to buy a diversified portfolio. Issuing a POB to replace one type of debt with another type of debt affects neither the size of the government's liabilities nor the size of the pension fund's economic assets. The sale of a POB allows the sponsoring government to reduce the interest rate on its debt and the pension fund to diversify its investments.
Investment risk is inherent in the funded defined benefit pension model.
If the market risk of a diversified investment portfolio - including equity, real estate and private investments - creates a material budgetary risk for the sponsoring government, then that risk should be examined for every government that has a pension fund. Paradoxically, investment risks typically are greater for well-funded plans precisely because they hold fewer Sponsor Bonds and other fixed income assets. An argument can be made that many public pension funds' portfolios are too risky as the funds strive to achieve the somewhat arbitrary investment return assumptions permitted by the Governmental Accounting Standards Board. However, the source of the money that is in the fund, be it from contributions, past earnings or bond proceeds, is irrelevant to the measurement of risk and the sponsoring government's ability to bear it.
In a right and proper world, GASB would rewrite its rules for pension accounting to include the government's guarantee of the pension's benefit payments as two assets on the balance sheet of the pension (and liabilities on the balance sheet of the sponsoring government): (i) a fixed income debt obligation equal to the unfunded pension liability valued at the government's cost of capital and (ii) the value of the government guarantee of the rate of return on all the investments in the fund as well as every other actuarial assumption. Ultimately the sponsor will have to pay to fill the hole of any unachieved assumptions.
This is not financial sophistry. In the vast majority of cases, the debt owed by governments to their pension funds will ultimately be paid in full, with interest. And the budgetary risk created by guaranteeing the rate of return on a large investment portfolio is also very real, but that risk is independent of the sources of funding of the pension investments. It is inherent in all funded defined benefit pension plans, regardless of the source of funding.
Criticism #2: A POB is risky for the sponsoring government because it converts a soft liability into a hard liability.
If what is meant by this statement is that an unfunded pension liability is less likely than a POB to have to be ultimately repaid, the courts' approvals of the bankruptcy exit plans for Stockton and Detroit clearly show this to be a fallacy. To quote Judge Rhodes in his Detroit decision, "The City has a strong interest in preserving its relationships with its employees. It has no similar 'mission-related investment' in its relationships with its other unsecured creditors, including bondholders." Pension liabilities are very hard to shed. The message to bondholders: get a lien or get in line.
If creating a hard liability means it is more difficult for the sponsoring government to postpone its repayment, then I say "YES." Actuaries and accountants have created rules that permit governments to pay less than the accruing interest on the unfunded balance each year even when they are paying exactly what the actuaries tell them to pay. This is an extremely well-disguised form of deficit financing for the sponsoring government. A "level percentage of payroll" amortization plan (upward sloping payments) will very often have ten years or more of negative amortization. Open amortization (extending the term at every new actuarial valuation) and periodic ad hoc re-amortization of closed systems can create perpetually increasing negative amortization. In these de-funding models, if every actuarial assumption is met, including fully funding the actuarially required contribution, or ARC (now actuarially determined contribution, or ADC), and achieving the targeted investment return, the unfunded liability is mathematically scheduled to grow forever.
While the repayment schedules for bond debt are fully disclosed and carefully analyzed, the disclosure of the projected amortization of unfunded pension liabilities - in actuarial reports, pension plan financial statements and the financial statements of the sponsoring governments - is abysmal. Rarely do you see a disclosure of negative amortization in an actuary's or accountant's report. In fact, they use the term "amortization" to refer to the payment on the unfunded liability even when that payment is less than the annual interest on the liability. I sincerely believe that many decision makers do not know what is occurring behind the curtain of actuarial science. Many governments that are dutifully making their full ARC/ADC payments are completely unaware of the ballooning liability buried in the actuarial computations. As a government creates its annual budget, there is a natural and understandable tendency to choose "funding" plans permitted under generally accepted accounting principles that invisibly push a growing liability further into the future, since they lower current contributions.
There are many good reasons 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 is a senior managing director at Raymond James Public Finance in New York
