Underfunded pensions are a growing challenge across the country, with state and local governments having $4.5 trillion less than is necessary to cover pension benefits owed going forward, according to the Federal Reserve.
Of the 181 public plans tracked by the Center for Retirement Research at Boston College, the National Association of State Retirement Administrators and the Center for State and Local Government Excellence, 31 have funding ratios that are below 60%. With funding costs rising and pressure mounting, 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 believe they can earn more from investments than they will have to pay to borrow. For example, over the past few months (June through August 2021), top-rated AAA, 30-year taxable municipal bonds yielded on average 2.56%, according to TM3. Many pension fund managers assume their investments will yield more than twice that figure.
According to The Bond Buyer, $6 billion worth of POBs were issued in 2020. In 2021, POB volume has continued to increase, with $7.8 billion issued as of August 2021 (Bloomberg).
A true POB vs. deficit financing
It’s important to note that the use of POBs falls into two categories. In what one might think 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.
The other category is a form of deficit financing. The sponsoring government uses the POB proceeds as a replacement, instead of a supplement, for its annual contributions to the pension fund. This usually does not improve the status of the pension fund over the long term and can be a signal of fiscal distress. 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. 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, changing future benefits, making more conservative funding assumptions or creating a more transparent system, there is likely to be more support. Common pension plan reform includes reducing benefits for new hires and implementing higher retirement ages, increased employee contributions, and cost-of-living adjustment (COLA) reductions for retirees and current workers. “We have seen numerous governments with strong bond ratings issue POBs in conjunction with implementing pension reform as well as building in budget reserves to mitigate investment return volatility,” said Kemp Lewis, senior managing director and co-head of Raymond James’ public finance office in New York.
There has been more market acceptance of POBs lately, so investors are viewing these as more than just exotic purchases. “The spread differential between POBs and equivalent general obligation bonds has narrowed significantly over the past 18 months,” according to Emily Giles, managing director in Public Finance/Debt Investment Banking at Raymond James.
Guidance through the POB process
Raymond James served as senior manager on the $324 million general obligation bond issue for the Town of West Hartford, Connecticut, in June 2021. The bond proceeds are being used to fully 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. In April 2020, Raymond James also served as senior manager for Riverside County’s $719,995,000 taxable pension obligation bonds, the largest California POB ever completed.
“In the case of West Hartford, they spent a good six-plus months engaging the actuary, investment advisor, municipal advisor, bond counsel as well as working with us to figure out the appropriate strategy for this pension bond given where they wanted to be,” said Alexander Shih, managing director, Public Finance.