Pension Obligation Bonds – Are They Right for Your Agency?

On April 29th, CSMFO hosted a popular training webinar: Pension Obligation Bonds – Are They Right for Your Agency? In case you missed it or want a refresher, here’s a quick recap!

Debby Cherney, Chief Executive Officer of the San Bernardino County Employee’s Retirement Association (SBCERA), started off the presentation with a high-level introduction of Pension Obligation Bonds (POBs), before taking a deeper dive into some of the more technical aspects of POBs. Debby stated that “with so many California governments being pitched the issuance of POBs due to current market conditions, we wanted to emphasize that the issuance is not so simple as a simple arbitrage play. Not only did we want to review the GFOA Advisory against POBs, but also take a deeper dive into some other risk areas that should be fully understood before issuing POBs.”

POBs are taxable bonds issued by a state or local government where the proceeds are invested in a pension system or trust. POBs can have a wide variety of deal structures regarding debt terms and amortization. Proponents for POBs argue based on interest rate savings from arbitrage as a result of issuing debt for less than the target rate of return of the pension system.

GFOA’s 2015 advisory argued against state and local agencies issuing POBs, which was strengthened in 2021. Debby reviewed key points of the GFOA advisory:

• POBs are complex instruments that carry considerable risk, especially if they incorporate guaranteed investment contracts (GICs), swaps, or derivatives.
• The likelihood that investments made with the POB proceeds won’t achieve the targeted rate of return, leaving both the POB debt service and new unfunded liabilities.
• Issuing taxable debt increases the debt burden, potentially crowding out other investments such as infrastructure.
• POBs may be structured in a manner that defers the principal payments or extends repayment over a period longer than the actuarial amortization period, thereby increasing overall costs.
• Rating agencies may not view the proposed issuance of POBs as a credit positive.

Todd Tauzer, Vice President and Actuary at Segal, reviewed some of the complexities of POBs analysis, including some key considerations before issuing POBs:

• Structure – Agencies should avoid complex or imprudent structures. Focus on transparency to counter complex structures, and accountability to counter imprudent structures.
• Contribution Rates – POBs increase contribution rate volatility. If you have more assets in the pension system, you have more assets that will increase and decrease with investment experience, which could impact future contribution requirements.
• Volatility Drag – Volatility creates a drag on compounding investment returns over time. For example, a 20 percent loss is offset by a 25 percent gain to take you back to zero.
• Timing Vulnerability – The profitability of POBs is particularly sensitive to market experience in the years immediately after issuance. An adverse experience can have an immediate and compounding effect, which is especially dangerous for governments in vulnerable financial positions. A negative experience after POB issuance creates an additional large amortization layer,
• The Leverage Effect – POBs are essentially governments borrowing and taking on debt to invest in the stock market. Taking on a fixed debt service to invest in a variable pension system is not “free arbitrage.”

Todd then reviewed some “negative” and “non-negative” public finance considerations. For the negative considerations, rating agencies warn that POBs do not fix underlying funding issues, should not extend past the amortization of the UAL to generate savings, should not start with zero-payment or interest-only window, should not be used to cover annual contributions, and will receive particular scrutiny if the issuer is financially distressed.

The “non-negative” public finance considerations include that POBs would most likely be considered neutral for credit rating agencies and ongoing finances if they are issued without any of the negative factors and maintain intergeneration equity. Additionally, POBs could be considered positive if it is part of a larger “funding package” that addresses underlying funding issues and improves funding discipline.

Looking back on the training, Todd shared that “Pension Obligation Bonds undeniably add risk to plan funding by taking on leverage to invest in the plan. A government should perform thorough, informed, and objective analysis prior to the determination of whether that risk is worthwhile or not.”

Michael Cohen, Chief Financial Officer of CalPERS, shared CalPERS perspectives on POBs. Michael shared that CalPERS does not have an official position on POBs primarily because there is an incredible amount of nuance in the issuance of bonds. However, when reviewing POBs, Michael recommended remembering to include PEPRA impacts in projections. Many agencies are trying to develop a plan for the next ten years as classic members retire and PEPRA employees become the majority. Participants can utilize CalPERS’s Pension Outlook Tool and treat a POB as an additional payment to try and project the overall impact on the pension system.