Pension Bonds Encourage Underfunding

Many economists consider Pension Obligation Bonds (POB) as risky gimmicks attempting to gamble on borrowed money. A recent article at ProPublica explains how a deeper problem with POBs lies not in mere investment risks, but in perverse political behavior.

Despite warning about their risks, POBs’ popularity among governments seems to have not waned. According to the article, governments issued $670 million of POBs during the first half of this year, more than double the amount sold for the whole last year. And more is yet to come.

Besides investment profits, new accounting rules may be an important factor driving the current POB boom. The new GASB rules require heavily unfunded plans to use a lower discount rate to value liabilities. This inadvertently encourages poorly funded plans to borrow money to resume using the high discount rate, creating a false impression that the funded status is better than it really is.

Pension bonds themselves are not as much a problem as the ensuing political behavior. Plans that issue POBs tend to subsequently have “pension holidays”, failing to pay the required contributions in full. A review by ProPublica of the 20 largest POB issues since 1996 found that governments in three-fourths of the issues underpaid pension contributions after the bond sales. This is consistent with public choice theory: issuing POBs makes the pension plan look artificially better, allowing politicians with short-term political horizon to shift money to more immediate needs at the expense of future taxpayers.

To read the full article, go here.