In July, Boston College’s Center for Retirement Research released a study showing that Pension Obligation Bonds (POBs), a financial instrument used by some state and local governments to pay down pension debt through borrowing, can leave governments worse off financially than they were before issuing the bonds. Cities like Detroit, Stockton, and New Orleans have all been negatively affected by bad POB deals. Places considering issuing POBs in the future, like the Commonwealth of Pennsylvania, should take note that if properly used in limited and specific circumstances, POBs can be a tool for fiscally sound governments or as part of a broader pension reform package for fiscally stressed governments. However, successful POB strategies are more the exception, and not the rule with considerable risks that can quickly sink a city or state.
A POB is a government bond that allows governments to issue taxable bonds with the proceeds of the bond issue going towards paying off all or part of the governments unfunded pension liability. POBs are intended to reduce the pressure on the government’s cash position and offer cost savings if the bond proceeds are invested through the pension fund in assets that achieve a rate of return higher than the cost of the bond. Governments can make money off these bond deals if the conditions for arbitrage are realized, but all too often they are not and the results can be ruinous for cities and states.
The Boston College study found that POBs’ net returns have varied depending on when the bonds were issued. The average return of bonds issued between 1992-2014 was 1.5 percent. The study found that governments that issued POBs in 1998, 1999, 2000 and 2007 lost money on their investment, and from 1992-2009 (a period which doesn’t include the gains from the most recent market upswing) the average rate of return on POBs was -2.6 percent. The rate of return findings from POBs issued between 1992-2009 were first reported in a similar Boston College study back in 2010, and referenced in a 2011 Congressional Research Services paper highlighting the riskiness of POBs.
The new study, which examined about 4,500 POBs issued since 1992, also found that economic factors such as a higher unemployment rate and higher debt-to-revenue ratio increased the likelihood of a government issuing a POB. With financially distressed governments being more likely to issue POBs, the results often mean even more financial problems. Rather than relieving distressed governments of financial pressures, Pension Obligation Bonds actually create a more rigid financial environment-turning a somewhat flexible pension obligation into a hard and fast annual debt payment.
The city of New Orleans, sold about $170 million in POBs in 2000 to finance the pensions of 820 retired firefighters. City officials expected that the bond proceeds would be invested in assets that would pay 10.7 percent a year (higher than borrowing rate of 8.2 percent on the bonds), but instead the city’s investments lost value. The city also failed to hedge against interest rate increases, leaving New Orleans paying 11.2 percent interest on the bond debt. The city was able to fix its financial blunder, when it was able to sell $200 million more in bonds in 2012 to refund the outstanding POBs that were issued in 2000 and costing the city money.
But things can turn out even worse for cities issuing POBs.
In 2007, the city of Stockton, California sold about $125 million in Pension Obligation Bonds to obtain cash to close a shortfall in its pension plans. For the deal to work out for Stockton, CalPERS needed to average at least 5.81 percent a year on its pension fund earnings, but CalPERS lost 25 percent in the financial crisis beginning in 2008, leaving Stockton in worse shape than ever, with new debt to CalPERS on top of its existing debt to bondholders. The failed POB strategy played a key role in the city’s decision to file for bankruptcy in 2012.
A similar outcome occurred in Detroit, Michigan when its POB deal went bad. In 2005, then mayor, Kwame Kilpatrick issued $1.4 billion in Pension Obligation Bonds, at the height of the market, to fund the city’s general employee pension plan. The POB issue made the city’s pension plan appear to be fully funded, without needing to increase employee contributions or laying-off city employees. The deal ended up going bad for Detroit in 2013, with the city still obligated to pay bondholders with even less day-to-day cash to meet its financial obligations than it did at the time of the bond issue. The debt from Detroit’s bad POB deal played a key role in the city’s decision to file for bankruptcy last July.
The state of Pennsylvania is currently weighing the risks and rewards of issuing POBs to shore up its pension system. With proposed budget cuts being so politically unpalatable and the state facing a $50 billion unfunded pension liability, Pennsylvania is considering issuing as much as $9 billion in POBs. The bonds would cost taxpayers $10.4 billion with interest over 30 years, and even more if the states pension fund investments perform poorly.
The risky strategy of issuing POBs is often employed by cities and states in a poor financial position to shoulder the investment risk that comes with it.While the nature of governments’ indebtedness changes, the total amount of indebtedness does not, and debt payments become more inflexible. Governments often times struggle to meet expected rates of return on their pension investments, and if they fail to achieve these expected rates of return after POBs are issued, the results can be disastrous. As Reason’s Adrian Moore put it,“Borrowing to make payments into a fund for future pension obligations is like me borrowing from my bank to pay my credit card. [It’s] bad financial management.”Cities and states considering issuing Pension Obligation Bonds, like Pennsylvania, should take note.