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With the cost to issue debt at record lows, there’s been an upswing in local governments turning to pension obligation bonds.
More governments are looking to a controversial borrowing practice to shore up their pensions even as a leading public finance organization is warning against it.
A number of governments have issued pension obligation bonds, or POBs, over the last year as record low borrowing rates and budget pressure from the pandemic-driven economic downturn have made them more appealing. Among the issuers are more than two dozen California cities, including Riverside and San Bernardino; Arlington, Texas; and Boulder, Colorado.
The wave has prompted the Government Finance Officers Association to issue an advisory reminding its members that it strongly recommends against issuing bonds to cover pension debt. GFOA’s government liaison director Emily Brock said the resurgence of the practice is concerning because, among other things, POBs tend to be complex financial instruments that increase a government’s bonded debt.
“Governments are not nimble, but these financial products need to be executed at the perfect time,” she said.
Pension obligation bonds are generally issued as a way of controlling governments’ pension contribution costs. The bond proceeds are put into the pension system, immediately providing a boost in investment assets and funded status. A better funding ratio means governments typically have more predictable or manageable pension payments in the future.
But POBs can be a gamble. In order for them to pay off, the bond proceeds in the pension system have to achieve a rate of return that is greater than the interest rate owed over the term of the bonds. What’s more, unlike general obligation bonds, POBs (also issued as certificates of participation) are taxable debt for the investors who buy them. That means governments have to pay a slightly higher interest rate on the debt compared with non-taxable bonds.
Timing bond purchases correctly can come down to luck. Some governments issued POBs in 2007 and 2008, only to see those proceeds disappear after the stock market crashed.
But Brian Whitworth, a director at Hilltop Securities who has been involved in POB sales, said the idea that issuing the bonds is risky simply because of their interest rates is a bit misleading.
“If you're only getting a 3.5% rate of return on all your pension assets [over the length of the bond], you have a much bigger problem,” he said. (Government funding plans for pensions are typically built on the assumption that the long-term rate of return will be at least 6% or 7%.)
In other words, there are broader risks to pensions from lackluster investment returns whether or not governments opt to issue POBs.
Whitworth added that the current low interest rate environment is driving a lot of the recent activity as most governments are seeing fixed rates between 2.5% and 4% for 25-year bonds. Governments are aware of GFOA’s guidance and Whitworth said he has observed many officials doing what they can to hedge against the risks with the bonds.
West Hartford, Connecticut, is a prime example. Officials there recently approved selling $365 million in pension obligation bonds in order to fully fund the city’s long-struggling retirement system. Payments to the system were increasing by more than $1 million a year and threatening to dominate West Hartford’s $310 million budget.
Mayor Shari Cantor said the city was meticulous in its approach and considered every possible risk. The finance staff studied the issue extensively and stress-tested thousands of scenarios.
To hedge against future volatility with investment returns, the city will set aside the roughly $30 million pension payment it would have had this year in a soon-to-be-created reserve fund. And to minimize the risk of early losses in the market, West Hartford plans on spreading out its investments from the bond proceeds over a couple years.
The city estimates that issuing the bonds would save $140 million in pension costs over 25 years and the pension reserve fund would build to $60 million. “And that’s assuming the cost of borrowing for the city is 3% and we think we can do better,” Cantor said.
She added that city officials have been openly considering the possibility of POBs for years as they have increased pension contributions while also steadily lowering the system’s expected rate of return to a more realistic target of 6.25%.
“We kept holding out and thought [our funding ratio] was going to start to turn, and it just hasn’t,” Cantor said. “It’s just taking too long and it’s eating up too much of the budget.”
Liz Farmer is a journalist and fiscal policy expert who often writes about budgets, fiscal distress, and tax policy.