Critics call pension obligation bonds a ‘dumb move’

Kanas Gov. Sam Brownback. Photo: AP

The former chairman of Goldman Sachs once called Pension Obligation Bonds lousy public policy.

Theyre the dumbest idea I ever heard. Its speculating the way I would have speculated in my bond position at Goldman Sachs, said Jon Corzine, who left Wall Street to serve as governor of New Jersey.

In retrospect, Detroit and Stockton, California, might agree. POBs, first deployed by the City of Oakland, California, in 1986, played a prominent role in the bankruptcies of both cities.

Nonetheless, POBs, debt instruments issued by state and local governments for the express purpose of pumping borrowed money into underfunded pension funds, have been picking up steam again.

The idea is to borrow monies at a relatively low interest rate say 4 percent and invest the proceeds within a pension to earn an assumed rate of return of, say, 8 percent.

The comeback of POBs shouldn’t surprise anyone. State and local governments are desperate for ways to address projected public pension deficits of $1.3 trillion.

In one of the more recent examples, trustees of the Kentucky Teachers Retirement System, a pension funded at barely over 50 percent with nearly $14 billion in unfunded liabilities, moved forward last fall with a proposal to jump aboard the POB bandwagon.

The trustees put two proposals at the feet of state lawmakers. One called for a $1.9 billion POB, the other a $3.3 billion POB. Evidently, Kentucky lawmakers were impressed with the trustees pitch, as a House committee opted for the bigger option this week, passing the bill to the state Senate, where it is expected to be reviewed next week.

That $3.3 billion would immediately bump the teachers funding level to 63 percent, according to KTRS trustees.

In Kansas, meanwhile, Gov. Sam Brownback, a Republican, is proposing Kansas sell $1.5 billion in POBs to help close the Kansas Public Employees Retirement Systems $9 billion funding gap.

On Wednesday, a committee in that states House voted to move the issue to a vote on the floor.

The Kansas treasurer said the bonds would pay no more than 5 percent. Compared to the 8 percent return expected of investments made by the pension fund, theres hardly any risk, say proponents.

They also say theres no time like the present to borrow more money, given that interest rates are so low. Waiting to borrow more money even until the end of the year could come with increased costs, as rates rise, they say.

Critics dont buy it. They say the strategy simply presumes too much, exposing strapped pensions to more risk and debt than they can bear.

What politicians are doing is nothing other than borrowing money to buy stocks, taking a bet on the stock market, said Andrew Briggs, who tracks retirement policy at the American Enterprise Institute, a conservative Washington, D.C.-based think tank.

Theres no reason to believe state and local governments have any particular insight into the stock market, he said.

Briggs suggested that politicians and pension trustees are enticed by POBs by the accounting gains they create, and not merely prospective returns.

The Government Accounting Standards Board allows an assumed rate of return of 8 percent on POBs, Briggs explained.

GASB standards allow pension funds to immediately claim an improved funding ratio once the cash is borrowed. That, in turn, means lower annual contribution requirements, which takes the strain off state and local budgets.

And all that takes place before theyve earned a penny of the higher returns theyve assumed. Its a dumb move from a longer-term perspective, said Briggs. But politicians dont care about the long term.

While Kentucy, Kansas and other states consider their options, the Center for Retirement Research at Boston College would most likely suggest financially weak states take POBs off the table .

On average, POBs have returned just about 1.5 percent to issuers, it says. Moreover, the POBs issued at stock market heights in the late 1990s and in 2007 have lost money.

Under the right circumstances, POBs could be a part of a productive strategy for overall pension reform, but evidence to date suggests that the jurisdictions that issue POBs tend to be the financially most vulnerable with little control over timing, according to the CRR report.

Timing, of course, can be critical.

As the CRRs review revealed, the average return seen in 2009, after the financial crisis, was a negative 2.6 percent.

The Government Finance Officers Association, which represents the federal, state and local officials charged with budget administration around the country, recently issued a blunt warning against the considerable investment risk of POBs, recommending state and local governments stay clear of them.

Along with the possibility that pensions fail to generate their presumed 8 percent return, issuing bonds can tie up debt capacity, limiting investment in other areas, the group said in its advisory.

Also, ratings agencies may see their issuance as a distress move, potentially triggering ratings downgrades, making future debt more expensive to issue.

Clearly, such admonitions have fallen on deaf ears in Kansas, largely because of what the plans proponents say was a successful POB issue in 2004, which raised $500 million on bonds issued at 5.39 percent in interest.

In the time since, KPERS has been earning 7.45 percent on average, meaning a profit of about $175 million so far.

Its already been done once, so it can work, KPRS Executive Director Alan Conroy told the Lawrence Journal World.

Brownbacks office didnt respond to questions about concerns surrounding POBs. Instead, it said only that the governor has worked very hard to take the pension system which was the second-worst funded in the nation at the time he took office and improve its ranking.

Pension law changes passed by Kansas in 2012, consisting mainly of higher contributions to the plan from the state and from workers, were projected to raise the plans funding level to 80 percent by 2025. Issuing the POBs now will achieve that by 2022, according to Conroy, the funds director.

That, of course, assumes the funds investment returns continue apace and that the state has no trouble meeting its expenses, including any new annual payments to anyone who buys its POBs.