Pension obligation bonds: benefits and risks.

• Author: Tigue, Patricia

Managing unfunded pension liabilities is an important responsibility of municipal pension fund administrators. Although public pension plans were 86 percent funded in 1992, the unfunded pension liabilities of state and local governments--currently estimated at approximately $150 billion--represent a significant burden on future taxpayers.(1) In recent months, several jurisdictions have issued taxable bonds to refinance their unfunded pension liability. These jurisdictions have found that, with interest rates at their lowest level in years, issuing taxable debt is currently a cost-effective option to fund their pension plans. Nevertheless, state and local governments contemplating this option need to consider the trade-offs before making a long-term debt commitment.

Calculating a jurisdiction's pension liability is a complex procedure. Most often, it is based on an actuarial estimate of the value of the assets in the pension fund and benefits to be paid over an extended period of time (e.g., 20 to 40 years). This process involves projecting such factors as salaries, inflation, number of retirements and deaths of beneficiaries covered by the plan, as well as earnings on assets. Unfunded liability is the difference between the benefits expected to be paid and the assets held by the pension fund, including contributions and assumed earnings.

The most common approach for administrators interested in reducing their unfunded pension liabilities has been to increase payments above the normal contribution until the unfunded liability is fully amortized. This generally occurs over a period of 20 to 30 years. The additional payments are sufficient to cover both the present value of the unfunded liability and an interest component based on an assumed rate. The cost effectiveness of using bond proceeds to fund the liability is dependent on this assumed interest rate and the interest rate on the bonds.

In the mid-1980s, some jurisdictions were able to issue tax-exempt bonds to purchase annuity contracts to fund pension obligations. The 1986 Tax Reform Act, however, effectively ruled out the use of tax-exempt bonds for purposes of investing in annuity contracts or other investment-type property to fund pension liabilities; under the provisions of the act, they are no longer eligible for federal tax exemption. The Internal Revenue Service (IRS) characterizes such bonds as taxable arbitrage bonds because the implicit interest rate on the annuity contract is considered to exceed the yield on the bonds.

Taxable Bonds for Pension Funding

Taxable bonds now have become an alternative for governments interested in reducing their pension fund obligation. In the past, issuing taxable bonds did not make economic sense because the debt service cost of the bonds outweighed any savings in required pension contributions. As interest rates have declined, however, some governments have found that taxable municipal debt can be issued at rates below the pension plan's assumed interest rate, resulting in significant savings over the life of the bonds. Interest rates on 30-year Treasury bonds are now in the range of 6.25 to 6.35 percent, as shown in...