Risky business? Evaluating the use of pension obligation bonds.

• Author: Burnham, James B.
• Position: Includes related article

Facing a $5 billion budget deficit for fiscal year 2004, the State of Illinois recently turned to its five retirement systems for savings in its operating budget. The plan: borrow money to refinance a portion of the state's $36 billion unfunded pension liability and use a chunk of the proceeds to cover operating budget contributions to the pension systems, thus freeing up nearly $2 billion to offset budget deficits. As attractive as this plan may appear from a budgetary perspective, the issuance of pension bonds generally carries significant risks that are often downplayed in light of immediate fiscal pressures and the concerns of pensioners. Using two pension bond issues by a previous adopter of this strategy, this article evaluates the conditions under which pension bond issuance may or may not be appropriate.

THE FACTS

The challenge of conscientiously managing pension fund obligations and their funding has never been an easy one. This is especially true after three years of declining stock markets in which the Standard & Poor's 500 has lost roughly 40 percent of its value. This decline in the value of equities has had a major impact on pension fund performance. As the recent bankruptcies of several major airlines and steel companies dramatically illustrate, past promises to retirees play important roles in a fiscal crisis.

The central issue facing many public finance professionals today is, "How do we reduce the unfunded pension liability in defined benefit plans?" The unfunded pension fund liability is the gap between what has been promised to retirees and what is likely to be available to meet those promises. One device to help close this gap, which has gained increasing popularity over the past decade, is the taxable pension bond. Since 1990, state and local governments have raised more than $18 billion through pension bonds (see Exhibit 1). In 2002, some 20 borrowers issued roughly $2.6 billion, with issue size ranging from $2 million to $775 million.

When permitted by state legislation, the pension bond is generally issued by the plan sponsor or pension system entity and is backed by tax revenues. Proceeds are immediately made available to pension fund managers for investment.

Before discussing the pros and cons of this funding device, it is important to emphasize three basic facts about pension bonds. First, the pension plan sponsor does not extinguish any underlying liability associated with the funding gap. With respect to the sponsor's balance sheet, pension bonds simply recast a footnoted contingent liability into on-balance sheet debt.

Second, issuing bonds for the purpose of investing the proceeds in pension fund assets is a classic example of risk arbitrage: "the simultaneous purchase and sale of assets that are potentially but not necessarily equivalent." In this case, the bonds (perceived by buyers as low-risk securities) are sold and the proceeds invested in riskier--and presumably higher yielding--securities.

Third, pension bonds increase the overall level of financial risk for the plan sponsor. Investments must be made in equities, high-yield debt, or highly leveraged portfolios (such as hedge funds) if returns are to exceed borrowing costs. While studies suggest that over sufficiently long periods of time (30 years is a frequent assumption) equities will outperform bonds by 4 percent to 5 percent, that performance comes with increased risk, which is magnified in the short term. (1)

Because pension bonds are used for financial risk arbitrage, the Treasury Department does not permit them to be issued on a tax-exempt basis. This naturally narrows the hoped-for margin of return on pension investments over pension bond costs.

PROS AND CONS

Like many complex decisions, particularly in government, "where you stand depends upon where you sit." From the perspective of pension plan beneficiaries, a substantially underfunded plan can be a source of worry. This is especially true in today's environment, in which pensioners in a number of large corporations...