STUMP » Articles » Pension Obligations Bonds ARE OF THE DEVIL (Don't do it, Brownback!) » 7 February 2015, 07:21

Where Stu & MP spout off about everything.

Pension Obligations Bonds ARE OF THE DEVIL (Don't do it, Brownback!)  


7 February 2015, 07:21

Did that get your attention?

I just think it’s a bit stronger than what this guy had to say:

“If you cover current obligations by borrowing money, you’re on an unstable course,” said Mr. Ravitch.


Okay, this may be overstating the case, let’s see what other experts have to say about POBs (pension obligation bonds):

“This should be a tool in a well-functioning governments arsenal,” said Alicia Munnell, the Center’s director. “Unfortunately, those that use them tend to be cash-strapped and desperate.”

If basically every government that uses Pension Obligation Bonds is cash-strapped and desperate, might it be that POBs are a shitty tool?

The reason this comes up now is that Kansas Gov. Brownback is considering using POBs to “fix” the problem of Kansas’s underfunded pensions and rising pension costs:

Kansas is considering a corner of the municipal-bond market most states have come to avoid because of its risk—a $1.5 billion sale of so-called pension bonds to boost returns at the state retirement system.

The strategy, which Gov. Sam Brownback is proposing in the face of a growing state deficit, would help lower annual state contributions to the Kansas Public Employees Retirement System. Under the plan, the state would issue bonds and then invest the proceeds, making a decadeslong bet that pension-fund returns will exceed current interest rates for taxable municipal bonds.

Where Kansas sees a market opportunity, some bond investors see a warning. Pension-obligation bonds remain only a sliver of the $3.6 trillion municipal market even as many states wrestle with oversize retirement-system shortfalls. Such debt offerings can be seen as a sign of distress since governments such as California, New Jersey and Illinois are among the largest issuers and hold the lowest credit ratings among states.

A couple of arguments are used to support POBs, but this is the big lie often used to push POBs:

Initial plans call for selling 30-year bonds at a rate below 5% and reaping pension-fund returns of 8%, according to state and pension-fund officials.

Oooh, where can I get this guaranteed 8% return? Is Madoff back in the market?

Does anybody see the problem with this fake arbitrage?

Forget about the theory, let’s look at the actual experience:

If examined from the stock market highs at the end of 2007, such deals returned an average of 0.8%, the Center said in a report last year. By 2009, however, most pension bonds were a net drain of -2.6%. Thanks to stock market gains following the recession, however, most of the deals were back in positive territory by 2014, returning an average of 1.5%.

Remember these returns are just measuring the difference between the interest rate the POBs were issued back against the return of the pension fund… as a whole, I’m guessing (as opposed to the portion invested at that time – but I don’t know this for sure).

You know what would be a better thing to do? Actually funding the pensions with real contributions and appropriately investing. Also, reducing the assumed rate of return.

Let us remember what the pension liability measures: the actuarial present value of promised future cash flows that were already earned by employees. They are an operational cost.

When there is an unfunded pension liability, that means the sponsor (employer) has accrued a debt due to operational costs, and that debt is owed to the pension fund.

I see that someone is try to push the lie that pension debt is just like a mortgage! lie:

This is incredibly dishonest. For most states, unfunded pension liabilities represent a manageable debt that can be paid down over time, similar to a homeowner making a mortgage payment. An initial mortgage debt of $300,000 might seem scary, but of course, the homeowner does not have to pay the bank this entire amount at once, instead paying it down monthly over 15 or 30 years. Pension debt works the same way.

No, it’s like a credit card balance, actually. Mortgages are intended to cover capital assets (e.g., a house) and finance paying it over the usable life. The expenses are supposed to be spread out as opposed to all up front.

But pensions aren’t a capital asset/expense. They’re an operational expense. They are for paying for current service by giving some money in the future, but the expense is incurred right now.

Just like when I go out to a fancy restaurant and put that tab on my credit card. I usually pay off my balance in full each month for credit cards, because I use them to pay for my current, operational expenses like groceries, the energy bill, my Amazon habit. If all I did was keep charging operational expenses to my credit cards and not paying off the balance, I’d be accruing debt like the unfunded liability in public pensions. The credit cards don’t expect me to pay off all the balance all at once, but I don’t need to be still paying for today’s meal at Per Se for the next thirty years.

That’s the unfunded liability, in analogy: a large credit card balance. Living beyond your means. Saying that you’ll pay for current expenses by future income… somehow.

So what would a Pension Obligation Bond analogy be?

Credit card balance transfer. The pension debt is being transferred from a debt to the pension fund to a debt to the POB holders.

I happen to do credit card balances all the time, because I do sometimes have short-term large expenses, and I want to spread it out over a year. So I will transfer the balance with one of those 0% promo APRs (with an up front 3% transfer fee). That’s fine by me, because I know I will have paid off that balance by the time the 0% is finished.

Now, what would be crazy to do (and what I have seen people do) is to use one of those balance transfers or cash advances so I can go gamble in Vegas. And if I lose…. good luck paying off that credit card.

I had this argument with a friend during the dot com boom, btw. He was racking up credit card debt, and held a large amount of stock and options in his own company (that had been going great guns in growth). I argued that he needed to pay off the sure debt (which wouldn’t wipe out all his stock holdings, btw) instead of assuming that the stock would grow 20% per year for sure. Because it wouldn’t.

And it didn’t.

Likewise, using a POB just so a pension fund can chase the yield it can’t get without taking on a lot of risk… yeah, that’s asking for trouble.

The reason POBs are of the devil is that they use accounting maneuvers that no private entity would be allowed to use — you would not be allowed to issue a bond and declare that you made a profit on the deal at issuance. That’s what is being argued when they say the 5% interest bond is going into cash that will for sure return 8%. That’s the argument.

And what if the market crashes?

What then?

You’ll see that Illinois TRS issued a POB between 2003 and 2005. That sure helped, didn’t it?

Oh look.

The assets at the end of fiscal year 2014 were essentially in the same place as the assets in 2007, after said POB was issued. And the liabilities have substantially grown over that time.

All that POBs do is put a fake contribution into the kitty, and moving the pension debt somewhere else. It’s all debt on the state balance sheet. It’s all debt for operational costs.

Any company that tried this crap would be downgraded heavily (oh wait, I think both Kansas and Illinois have been downgraded quite a bit.)

So watch out for the snake-oil salesmen offering this magic cure to debt accumulated by bad behavior over multiple years.

POBS ARE OF THE DEVIL, and don’t you forget it.

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