Wednesday, January 20, 2010

New issue brief: "Pension Obligation Bonds: Financial Crisis Exposes Risks"

The Center for Retirement Research at Boston College has released a new issue brief titled "Pension Obligation Bonds: Financial Crisis Exposes Risks" by Alicia H. Munnell, Thad Calabrese, Ashby Monk, and Jean-Pierre Aubry. The paper is well worth reading as pension obligation bonds are becoming a more popular – but more risky – means of financing public employee pension plans.

My quick take: A pension obligation bond is issued by a state or local government and explicitly backed by that government. The proceeds of the bond sale are deposited into the government's public sector pension fund as a means to reduce the amount that the government must directly contribute to the pension. The driver behind the sale of pension obligation bonds is a difference in assumed interest rates between the bonds themselves and the assets the proceeds of the bonds are invested in.

State government bonds generally pay low interest while public pension accounting practices assume that pension assets will earn high returns by being invested in stocks. As a result, pension obligations bonds reduce the government's measured liabilities – that is, due to the assumed interest rate difference, these bonds reduce the unfunded pension liability by more than they increase the government's explicit debt liability. This makes pension obligations bonds appear to be an arbitrage opportunity for state and local governments.

Of course, this is all an accounting gimmick: we can't simply assume that pension investments will earn higher returns without risk and there is a good chance that realized fund returns will be lower than the interest rate the government pays on pension obligation bonds. In reality, pension obligation bonds are simply state and local governments doubling down on their pension liabilities – taking more risk in hoping that the gamble pays off. If it does, that's great. If it doesn't, though, already massive public sector pension deficits will only get larger.

Anyway, that's my take. You can read the whole CRR issue brief here (they're a little less skeptical of PBOs than I am).

1 comment:

JG said...

Borrow at a low rate to invest at a higher rate. What could make more sense?

The S&Ls did it, worked for them!

General Motors did exactly this a couple years ago -- floated a mega-billion bond issue to fund up its pension liabilities, figuring stock market returns were sure to beat the interest rate it had to pay on the bonds.

How'd the stock market do last year? How'd GM do? How'd GM's bonds do?