POWIP Piece of Work In Progress – Former Abode of Dan Collins

Pension Obligation Bonds: the grandaddy of bad pension finance

Stephen Malanga on municipal debt – and an important tie to pensions:

Another weapon in the debt arsenal is the so-called pension-obligation bond. For two decades, governments have played a risky arbitrage game in which they issue bonds and then deposit the money in their pension funds to be invested in the stock market with the hope that the money will outperform the interest rate on the bonds. In a stock market that's been stagnant for years, pension bonds have become fiscally toxic. As the Center for State and Local Government Excellence noted in a report earlier this year, most pension bonds issued since 1992 have been money losers for states and cities, exacerbating severe underfunding of pension systems in places like New Jersey.

Ah yes, ye olden POBs. The way the game is supposed to go is this: the municipality borrows at 4.5%, and the assumed average asset return is 8%. Arbitrage! Free money!

Yeah, well, that's the =assumed= return, not the actual return.

Let me give you a real life example: I had a friend who worked for a tech company in the 90s. He showed me his employee options/stock holding statement one day, and he was halfway to being a millionaire. On paper.

I was trying to get him to exercise some of his options to pay off his credit card debt – I argued that his expected gains in the future were unsure, but that credit card debt was sure, high interest, and going to be a problem if his employment at that company cratered.

He kept arguing that nothing went up as fast as that company stock, and it had 4 splits since he had arrived... I told him nothing would fall as fast either [boy, did I get that right]. He was overexposed to one company: it was the source of his regular employment [like an inflation-linked bond that might default [could get laid-off], he had options [which could easily go underwater], AND he had company stock. So within a year all his paper wealth was wiped out. [In lieu of “I told you so”, I told him that his paper wealth was illusory to begin with. He did not appreciate my perspective on the matter.]

Having high debt with regular cashflow servicing needs and then having risky assets to try to pay them off... you're going to run into trouble more likely than not. This is why there's the old folk wisdom of not betting the milk money.

So the various states and municipalities that have played the POB game... many have found out that the bills are coming due at the most inopportune time: right after the pension portfolio cratered. Even if they could get the 8% going forward, they are massively in a hole.

If you are not yet convinced that POBs are not a good idea, take a look at this maneuver:

Retracing the strategy, in 2004 Northbrook fulfilled its pension obligation by swapping pension bonds with Highland Park. Back then, Northbrook's unfunded liability for police and fire was $15.2 million; Highland Park's was $16.6 million.

Jeffrey Rowitz, Northbrook's finance director, explained the sum of bond issues was higher than unfunded liabilities, so the village issued $16.6 million in pension funding bonds and received the same sum of Highland Park's bond in return. And what the bond swap did for both villages was save them about $350,000 annually in annual debt service. The swap was possible because both villages shared a AAA bond rating and had a similar-size debt.

"We gave $15.2 million of the Highland Park bonds to our pension funds to fully satisfy our unfunded liability and retained the remaining $1.4 million in a special revenue fund to help avoid spikes in future tax levies," Rowitz said.

The original pension bonds were expected to last through 2012. But by 2009, $213,885 was needed for the police fund, and the fire fund received $561,225. The 2009 property tax levy to support both funds was only $36,910, so Rowitz said the required contribution for the funds was about $700,000.

"By planning ahead and holding the excess Highland Park bonds in reserve, we were able to use a portion of them to fund most of the 2009 (pension fund) increase," he said.

If only they were smart enough to borrow from their own funds a la NY, they wouldn't have needed to waste all this effort swapping debts and pretending it's an invesment.

This is dumb shit. Who told them that this was fulfilling a fiduciary duty? They got lucky that neither side has =yet= gone under. But if one defaults, then the other likely would, and no one would have been protected from any downside there. This is as illusory as Paterson's proposal for the NY pension fund to borrow from itself.

Meep

Meep is a member of the Irish Catholic mafia, having a suspiciously high number of green-eyed, red-haired friends. While she doesn’t have red hair herself [except when she goes into the sun (rare for any vampire)], she does have green eyes. She’s a raving Papist and is a life actuary on the side [i.e., she counts dead people]. An amateur pain-in-the-ass [willing to go pro!], she likes covering retirement, mortality, math, and education issues.

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