53% of Houston voters back a tentative plan to issue Pension Obligation Bonds (POBs) to support the city’s foundering pension system. Does this make sense? As we’ve discussed many times before, the history of POBs hasn’t been pretty.
The idea of issuing a bond to close the funding gap makes sense, but both the timing and implementation have left a lot to be desired. It would be great if plans could borrow at 4% and earn 8% on their investment. That potential arbitrage is what intrigues plan sponsors in the first place. However, most often we’ve seen interest in doing this at the peak of a market cycle, and not at the bottom.
Furthermore, subjecting the principal from the bond to the volatility of a traditional asset allocation (chasing an ROA of 7.5%) doesn’t make sense. We would highly recommend that plans engaging in this activity use the proceeds from the bond to immunize or cash match the plan’s retired lives as far out as they can. This will allow future contributions and the plan’s current assets to have an extended investing time horizon that will permit the portfolio’s less liquid assets to actually capture their liquidity premium.
We don’t know when the next equity market correction will occur, but we are a lot closer to a peak than a bottom at this time. Would the 53% of Houston voters supporting this idea continue to support it if they knew that these assets were going to be subject to potentially significant market risk? What would they say if they were on the hook for 100% of the principal and interest and then had to make additional contributions when the assets declined 20% or more? It has happened before and there is no guarantee it couldn’t happen again. Caveat emptor!