“Some state and city governments have turned to pension obligation bonds (POBs) to pay their unfunded liabilities in their pension programs, and Moody’s lists these bonds as a part of the net tax-supported debt. However, the Government Finance Officers Association advises against issuing these bonds at all because they carry significant risks, both for the investor buying them and for the government issuing them.”

The above quote appeared earlier this week in a ValueWorks article, by Michelle Jones, titled, “State Debt Burdens Are Improving, But Pension Situation Only Getting Worse”. We won’t argue with the fact that many of the POBs issued earlier this century have not provided the benefit that was expected.  Why? Unfortunately, most plan sponsors and their consultants put the proceeds from the bonds into a traditional asset allocation hoping to achieve an arbitrage between the forecasted return on asset assumption (ROA) and the interest rate on the loan. This is the wrong strategy!

POBs are not an inappropriate pension financing tool provided that proceeds are used to de-risk the pension system instead of injecting greater risk as they have done in the past.  We would recommend that any pension system planning to use a POB would adopt the alpha/beta approach that KCS and Ryan ALM have been espousing for years. We would highly recommend using the bond proceeds (beta assets) to defease the plan’s Retired Lives through a cash-matching strategy. The remainder of the assets (alpha assets) would be in a broadly diversified asset allocation excluding traditional fixed income, which is highly correlated to pension liabilities. The goal of the alpha assets is to beat liability growth and not the ROA.

By defeasing the plan’s Retired Lives, the system has secured the promised benefits in the near-term, improved liquidity to meet those benefit payments, converted a highly interest rate-sensitive fixed income allocation into a much lower risk strategy, and extended the investing horizon for the alpha assets to capture the liquidity premium that exists in these assets.  As success is achieved in the alpha portfolio versus liability growth, transfer excess alpha assets to the beta portfolio further improving the plan’s risk profile.

POBs have been tainted by poor execution. Invested properly, these bonds can provide significant improvement to a plan’s funded status while reducing contribution volatility.