Not Your Father’s POB

I was reading an opinion piece in The Press-Enterprise, titled “Game-Changer For Riverside’s (CA) Budget”. The piece discussed The Riverside Council’s action to reduce the budget by 10% due to a loss of revenue and rising expenditures related to Covid-19. I was impressed. As a Councilman in Midland Park, NJ, I know how difficult it must have been to identify those cuts. But, more important for me was the fact that they had approved going to the market for a Pension Obligation Bond (POB).

What I found interesting was the fact that the author was opposed to the use of POBs, and cited the fact that the Government Finance Officers Association (GFOA) “isn’t a big fan of pension obligation bonds because of downside risks”. Historically, POB proceeds were invested in a plan’s traditional asset allocation with the hope that the ROA would be achieved and the arbitrage between the ROA and the cost to borrow would be realized. In many cases, the bond proceeds were invested at the height of the market only to suffer significant losses. Yes, that implementation comes with downside risk!

We don’t believe that you engage in a POB to play roulette with the proceeds. We believe that sound policy has you investing those assets in a cash flow driven investing (CDI) implementation that defeases as much of the plan’s retired lives liability as possible. This significantly reduces the downside risk, insures that retirees get their promised benefits, stabilizes contribution expenses and the funded status, extends the investing horizon for the remaining alpha assets, and eliminates interest rate risk. There are other benefits to this implementation, but I think that you get the drift.

Based on what has transpired since the outbreak of the Covid-19 virus, it is highly likely that state and municipal budgets will be impacted for years to come. DB pension systems are too important to the participants, their communities, and to the local economy to mess around with the funding. Now is the time to adopt a POB, but utilize our implementation and don’t play games with the proceeds. We stand ready to assist you in any way that we can.

2 thoughts on “Not Your Father’s POB

  1. Russ, good morning. I know that you have a different view of what to do with the proceeds of a pension obligation bond. Setting that aside for a moment; and I am responding to many critics of POBs who focus on the potential for negative arbitrageon the POBs; pension liabilities are essentially a debt of the plan sponsor (some call it a soft debt) and in the absence of a POB, if the plan in a given year returns less than the assumed investment rate, the plan has experienced “negative arbitrage”. Thanks!

    • Good morning, Chris. Great to hear from you. I’m not sure why the pension liability is referred to as a soft debt. Pension plans either earn $s through investments or contribute $s to fully fund the plan to meet the promise that hase been made to the participants. The plan sponsor is definitely on the hook for any shortfall not achieved through investments. Yes, years in which the plan fails to meet the ROA plans experience negative arbitrage. For many public funds that have 7+% ROAs failure to meet the long-term objective means that they habitually underfund their plans – see NJ. Big returns like last year are nice, but if you are sitting at 40% funded, you need a roughly 18% return just to keep the deficit at the same level.

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