Yesterday’s Implementation

I frequently read many of our industry’s publications. I often find the articles to be spot on. However, there is one area where I continue to question the reporting, as it is based on yesterday’s approach. I am specifically referring to pension obligation bonds (POBs). I’ve reported on POBs many times in this blog during the last few years. I believe that they can be effective tools for public pension systems, similar to Ryan ALM’s input, which became a critical part of the Butch Lewis Act (multiemployer legislation). However, our appreciation for POBs is predicated on the fact that the proceeds from the bonds must be used appropriately.

Now, to be fair, POBs have had a checkered history, as many of these instruments have been issued at the peaks of market cycles. Compounding the problem has been the fact that the proceeds have been invested in a “traditional” asset allocation. The thinking was that there exists an arbitrage between the cost of the bond (it’s yield) and the return on asset (ROA) assumption. By investing the assets that cost 4-5% in an asset allocation with an assumed 7.25% ROA, the plan would “capture” this differential. But, as I mentioned previously, these instruments were often brought to market at the peak of an investing cycle dooming the implementation from the start. Instead of capturing that arbitrage, the POB proceeds had a negative return that the plan had to make up as well as fund the debt service on the POB. It is no wonder why POBs get a bad wrap in some circles.

Why are we hearing more about POBs at this time than we have for many years? First, interest rates are at historic lows, and the old arbitrage crowd is salivating at the possibility of finally achieving the promised reward of a major spread between the ROA and the interest payment. Second, many public pension systems are poorly funded, and in this current covid-19 environment additional contributions are not likely, as states and municipalities deal with troubled budgets because revenues have fallen, while expenses have escalated. Making the annual required contribution may not be possible without dramatically impacting other critical spending needs. Given this situation, POBs seem a logical funding solution. Third, high equity P/E valuations and historically low interest rates make achieving the ROA less likely in the near-term.

So, why do we like POBs? Well, it isn’t for the interest rate spread and it certainly isn’t because I believe that injecting the bond proceeds into a traditional asset allocation at these valuations makes sense. I like POBs because public pension systems need liquidity to meet the promised benefits and expenses, and they can meet that need by issuing a POB at this time. However, we are not going to take the proceeds and inject them into the plan’s current asset allocation. Hell no! We are going to calculate what it would cost the plan to defease the Retired Lives Liability (RLL). Once that is determined by the plan’s actuary, that becomes the amount that should be borrowed in the bond offering.

When the proceeds from the POB become available, the plan should immediately (don’t pass go, don’t collect your $200.00) use those funds to defease the RLL through a cash flow matching bond portfolio. This action will ensure that the promised benefits are paid. The current assets in the fund and any future contributions can now be invested in a more aggressive implementation, as they are no longer a source of liquidity. Asset allocation can now reduce or eliminate their exposure to fixed income since the POB is providing the bond funds. Furthermore, the current assets now have a long runway of time to grow unencumbered. Their objective is to beat future liability growth.

The benefits are numerous: 1) dramatically improved funded status, 2) enhanced liquidity to meet benefit payments, 3) a likely greater allocation to risk assets, 4) a longer investing period that protects the fund during choppy markets, and 5) more stable contribution expenses, among other benefits. Does this sound to good to be true? We recently did a project for a municipality that was interested in possibly issuing a POB. Our analysis indicated that this very poorly funded plan could save roughly $10.2 billion in future contributions, reduce the ROA needed to fully-fund the plan from 7.75% to 6.75%, stabilized contributions at $800 million per year as opposed to the forecast of increases to >$1.4 billion, and repay the $5 billion POB back to the city in 30 years. It isn’t magic – just math! Furthermore, it isn’t gambling, as our process isn’t betting on the markets outperforming the cost of the bond, as plans and their advisors have done for years. We think that you should consider POBs. Just don’t rely on yesterday’s implementation!

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