Pension Obligation Bonds

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Type: 
Advisory
Advisory: 

GFOA Advisories identify specific policies and procedures necessary to minimize a government’s exposure to potential loss in connection with its financial management activities. It is not to be interpreted as GFOA sanctioning the underlying activity that gives rise to the exposure.

Background: 

Pension obligation bonds (POBs) are taxable bonds1 that some state and local governments have issued as part of an overall strategy to fund the unfunded portion of their pension liabilities by creating debt.  The use of POBs rests on the assumption that the bond proceeds, when invested with pension assets in higher-yielding asset classes, will be able to achieve a rate of return that is greater than the interest rate owed over the term of the bonds.  However, POBs involve considerable investment risk, making this goal very speculative.2  Failing to achieve the targeted rate of return burdens the issuer with both the debt service requirements of the taxable bonds and the unfunded pension liabilities that remain unmet because the investment portfolio did not perform as anticipated. In recent years, local jurisdictions across the country have faced increased financial stress as a result of their reliance on POBs, demonstrating the significant risks associated with these instruments for both small and large governments.

Recommendation: 

The Government Finance Officers Association (GFOA) recommends that state and local governments do not issue POBs for the following reasons:

  1. The invested POB proceeds might fail to earn more than the interest rate owed over the term of the bonds, leading to increased overall liabilities for the government.
  2. POBs are complex instruments that carry considerable risk. POB structures may incorporate the use of guaranteed investment contracts, swaps, or derivatives, which must be intensively scrutinized as these embedded products can introduce counterparty risk, credit risk and interest rate risk.3
  3. Issuing taxable debt to fund the pension liability increases the jurisdiction’s bonded debt burden and potentially uses up debt capacity that could be used for other purposes.  In addition, taxable debt is typically issued without call options or with "make-whole" calls, which can make it more difficult and costly to refund or restructure than traditional tax-exempt debt.
  4. POBs are frequently structured in a manner that defers the principal payments or extends repayment over a period longer than the actuarial amortization period, thereby increasing the sponsor’s overall costs.
  5. Rating agencies may not view the proposed issuance of POBs as credit positive, particularly if the issuance is not part of a more comprehensive plan to address pension funding shortfalls.

 

Committee: 
Retirement and Benefits Administration
Notes: 

1 The Tax Reform Act of 1986 eliminated the tax exemption for pension obligation bonds.

2 Alicia H. Munnell, Jean-Pierre Aubry, and Mark Cafarelli, “An Update on Pension Obligation Bonds,” Center for Retirement Research at Boston College, July 2014.

3 See GFOA Advisory – Using Debt-Related Derivatives and Developing a Derivatives Policy (2015)

Approved by GFOA's Executive Board: 
January 2015
Applicable to Canadian Governments: