Risk of a sure bet

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A number of pension plan sponsors took gambles over the past several years by selling bonds to finance their pension obligations. They believed they could invest the bond sale proceeds in ways that would earn returns greater than the interest they were paying on the bonds.

The extra return would accrue to the pension plan and help make up for any funding shortfall.

Connecticut only last April sold its biggest bond issue ever, $2 billion, using the proceeds to finance its pension funding shortfall.

“We achieved a favorable borrowing cost of 5.88%, which is well below the 8.5% assumed long-term return on assets of the (Connecticut) Teachers' Retirement Fund,” according to a statement last April by Denise L. Nappier, state treasurer and sole trustee of the $23 billion Connecticut Retirement Plans and Trust Funds, including the teachers' fund. “This will provide ... potential savings to taxpayers of billions of dollars.”

In 2003, Illinois sold $10 billion in pension obligations bonds, distributing the proceeds to its state-funded pension systems. Among them, the Illinois State Board of Investment invested its $1.55 billion share of the proceeds across its asset allocation. Through Oct. 31, its return was 4.76%. The bonds were sold at an interest rate of more than 5%, thus costing more than the investments have earned.

General Motors Corp. sold $13.5 billion in debt in 2003 to fully fund its pension deficit.

Their gamble generally might not have turned out as expected. With the market meltdown, the sponsors generally might be worse off than they were before the bond sales because investment returns have fallen below the borrowing rate.

The long-term investment horizon of the bond-sale strategy has yet to play out, but after several years it generally hasn't worked as expected. For example, in 1997 New Jersey sold $2.8 billion in bonds, at what turned out to be the then top of the market.

“It's the dumbest idea I ever heard,” New Jersey Gov. Jon Corzine, elected in 2006, was quoted last May commenting about pension obligation bonds.

Even so, a Moody's Investors Service report Nov. 17 noted, “More state and local governments may decide to issue pension obligation bonds to help address emerging or widening pension funding gaps.”

Such bond issues would be a mistake, unless the sponsors well understood the risk and communicated it fully to participants, as well as to taxpayers or shareholders.

Generally, these sponsors don't mention the risk and many appear not to appreciate it. If the pension obligation bond sale is such a good idea, why don't better funded plans issue them in a play for higher returns? In 2003, Illinois Gov. Rod R. Blagojevich likened the bond issue to a mortgage refinancing. But the state didn't lock in a lower financing rate, it merely took on more investment risk.

This financing strategy places the funding of past and current retirement obligations that should have been paid as earned onto future generations, plus the cost of any shortfall in investment return relative to the borrowing costs.

Plan sponsors often turn to pension obligation bonds in desperation to make up big funding shortfalls. For public plan sponsors these deficits have stemmed generally from the sponsors shortchanging contributions, resulting in large pension deficits.

The lure of the historical upward slope in investment returns attract plans sponsors to the bonds, making the arbitrage seem like a sure bet.

Issuing the bond has two positive features. The bond market imposes a funding discipline on plan sponsors unwilling to properly fund their plans to ensure the debt service is paid. And participants benefit from a boost in funding. But pension obligation bonds are no substitute for proper funding of plans.

The market meltdown might serve as a warning of the dangers of using debt to finance retirement plans.

Unfortunately, many pension plan sponsors have yet to learn to properly fund their plans.