There's a new gimmick in Pensionland that purportedly arbitrages high actuarial interest rates against currently low borrowing rates. It's called pension obligation bonds, or POBs.
The idea is straightforward. A pension fund pays interest on its unfunded liability at the actuarial interest rate, which is currently higher than the rate at which it can borrow. Accordingly, a benefit is derived if the fund substitutes a lower interest obligation for the higher interest pension liability. This is accomplished by issuing bonds and using the proceeds to fund liabilities.
Despite the apparent gain, the reality is these POBs are not an arbitrage at all, but rather a leveraging of pension investments. This may be good or bad, but it's certainly not "found money."
A quick reality check is provided by the fact this so-called arbitrage would vanish if the actuary lowered the interest assumption to conform to the current market interest rate environment. In so doing, liability estimates would increase, thus increasing contributions.
The fault in the POB strategy is that it takes too much advantage of a situation that already reduces contributions below what they probably ought to be. The purported arbitrage would only work if the bond proceeds could be invested in comparable quality bonds at the actuarial interest rate. Because this is not possible, POBs must be evaluated in light of their effects on the payment of pension liabilities.
The only two factors that effect payment of pension liabilities are "the promise" and "the experience." A POB alters experience, but not in a way that is necessarily beneficial.
In order for a POB to be beneficial, the proceeds must be invested in assets that return more than the interest expense. The POB strategy is comparable to General Motors Corp. issuing bonds. The value of the company is initially unaffected by the capital structure change, but ultimately affected by the success with which the bond proceeds are deployed.
Unlike General Motors, however, POBs also affect the actuarial treatment of the plan. Initially, the value of liabilities is unaffected because there has been no change in future benefit payments, but contributions are lowered because of the exchange of low-interest bonds for high-interest liabilities. The actuarial treatment of a pension plan establishes the budget by setting forth how benefit payments will be systematically funded into the future. It's simply "pay me now or pay me later."
A POB lowers current expense thereby increasing future contributions, all other things equal. For public pension funds, which are the only plans that can issue POBs, this is a transference of pension costs to future generations (again, all other things equal).
Offsetting this transference is the good possibility that leveraged pension assets will perform better than unleveraged assets. This outperformance will, of course, be the case if the return earned on investments exceeds the interest rate paid on POBs.
In today's low-interest rate environment, it seems likely this leverage will be rewarded, but it is categorically not the arbitrage opportunity being presented by its advocates.
In fact, the plan sponsor may find it difficult to convince the actuary to lower contributions in light of POBs. To lower contributions, the actuary must take the view that the proceeds of the bond sale secure pension liabilities, which means he must see the holder of a POB being paid from future contributions, i.e., taxes.
This position puts the actuary in direct opposition to the POB bondholders, who certainly will view their loan as secured primarily by plan assets and only secondarily by future tax revenue. The resultant conflict could be resolved if POBs were issued as state obligations rather than pension obligations, but this would undermine the major appeals of POBs: namely, you don't need voter approval for POBs, and you don't reduce the state's borrowing capacity for other projects.
But there remains the potential benefit of leverage, which, as stated above, seems probable. With leverage comes increased risk, which should be taken under consideration in investing the proceeds of a POB issue. However, the risks of unintended consequences far outweigh the investment risks.
The risks of unintended consequences arise from the illusion of greater wealth in the pension plan on the parts of special interest groups, managers and consultants, and beneficiaries.
Special interest groups will heighten pressure on these "nouveau riche" plans and will gain support for their programs. Consultants and managers will advocate POBs to collect the associated fees. Beneficiaries will believe sponsors can more readily afford benefit improvements, and will receive them.
In other words, "the promise" will be increased and assets will be diverted, thereby hampering "the experience."
In the end, certain groups will benefit at the expense of the taxpayer, and maybe the bondholder. Perhaps this is a consequence that is intended. Who knows?
Ronald J. Surz is vice president at Centurion Trust Co., Chicago.