Issuing of pension obligation bonds has slowed dramatically, while some issuers are staring at losses because of unfortunate market timing.
POBs, taxable bonds, had been used by state and local governments, especially in California, to reduce their unfunded pension liabilities. The borrowed money was invested by the pension fund in hopes of reaping stock market gains in excess of the bond interest rates.
When all goes as expected, the issuer saves the difference between the debt service on the bonds and what it would have contributed to its retirement system under its funding schedule.
But several governments came to market with their POBs shortly before the stock market dropped. As a result, they can't earn a high enough return to exceed their annual interest rate payments on the debt.
New Jersey, for example, issued $2.75 billion worth of POBs in 1997, and has been unable since at least 1999 to outperform the 7.64% annual interest payments, according to a spokesman.
In Philadelphia, investment returns on a $1.29 billion issue from 1998 have not been able to cover the 6.87% interest on the bonds, according to Janis Davis, director of finance.
Not `a winner'
"We haven't gotten the kind of returns that allow us to cover the debt service," said Ms. Davis, who was not finance director when the bonds were issued. "It hasn't been a winner from that standpoint."
By the time the bond was issued, she said, "the market had left." All city officials can do now, she said, is to "look to the future and hope for a turnaround in the market."
The peak period for POB bond issuance was the early 1990s. Most of those issues were able to capitalize on the bull market and fulfill their objective of reducing unfunded liabilities through excess returns. Indeed, it is estimated government agencies have issued as much as $20 billion in outstanding POBs, with more than $10 billion of that coming in the early and mid-1990s, according to Parry Young, credit analyst at Standard & Poor's Ratings Service, New York.
Issuing pension bonds "is an arbitrage action and is not without its risks," said Mr. Young.
According to a survey by Mercer Investment Consulting, New York, the median public plan lost 5.9% for the 12-month period ended June 30. Over a five-year time frame, the median public plan was up only 5.4% and returned zero for the three years ended June 30. Those returns are far below the average POB interest rates of 6% to 7%.
Still some interest
A few hardy governments are eyeing pension obligation bonds despite market conditions.
Rhode Island Gov. Lincoln Almond recently signed legislation giving the city of Woonsocket the authority to issue a $90 million POB after vetoing the bill last year. Louisiana Gov. M.J. Foster Jr. last year proposed selling pension bonds to reduce the $5.9 billion unfunded liability in the state's retirement system. And, the West Virginia Legislature has been debating issuance of bonds to reduce a $3.8 billion unfunded liability for the state's teacher retirement system.
Several municipal governments in Massachusetts have expressed an interest in issuing pension bonds, said Tony DeGregorio, staff attorney to the Committee on Taxation in the Massachusetts House of Representatives, Boston. He said hearings were held in the Public Service Committee last year after several requests for exemptions to issue pension bonds were filed in the Legislature. Massachusetts law prohibits POBs, but local governments may request special legislation authorizing them.
Mr. DeGregorio said recent petitions from Salem and Melrose to issue bonds have not been approved, although a request by Springfield was approved last month. The city of Worcester sold $220 million in bonds in 1999.
Worcester Treasurer Tom Zidelis said the POB brought the Worcester Retirement Fund to a fully funded status from 56% funded at the time. "In terms of performance of the proceeds, we had a good first year but the next two years we've taken a beating in the markets," he said.
The Worcester POB was issued at a favorable 6.31% rate and Mr. Zidelis said over the 30-year term of the bond he expects asset returns to average 8%, or higher.
Once attractive, now obsolete
The same factors that made early issues of POBs attractive may also have made them unnecessary. According to a 2001 survey by the Public Pension Coordinating Council, the average public pension plan was 103% funded, up from 88.7% in 1997, largely because of increased diversification and increased equity allocations. The PPCC is an industry group composed of leaders from the National Association of State Retirement Administrators, the National Conference on Public Employee Retirement Systems and the National Council on Teacher Retirement.
Since pension obligation bonds typically mature in 20 to 30 years, governments that assumed their debt burden near the top of the market and, therefore, suffered losses, still have time to catch up, said William Reimert, consulting actuary at Milliman USA, Philadelphia.
"When the market is headed down, it seems straight down," he said. "When the market was going up, it seemed straight up. Who knows what the next two years will bring."
