Pensions & Investments ran two seemingly unrelated articles on Aug. 19. One was titled "1,585 basis points shy: Ohio fund's guaranteed option misses the mark in its 1st year." The other was "Lousy timing: Pension obligation bonds feel pinch of bad market."
Each of these schemes is vulnerable at the moment because each has invested in stocks at a time when stock performance has been awful.
Let us decompose each of these transactions and see what is happening to the taxpayers of Ohio, where a fund guaranteed a return, and in New Jersey, Philadelphia and other states and municipalities that have issued - and may be contemplating further issuance of - pension obligation bonds.
The State Teachers Retirement System of Ohio promised to eligible participants of the system's 401(k) plan a 7.75% return, structured as a guarantee by the system's defined benefit plan. Because the defined benefit plan (and the defined contribution investment clone) is expected to earn 8% annually, after a 25 basis-point administrative cost, the guarantee is deemed to be costless to Ohio's taxpayers.
But look at the transaction from the taxpayer's point of view. In effect, the defined benefit plan borrows the money invested by the 401(k) participants and invests it according to the asset allocation of the defined benefit plan. The defined benefit plan promises to pay 7.75% to the 401(k) no matter how the assets actually perform. To the taxpayers, this is equivalent to having the defined benefit plan borrow money at 7.75% to invest (partly) in stocks.
Now it should be clear why I lump pension obligation bonds and Ohio's guarantee together. Just as the Ohio fund has done it in its own way, states and municipalities that underwrite pension bonds also borrow money to have their defined benefit plans invest in stocks. Internal Revenue Service rules have, since the mid-1980s, made such borrowing taxable to the bondholders. Thus the public entities that issue pension bonds borrow at their own taxable bond rates. Such rates are invariably greater than comparable Treasury rates.
The common error of all these schemes is that they are borrowing much more expensively than they need to borrow. These defined benefit plans, if they wish to borrow money to invest in stocks, may do so in a variety of fashions and they need never pay much more than Treasury rates for such loans.
The following alternatives are available to virtually every defined benefit plan: Sell Treasury holdings of the plan; or engage in debt-for-equity swaps with highly rated and well-collateralized counterparties; or use various exchange-traded equity futures contracts; or engage in securities lending and invest the collateral in stocks.
Selling Treasury securities, for example, is equivalent to borrowing at the same rate as Treasuries. Investing in stock-index futures is equivalent to borrowing within a few basis points of the Fed funds rate.
Any entity with a large, liquid pool of money, such as the Ohio fund, can borrow at near the Treasury rate if not unduly constrained by policy.
Although the Ohio plan and various pension bonds affect taxpayers in much the same fashion, Ohio taxpayers may take some solace from knowing that their loss is the 401(k) participants' gain. Under most pension bond arrangements, investment bankers and local politicians win immediately while taxpayer losses continue as long as the unnecessarily expensive borrowing remains outstanding.
Supporters of the Ohio and pension bond schemes might say they are not borrowing. They might further say they are not leveraging the risk to their taxpayers because the asset allocations of their defined benefit plans remain no riskier than before. They might argue that my borrowing analogies differ because, when the defined benefit plan borrows by any of my suggested methods, the resulting asset allocation is more risky.
But the capital market risk to taxpayers who support these defined benefit plans is not correctly measured by the fraction or percentage of the plan assets invested in equities. The correct way to measure the taxpayers' risk is to look at the absolute equity exposure - a convenient measure might be equity dollars per taxpayer. Viewed in this fashion, it is clear that pension obligation bonds and the Ohio guarantee are each increasing taxpayer risk in the same way as my more efficient borrowing approaches do. Borrowing expensively when one can borrow cheaply is a negative service to one's constituents. Borrowing at these higher rates is foolish and expensive to taxpayers.
