It's finally now time for public pension funds and their sponsoring employers to make lemonade from lemons. The market value of public pension stock portfolios has shrunk dramatically in the shadows of the COVID-19 crisis, coupled with the recessionary impact of the Saudi-Russian oil price war. Stock indexes are down 35% or more from their peaks just earlier this year, in a dramatic sell-off.
As trustees and chief investment officers scramble to quell fears of stakeholders, and public finance officers watch their sales and income tax revenues plummet, liquidity and even solvency fears are resurfacing in some places. The potential inability of state and local governments to sustain their pension promises is once again making the news.
Before we start ringing the alarm about pension funding and pension deficits, it's now the time to revisit a worthwhile public finance strategy and instrument that may be able to come to the rescue of public employers. It works for both their underfunded pension funds as well as their often unfunded retiree medical benefits, known as other post-employment benefits, or OPEB. The pension obligation bond, and its more appropriate "benefits bond" cousin for OPEB plans, could never be more timely — and more vital to the future health of states and municipalities.
The basic pension obligation bond concept is relatively simple, and has been used for 45 years, albeit with sketchy results because of ill-advised timing. A state or municipality issues taxable POBs at low interest rates (now about 3% plus for a 30-year AA credit) and puts the money in trust to invest in capital markets at low, distressed levels. It's essentially an arbitrage strategy, to reduce the employer's cost of the pension fund by converting "soft debt" into "harder debt." In the long run, a stock index portfolio purchased at distressed low market levels can reasonably be expected to earn far more than the employer's POB interest rate. If done properly and timely, the net cost to taxpayers for funding the public pension plan will be dramatically lower. (Because it's sheerly capital markets arbitrage, Congress requires that the POB bonds be taxable, so that lower-cost tax-exempt bonds are used only for public purposes like infrastructure.)
In the last recession, both Milwaukee County and Contra Costa County issued POBs in a timely way, and showed us all how it is possible to underwrite a successful deal. Even with the latest market slump, they are both well "in the money" because even now stock indexes trade at three times what they did in late 2008.
The challenge, of course, is managing this clearly leveraged strategy. It's arguably like borrowing on a second mortgage to fund your IRA, which nobody in their right minds would do as individuals. But state and local governments are not individuals and they have the ability to be long-term, deep-pocket investors just like Warren Buffet of Berkshire Hathaway. They can buy straw hats in winter and hold them, if they act quickly.
I've done historical research on stock market and business cycles, economic recessions and expansions, for all bull and bear markets since World War II, and can attest that there is no business cycle in that history when the S&P index was off by more than 35% and it wasn't higher in two years, and returned high double digits over the following decade. The worst such period followed the 1973-74 bear market and ensuing stagflation period, but even then, equity investments acquired during what have been the "POB window" did admirably over a decade.