-->It's Time to Worry About Pension Obligation Bonds: Joe Mysak
Sept. 24 (Bloomberg) -- If you're a taxpayer, start worrying.

States and municipalities are going to sell billions of dollars in bonds to help fill holes in their pension plans caused by the stock market bubble bursting. Those market losses only started showing up last year because of the delay in the way public pensions report performance.

Using bond money to pay for future pension liabilities isn't at all like refinancing a debt you owe, as proponents say. ``At its heart, it is a risky arbitrage transaction,'' says a report entitled ``Pension Obligation Bonds or Bombs?'' It was just published by Sage Advisory Services, a money management company in Austin, Texas.

The Sage report carries a list of pension obligation bond issues, and Sage advises not to buy any. States and municipalities have sold a surprising $31 billion of such bonds since Los Angeles County first did so in 1986.

Sage isn't alone when it comes to worrying. Fitch Investors Service just published a report on the rising cost of public pensions, and observed: ``Using pension obligation bond proceeds to pay current and subsequent year pension contributions is considered by Fitch to be a type of deficit financing -- the use of borrowing funds to pay for an annually recurring expense.''

Translation: Pension obligation bonds can be hazardous to the health of a municipality's credit rating.

How It Works

Here's how it's supposed to work. States and municipalities are expected to put aside cash every year in the pension plans set up for their employees. In reality, some states and municipalities don't put in those annual contributions, or don't put in enough.

Making matters worse has been a decline in the value of the investments in the funds, usually a conservative mix of stocks and bonds. Most pensions are also considering going into investments that are a lot riskier to make up for lost ground.

Public pension funds took a beating during the bear market. Wilshire Associates last year estimated that 80 percent of them are now under funded.

So, many states and municipalities are considering selling pension obligation bonds, or POBs. They sell the bonds on a taxable basis, because they aren't allowed to raise money in the tax-exempt market and invest it in higher-yielding securities.

Place Your Bets

Taxable rates are higher than tax-exempt rates. A top-rated municipality can borrow money for 30 years right now at 4.70 percent in the tax-exempt market, and 5.85 percent taxable.

Issuers who sell POBs are betting that their investments will earn at least what they're paying on the bonds -- at least 6 percent. The real number they have to hit is higher, usually between 8 percent and 9 percent, if the bonds are going to have any kind of positive impact.

Four years ago, when some public pension plans were earning 20 percent or more, that looked like a pretty safe bet. Today, making 9 percent is decidedly ambitious.

Most of the municipalities that sold POBs to achieve actuarial nirvana are worse off than they were. They lost the money they raised through the bond sales, and then some. They have to make more contributions to their pension plans, and they now have to pay debt service.

Political Gimmicks

POBs are political gimmicks, a short-term fix to a long-term problem. In exchange for a year or two of budget relief, state and local governments saddle their taxpayers, present and future, with billions of dollars in debt.

Perhaps the classic example is New Jersey's $2.8 billion pension obligation bond, sold in 1997.

This bond issue wasn't really necessary at all. The state's pension fund was in good shape. So was the state, at least in comparison to the oceans of red ink it -- and so many other states -- faces today.

The Whitman administration did a sales job. The state's lawmakers with few exceptions bought it, to avoid making hard decisions on taxes and spending.

In January 1997, New Jersey Governor Christine Todd Whitman proposed selling $3.4 billion in POBs. She wanted to use the proceeds, along with $2.3 billion in surpluses the pension fund had built up, to pay off the fund's estimated $4.2 billion unfunded liability. She also wanted to use a portion of the surpluses to balance the state's budget for two years.

That was the key: two years of budgetary relief.

In return, the state's taxpayers got a debt of $2.8 billion, which, with interest, amounts to more than $10 billion.

Railroad Tracks

The Whitman administration said the state was refinancing ``a debt we already owe.''

The funny thing about pension plans and their liabilities is that they are all based on actuarial estimates. The numbers don't meet off in the distance, like railroad tracks. That's an illusion.

The state sold $2.8 billion in POBs. Nothing turned out the way the state said it knew it would.

Those taxpayers who don't need any more to worry about should give some thought to what Fitch says in its latest report: ``If a plan is brought to full funding status by virtue of a POB issuance, there may be a temptation on the part of elected officials to sweeten pension benefits, particularly in areas where there is significant labor pressure.''

Last Updated: September 24, 2003 00:01 EDT
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