State Budgets

Pension Obligation Bonds Could Unravel Pension Reform Victory

POBs gamble with the hard earned money of both current and future taxpayers.

A proposal to issue pension obligation bonds (POBs) to meet the annual required contribution (ARC) to the Pennsylvania State Employees’ Retirement System, may be presented to the legislature in the next week. Issuance of POBs will undo much of the pension reform success of this past year, add to Pennsylvania’s long term structural deficit, delay needed budgetary reforms by masking the cash flow problem, and potentially result in a higher future tax burden.

The pension reform achieved just one month ago requires the commonwealth to fully fund its share of the defined contribution plan each year. This statutory requirement ensures that no further long-term liabilities can accrue from the typical annual underfunding. POBs circumvent this pillar of reform by enabling the State to borrow a portion of the ARC and placing this borrowed capital into the pension fund. Future taxpayers are liable for payments on this new debt. Far from actually funding this year’s pension contribution, POBs encumber future taxpayers with this year’s pension funding costs.

POBs place the Commonwealth’s economic security at risk by gambling with the hard earned money of both current and future taxpayers. Supporters of POBs hope to invest proceeds from the bonds into investment vehicles with a rate of return in excess of the interest payments on the bonds. For instance, earning 5 percent returns on bonds issued at 3 percent equals a 2 percent net return on borrowed money. But POBs have a 30 year history of often failing to earn a rate of return greater than the interest rate on the bond. Thus, POBs will likely compound the pension crisis.  This could saddle taxpayers with higher taxes, reduced state services or both. While profitable POB arbitrage is possible, this rarely occurs and is largely due to circumstances outside the control of state governments.

Two recent examples of this arbitrage failing to materialize occurred in Illinois and New Jersey. Illinois issued POBs of $10 billion dollars in 2003, $3.5 billion dollars in 2010, and $3.7 billion dollars in 2011. The current debt service on these bonds is a significant factor behind the ongoing budget crises and historic tax increases, such as the 66 percent increase of Illinois’s income tax rate in 2011. In 1997, New Jersey issued $2.8 billion dollars of pension obligation bonds at an average interest rate of 7.64 percent.[2] The desired opportunity for arbitrage failed to materialize as the rate of return has lagged behind their all-in total interest cost. In fact, the 10 year return through 2015 (7.05 percent)[3] was 0.59 percent below the POBs rate. For that 10 year period, every $1 of investment income generated in the pension fund from the POBs cost the state approximately $1.08 in bond interest payments – a net loss.  This mistake two decades ago is likely to compound New Jersey’s budget challenges in the late 2020s when the POBs finally mature. Despite these examples, proponents of POBs seek to implement a similar scheme in Pennsylvania.

All considered, it’s no surprise the nonpartisan Government Finance Officers Association (GFOA) “recommends that state and local governments do not issue POBs,” summarizing the fiscal threat posed by POBs as follows: “In recent years, local jurisdictions across the country have faced increased financial stress as a result of their reliance on POBs, demonstrating the significant risks associated with these instruments for both small and large governments.”[4]

Issuance of POBs will negate the recent pension reform victory by shifting current pension costs to future taxpayers and gambling the commonwealth’s fiscal health on risky arbitrage. Spending reforms (such as priority based budgeting concepts explained in the State Budget Reform Toolkit) should be explored as the alternative to such risky financial measures.

In Depth: State Budgets

Smart budgeting is vital to a state’s financial health. The ALEC State Budget Reform Toolkit offers more than 20 policy ideas for addressing today’s shortfalls in a forthright manner, without resorting to budget gimmicks or damaging tax increases. One way to stabilize budgets over time is to embrace…

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