Pension Obligation Bonds – Pros, Cons, & Issues
A Pension Obligation Bond (“POB”) is a debt instrument issued by a municipal entity such as a Town to fund all or a portion of the Unfunded Actuarially Accrued Liability (“UAAL”) for its pension or OPEB plan.
A POB is designed to take advantage of an arbitrage opportunity whereby the Town can issue taxable debt at a lower rate than what can be earned by the pension fund. Access to this capital enables a Town to invest it and realize relatively strong profits. Ultimately, this can have the positive effect of reducing the long-term costs of the pension plan.
POBs carry with them a potential for risk and reward. It is important to evaluate how they will affect a Town’s financial viability, not just in the short term but in the long term.
Their overall effectiveness cannot be concretely demonstrated until the end of the loan cycle, which is typically 20 or 30 years.
Pension plans have a built-in element of flexibility to adapt to shifts in priorities and economic conditions, whereas POBs operate under stricter parameters. This introduces leverage to the Town’s balance sheet in that the flexibility of its annual required contributions under GASB 67/68 is largely converted to this fixed debt repayment schedule.
If the funds are invested well, a surplus may occur. This can lead to contribution holidays and/or pressure for increases in other benefits. Towns face such political pressure, while also having to keep an eye on the future. Market conditions are constantly changing, so it is best to prepare for lean times even during strong economic cycles. Even if POBs are achieving strong returns, this positive uptick may have the unintended consequence of “crowding out” the Town’s ability to issue other debt for capital improvements.