Pension Obligation Bonds And How They're Viewed
A Pension Obligation Bond has a ripple effect. The key is to thoroughly investigate from the outset whether or not this financial instrument is the most suitable choice. It is a long-term commitment involving a fixed repayment schedule. The rewards forever hold the promise of outweighing the risk. Each municipality has a different degree of tolerance for such fluctuation. The issuance of a POB also comes under the radar of rating agencies.
How do rating agencies view Pension Obligation Bonds?
Moody’s Investors Service and the other two top agencies are effectively neutral on the issuance of POB’s. The reason is that existing pension debt is simply swapped out directly for a POB. However, if the debt incurred by a POB is structured merely to achieve short-term budget savings, the rating agencies would view this issuance negatively. The trade-off of the softer funding structure of the pension plan for a fixed debt POB repayment schedule can be a negative, but the potential interest savings over the long-term can outweigh this issue.
Moody’s has recently announced they are considering changing their rating analysis to give more weight to debt and pension liabilities from 10% to 20% and decrease the weight for economic factors from 40% to 30%.
What is the appropriate size of a Pension Obligation Bond?
There is no “magic figure” for the proper size of a POB. This will be based on the Town’s ability to service the debt, its bond rating and issuing costs, the expected rate of return and the Town’s willingness to trade soft contributions for a fixed repayment schedule.
Let us break down an example in which the Town issued a POB for the entire unfunded balance of $33.8 million and all actuarial assumptions were realized as expected. In this case, the Town would still be required to fund the annual normal cost of approximately $700,000 for FY 2014 increasing by about 4.0% per year.
As the UAAL is based on a 20-year amortization and a 7.75% interest rate, the Town could potentially achieve an annual savings of approximately 2% or $675,000 (the ultimate savings will be based on actual issuance rates and returns achieved on investment of the issuance). The Town may decide on a lesser issuance (i.e., setting a goal of 80% funding) to preserve some budgetary flexibility.