Cities and towns in California issued about $7 billion in pension obligation bonds (POBs) across 2020 and 2021, the two years with the highest level of borrowing activity to fund pensions in state history. Policymakers in the state had sought to take advantage of historically low interest rates brought about by Federal Reserve policies to keep rates low in response to the COVID-19 pandemic.
With the exception of local government officials in Arizona, counterparts elsewhere showed less interest in this approach. In fact, pension bond activity in these two states alone accounted for about half of the $10 billion in issuances in 2021. That year saw the second-highest level of annual POB activity on record, according to research by Municipal Market Analytics (MMA) and The Pew Charitable Trusts.
POBs are taxable bonds that some state and local governments have issued to reduce unfunded pension liabilities by creating debt on their balance sheets and investing bond proceeds in their pension plans. In effect, the governments engaging in this strategy have collectively made an outsize bet on the financial markets to help bring down pension costs. The volume of POB issuance nationwide has abated with the sharp rise in interest rates last year. Still, ongoing turbulence in the markets and the prospect of a recession indicate that these transactions, particularly those issued when stock valuations were at all-time highs, require increased monitoring going forward.
In a bid to save costs, POB issuers borrowed at low interest rates to help fund their pension liabilities with the expectation that the investments would earn a higher rate of return than the cost of repayment on the bonds. For cash-strapped government pension plan sponsors, a POB can offer immediate budget relief by boosting the plan’s funded level and reducing actuarially required contributions. And over the long term, these borrowings have the potential to generate significant savings, as long as investment earnings exceed borrowing costs over the life of the bond.
But such savings are by no means guaranteed. More than two-thirds of public pension assets are invested in equities and other investments that fluctuate with the markets and the economy. As a result, issuing a POB is essentially a leveraged bet and carries significant risks. For this reason, the Government Finance Officers Association historically has discouraged the practice, with the explicit recommendation that “state and local governments do not issue POBs.”
Investments made by various governments during the stock market peak in 2021 are most at risk. Just as federal monetary policy had the effect of lowering interest rates, fiscal policy in the form of $5 trillion in federal stimulus helped to fuel economic growth, boosting corporate profits and stock prices. By one standard measure of stock prices, the price-to-earnings ratio, valuation levels during 2021 were higher than at any point since the dot.com bubble. In contrast, valuations during 2003 and 2008, the two highest POB volume years before the recent surge according to research by MMA, were below historical averages and followed by periods of above-target returns for public pension funds. (See Figure 1.)
More recent results demonstrate why asset price levels and timing matter. Beginning in the first quarter of 2022, stock prices tumbled amid growing concern over the Federal Reserve’s struggle to tame inflation, and bond values fell as interest rates rose. As a result, a majority of new monies invested in pension funds during most of 2021 and early 2022, including one-time proceeds from pension bonds, have so far likely generated negative returns based on Pew’s analysis of median pension fund returns from Wilshire Trust Universe Comparison Service. (See Figure 2.)
To be sure, these outcomes reflect only short-term results and are not a reason to panic. Borrowing governments typically have 15 to 20 years to repay bond proceeds and generate investment gains over the life of the bonds. In addition, most pension systems expect long-term returns of at least 6%, while governments borrowed at historically low average rates of 3% to 3.5% during the recent POB surge. As a result, if state and local pension funds come close to meeting their return targets over the next two decades, even transactions most at risk today can be expected to generate gains above borrowing rates.
At the same time, policymakers should not underestimate the importance of when POBs are issued and invested. Municipalities that invested funds at the very peak of the market are much less likely to see cumulative returns over the life of the bonds that meet original expectations. And in the event that long-term returns fall short, issuers will eventually need to make up the difference through increased contributions from the sponsoring government’s budget. This long-term budget impact could be especially pronounced in California as a tale of two groups of cities: those that issued POBs and invested bond proceeds in 2020 before the run-up in the market and those that shifted bond proceeds in 2021 when valuations were highest.
Given the high volume of bond issuance in 2021 and the market losses that followed, increased assessment and monitoring of POB market risk may be warranted. Issuing governments, for example, could provide regular disclosures at the time of issuance and then periodically that assess the current status and future outlook of each transaction. Disclosures could provide information on estimated savings—or losses—of invested bond proceeds to date, as well as on expected returns, the probability of losses, and the potential impact on employer contributions.
These types of analyses are sometimes done already. Riverside County in California, for example, publishes annual reports assessing ongoing POB performance alongside a forward-looking outlook of pension liabilities and costs. And a case study of the POB issued by West Hartford, Connecticut, in 2021 outlines the quantitative assessments used to help policymakers assess—and manage—the potential risks of borrowing prior to issuing the bond. These assessments, however, are not performed consistently across jurisdictions, and adopting a more standardized and transparent approach would better serve government stakeholders and bondholders.
State governments and other entities also may have a role to play. In California, the State Treasurer’s Office already maintains an extensive database of all POB transactions in the state and has direct access to investment performance data for the California Public Employees’ Retirement System (CalPERS), the state’s $400 billion pension system. Most state and local government entities participate in CalPERS, which could allow for regular monitoring into how POBs in the state are performing. Similarly, government finance organizations and fiscal watchdogs could recommend periodic risk assessments of issued POBs to encourage issuing governments to more carefully monitor and evaluate bond performance alongside expected and potential investment outcomes, while still maintaining their official recommendation against the practice.
Greg Mennis is a principal officer, Stephanie Connolly is a principal associate, and David Draine is a senior officer with The Pew Charitable Trusts’ state fiscal policy project.