Archive for the ‘MAPERS’ Category

 

George Vitta and Katherine Ghannam will attend the MAPERS 2011 Fall Conference on Sunday, September 18 through Tuesday, September 20 at the Amway Grand Hotel in Grand Rapids, Michigan.

 

The three days of educational programming targeted to public retirement plan trustees includes new a ‘New Trustee Workshop’ geared toward first term fiduciaries, investment education sessions on managing risk while pursuing returns and investment strategies.  Of great interest to many of our clients will be the review and discussion of the MAPERS membership survey conducted earlier this year.

 

The theme for the conferences’ social events is the ‘Awesome 80s’.  While most of us recall the era of trend-setting fashion and the driving beat of the dance music, we may prefer to forget the 12 – 15% mortgage interest rates that prevailed through much of the decade.

Asset Strategies Portfolio Services, Inc. is an institutional, investment consultant located in Auburn Hills, Michigan.  For more information, please call 248-373-9900.

By:      Katherine T. Ghannam, CPA

Historically, governments have used various strategies for managing shortfalls in pension and OPEB commitments during times of fiscal stress.  Some chose to defer annual contributions.  Some change actuarial assumptions.  Others change the benefit promise.  Still, others are obligated by statute to make annual contributions.  In these cases, governments may choose to issue a POB to fund their pension or OPEB commitment.

In addition, GASB 45, the accounting rule established in 2004, requires that other post-employment benefits (OPEB) be accounted for in a similar manner to pension obligations.  Government employers must measure and report the liabilities associated with OPEB.  (The most common OPEB are retiree health care obligations) The result has brought attention to the unfunded liabilities associated with these benefits.  Employers must now calculate these liabilities and provide actuarial reports prepared calculating the unfunded OPEB liabilities.  Issuing Pension Obligation Bonds is a strategy many public plans have used to address underfunded liabilities, with varying results.

POBs are bonds issued by state and local governments as a way to finance the employer contribution to pension/retirement funds or other post employment benefit funds (OPEB) in which its employees (and beneficiaries) are participants.  Bond proceeds are deposited in the pension or OPEB trust fund for investment and the issuing government repays the bond (principal and interest) from the general fund. The theory is to borrow funds at a low fixed interest rate, and then invest the proceeds in securities that are projected to earn higher rates of return.

Historical Background

In the 1990s more than $10 billion in POBs were issued.  Two factors contributed to this occurrence; First taxable interest rates fell considerably, bringing the cost of POB borrowing down.  Second, pension funds generated higher returns by increasing their equity holdings substantially over the decade.  This period of strong equity market returns led many trustees and actuaries to assume that future returns would be high as well.  The combination of these two factors was enough to convince some governments that POBs offered an attractive “actuarial arbitrage.”[i]

By 2009, total POB issuance increased to over $40 billion on state and local governments’ balance sheets.  However, even with a spike in issuance in 2003 due to one state’s issuance of $10 billion POBs, the total amount issued in any one year has not exceeded more than 1% of the total assets in public pension funds.[ii]

 Reasons to consider POBs

The reason most often given is that issuing bonds provides an actuarial arbitrage opportunity.  In theory, this could reduce the cost of pension or health care obligations.  Current actuarial assumptions assume investment returns of 7% to 9%.  By commingling the proceeds from POBs with the pension or retiree health care fund’s investments, the assumption is that the bond proceeds will grow at the actuarial assumed investment returns.  The pension or health care plan has the ability to invest in riskier, high return assets, hence the arbitrage opportunity.  This is especially compelling to governments whose taxable borrowing costs are in the 5% to 6% range or lower.

• For example, during 2002 and 2003, two Wisconsin counties borrowed $7 million at less than 3%.  In turn their combined investment returns on the borrowed funds were greater than 20%.  They were rewarded for taking on the additional risk.

A second reason often cited is budget relief.  During difficult economic times, state and local governments can use POB proceeds to reduce underfunding.  While some states face legal requirements to reduce underfunding, other states may put off funding.  POBs are fixed payments that must be paid over the long-term, forcing governments to deal with the benefit funding issue as a non-negotiable portion of the government’s budget.  POBs transform pension and health care liabilities into another debt obligation which is generally paid for out of the budget.

A third reason to consider POBs; they may be viewed as a better alternative to (i) paying more into the plan,  (ii) asking employees to pay more into the plan,  (iii) reducing benefits, or (iv) hoping the gains on pension investments will subsequently exceed the assumed rate of return. [iii]

Risk Factors

The disadvantages and risk factors fall into a number of categories including arbitrage risk, leverage risk, market risk, and political risk.

Arbitrage:  POBs are essentially an arbitrage play.  Success is based on the premise that investment returns will exceed borrowing costs.  However, these assumptions may not be correct.  Borrowing millions to fund pension or health care benefits is a risky strategy.

Examples

• A Chicago area public retirement plan was $1.5 billion underfunded in 2007.  It lacked sufficient cash to pay retires through 2013 and was underfunded by approximately 62%.  The agency decided to raise the money from a bond sale.  Before the end of 2007, the fund was paying more out to bondholders than it was earning on its new influx of money.  The plan unwittingly put itself further behind.  It borrowed money at the end of a four year bull market, $1.9 billion, at 6.8% interest rate.  Most of the money from the sale, held in a money market fund, earned 2%, substantially less than the borrowing rate.[iv]

 

• In 2008, a plan in Puerto Rico issued $2.9 billion in pension bonds at 6.5%.  They anticipated earning 8.5% by investing the proceeds in the capital markets.  When the financial markets collapsed in 2008, the retirement system had a loss of more than $200 million instead of the 8.5%, expected earnings.[v]

Pension funds typically outperform municipal bonds, as they are heavily weighted in equities and corporate securities.  However in the event of a major stock market correction it could set a pension bond program (i.e. repayments) back many years.

Leverage: POBs increase the overall level of financial risk for the issuer.  Investments must be made in riskier asset classes to compensate for the borrowing costs of POBs.  POBs are a means of substituting one long-term debt for another.  Borrowing for any purpose increases leverage, and incurring debt to pay for unfunded debt obligations is no exception. The pension plan issuer does not extinguish any underlying liability associated with the funding gap. With respect to the issuer’s balance sheet, it simply moves a footnoted contingent liability into an on balance sheet liability.[vi]

Timing:  POBs can run into considerable timing risk as the proceeds are received in one lump sum for investment in the financial markets.  Dollar-cost averaging is the preferable method of investing large sums of monies.  Research has suggested that the best time to invest the proceeds would be during a recession or when the stock market is depressed.  However, that would require knowing when the market has “bottomed” or knowing when the market is at a “top”.  You also run the risk that interest rates may fall below your borrowing costs.

Political:  There is always political risk with POBs.  If the POB is used to fully fund the pension or health care plan and subsequent higher than average returns result in an overfunded status, you may run the risk that special interest groups will call for increased benefits, thereby incurring new liabilities. The liability for the underfunding is moved from the plan’s balance sheet to the sponsor’s balance sheet.  Plan sponsors need to be realistic about investment expectations, while the 1990s experienced higher than average investment returns the excess funding status that existed quickly disappeared when the markets declined in the 2000s.

In order to assess the extent to which POBs have been successful, a study was completed by the Center for Retirement Research at Boston University to calculate the internal rate of return of the universe of taxable POBs issued since Tax Reform Act of 1986 through July 1, 2009.  The universe included 2,931 POBs issued from 236 different government entities, totaling approximately $53 billion in 2009 dollars.[vii]  The study assumed that the proceeds were invested in approximately 65% equities (S&P 500 total return index) and 35% bonds (Barclay’s 10-year bond total return index).  For each bond they calculated the growth of the invested bond proceeds for that year, and then subtracted the interest payment (using the stated coupon rate).

The bonds were valued at the end of 2007, the peak of the stock market and then valued again at the end of 2009.   The conclusion reached is that only bonds issued before 1997, and those issued during dramatic stock market downturns, have produced positive returns.  All others are underwater.

Conclusion:

POBs are usually taxable bonds issued by state and local governments to fund pension and health care benefit plans.  They transfer a current obligation of the benefit plan to a long-term fixed obligation of the government.  There are considerable risks to issuing POBs including arbitrage/investment, market, timing, and political risks.  After the recent market collapse in 2008, most POBs issued since 1992 are in the red.  Interestingly, research indicates that most POBs are issued by financially stressed issuers, who are not in a strong position to shoulder the investment risk.[viii]

Nevertheless POBS may be beneficial for certain issuers under the right market conditions.

A thorough analysis of the pros and cons is required and all the risks should be evaluated.  There should be a clear POB plan with attainable actuarial and investment assumptions and a conservative financing structure.

Other considerations provided in testimony by Ron Snell with the National Conference of State Legislators, included:[ix]

• Bond issuers should have the capacity for added risk.
• Bond issuance should not be so large that it limits borrowing for other purposes.
• An issue should be no more than about 20% of the pension fund’s assets (to limit risk, and facilitate investment).
• Debt service should be in roughly equal annual amounts.
• POBs should not be used to shift current financial problems into the future.

 

Appendix

Other Issues

Guaranteed:

By law, states must guarantee public pension fund debts.

Types of POBs:

Most POBs are payable from the general fund of the local or state issuing government.  They must satisfy or be exempt from the debt limitation provisions stated in the state constitution and generally fall into one of three categories.[x]

• General Obligation Bonds, which refer to bonds that satisfy any constitutional debt limitation and are backed by the full faith and credit and taxing power of the issuing state or local government.

• Obligations imposed by law, which is an exception, recognized in a few states from the otherwise applicable debt limitation contained in the state constitution. It applies to obligations imposed on the state or local governments by the constitution or by statue.  For example all POBs issued in California during the last ten years or so have all been obligations imposed by law.

• Annual appropriation bonds are not considered debt subject to a constitutional debt limit because the state or local government issuer has no legal obligation to pay them and payment is therefore subject to annual appropriations of funds for that purpose by the state legislature or governing body of the state of local government.

Debt Capacity:

A final point related to a jurisdiction’s debt capacity. Issuing bonds may reduce debt capacity that otherwise could be used for capital infrastructure replacement.  This is a particular concern if a jurisdiction has statutory or constitutional limitations on the amount of debt it can issue and if pension bonds are subject to the cap.  Governments contemplating pension bonds must carefully evaluate the opportunity costs.

• Taxes Issues/Higher borrowing rates:

Pension Bond sales are similar to ordinary municipal bonds, in that they are guaranteed by taxpayers.  However the government recognized the difference between pension bonds and other municipal bonds.  General obligation bonds are typically used to pay for construction of schools, hospitals and other public works.  In 1986, tax reform bill, decided that pension bonds income should be subject to federal income tax, implying higher borrowing rates.

• Bonds Issuance Ratings:

It appears that the specific motivation for issuing the pension bonds plays a key part in how they are rated, and such debt can effect an issuer’s other ratings.  Usually the rating is not affected if the savings are spread out over the life of the program. But if viewed differently often a downgrade can occur.  Because POBs replace existing pension obligations, they are not generally viewed as adding to the debt burden of the local or state government issuer.

“Standard & Poor factors the effects of a pension obligation bond strategy into the long-term rating of the sponsor.  Standard & Poor has viewed POBS as a strategy for saving on carrying charges as long as the transaction was structured conservatively and the assumptions were reasonable and attainable.  This requires a clear financing plan including reasonable assumptions and manageable leverage.  Prudent expectations for investment returns and the cautious use of resultant savings help insure a POB’s success.  Another positive factor for a POB is, of course, to be fortunate enough to sell the bonds in a low interest rate environment, thereby increasing the spread between interest costs and investment return expectations and lowering the risk of underperformance.”[xi]

• Actuarial assumption:

General discussions with the actuary regarding issues and concerns that are relevant to assumptions made in regard to issuing a Pension Bond.  Discuss possible changes in actuarial assumptions, rates, rate of inflation, etc with the actuary.

• Michigan issue:

Legal Authority:  Bill not passed as yet by Senate – not law in Michigan

• Michigan has passed legislation in the House, Bill 4074, 4075, and 4077.  Senate Bill 927 is reportedly out of committee with the recommendation that it pass, and is pending on the floor.   If passed, the bill authorizes a form of “POBs” on retiree health benefits.  The Senate Bill 927 would permit county and municipal governments to issue pension obligation bonds for their retiree health care costs.  In fact the bills would make it harder to reduce the benefits to something more reasonable.  A similar bill in 2006 was vetoed by Gov. Jennifer Granholm, reportedly due to a tiff with Oakland County Executive, Brooks Patterson.   Both bills would allow local governments that meet minimal solvency standards to “sell bonds” and invest the proceeds in the financial markets where presumably their money manager’s expertise would earn sufficient returns to pay both the interest on the debt and some of the future retiree health benefits.

• An interesting point to note is that both bills acknowledge that under current law, there is no contractual obligation to pay these benefits.  Both bills would convert what currently appear to be nothing more than promises into a financial obligations and liability of the taxpayer.  Future taxpayers would be on the hook to repay the debit represented by the bonds that the bills would authorize.  Perhaps, it makes more sense to reduce these benefits as they appear to be unsustainable.

• Legal Information and Disclosures

This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice.  Asset Strategies Portfolio Services, Inc. has no duty or obligation to update the information contained herein.

This memorandum is being made available for educational purposes only and should not be used for any other purpose.  Certain information contained herein is based or derived from information provided by independent third-party sources.  Asset Strategies Portfolio Services, Inc. believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Asset Strategies Portfolio Services, Inc.

George Vitta led a breakfast roundtable discussion at the Michigan Association of Public Employees Retirement Systems conference on Tuesday, May 3, 2011.  The MAPERS Spring conference was held at the Grand Traverse Resort in Acme, Michigan near Traverse City.  The theme for the weekend was the old west.  Discussion with conference attendees focused on the role of the investment consultant, current themes in asset allocation strategy, capital market opportunities and risk management techniques.  The table was full with twelve participants, who had a rare opportunity to ask any question of a consultant and not get billed.  Free advice . . . priceless!

 

Auburn Hills based investment consulting firm Asset Strategies Portfolio Services, Inc. has been a MAPERS member for 20 years.  For more information please call 248-373-9900.