Issuing POBs is more prevalent over the last few years as interest rates have declined and remain at historical lows. While pension plan investment return assumptions (also known as discount rates) have steadily declined over the years, they remain at a healthy level (or spread) above today’s interest rate costs on POBs. This spread difference is appealing to states or municipalities as it can potentially create long-term savings for the municipality provided the investment portfolio can achieve its long-term investment return assumption. Investment results that fail to meet the plan’s long-term investment return assumption would impair the plan’s funded status and the plan’s annual contribution would increase accordingly while interest payments on the POB would still need to be paid.
Investing POB Proceeds – Cautionary Tales
From the state or municipality perspective, POBs can be an attractive alternative to earmarking general funds to the pension plan to shore up the funded deficit or hoping that investment results will meaningfully exceed the plan’s assumed long-term rate of investment return. However, the decision to issue a POB should be given careful and thoughtful deliberation.
The issuance of POBs can result in less favorable outcomes than planned. Plan Sponsors employing aggressive investment strategies; untimely market initiatives; or sudden and prolonged economic downturns after issuance can result in unforeseen higher operating costs. For instance, in 2015, the Government Finance Officers Association (GFOA) cautioned states and municipalities against issuing POBs, pointing out implications around investment underperformance that may further burden the state or municipality with debt service requirements and unfunded pension liabilities resulting in higher total operating costs. In addition, the GFOA cautions Plan Sponsors against structuring POBs in a manner that defers the principal payments; for example, an interest-only payment structure in the early years, or a structure that extends repayment over a period longer than the actual amortization period, thereby increasing the overall costs to the Plan Sponsor.
Establishing a Governance Process
The decision to issue a POB by a state or municipality will vary from issuer to issuer. For myriad states and municipalities, the significant growth in the unfunded accrued liabilities (a byproduct of market downturns, updated mortality tables and lower investment return assumptions), resulted in significant increases in the ADEC and is expected to double over time in some cases. This challenges the state or municipality operating budget, which in turn potentially diverts monies intended for other projects or services, putting the onus on current and future taxpayers.
As noted previously, understanding some of the drawbacks to POBs issued by other communities can foster an open dialogue amongst all stakeholders who are considering a POB package. The Town of West Hartford, for example, explored quantifying the risks of a POB issuance with guidance and input from its advisors. They employed a collaborative and judicious approach to assess the impact of a POB issuance on the town’s current bond rating and operating budget. In fact, they used stochastic modeling to help stakeholders consider potential outcomes and the impact on the town’s financials.
At the core of the POB transaction, the Plan Sponsor contributes the proceeds of the debt issuance into the pension fund with the goal of achieving its long-term return assumption through a prudent investment strategy. Chris Kachmar discussed ways to mitigate the risk of a large loss on the bond proceeds shortly after the issuance with Fiducient Advisors’ consultative approach that invests the proceeds initially in a low-yielding conservative portfolio. After that, the investment manager invests the proceeds in accordance with the pension’s long-term investment strategy through a disciplined, dollar cost averaging approach over a period of at least six quarters. Additionally, the size of West Hartford’s issuance warranted an examination of the current portfolio’s structure to ensure the investment managers had the capacity to undertake additional funds and to explore other asset classes that might complement the portfolio’s long-term goals and objectives.
In addition to analyzing the factors described earlier, the Town was also transparent in its goals, objectives and processes to fully inform stakeholders and constituents, including the Town’s taxpayers, town council and credit agencies as well as the State of Connecticut’s Treasury and Office of Policy & Management.
To issue… or not.
The question often asked when debating whether to issue POBs is:
How will the issuance materially impact the state or municipality’s risk profile?
As we mentioned the mathematical mechanics previously, in theory borrowing at 3 percent and investing the proceeds at 6.25 percent, for instance, should save the sponsor money over the long term. However, the timing and magnitude of an economic and market downturn are unpredictable; adverse market performance (relative to the discount rate) could have negative consequences as the pension plan may again become underfunded, forcing the sponsor to deal with higher contributions in addition to paying the debt service. Similarly, plans able to take advantage of the meaningful benefits of a POB issuance (higher funded status) should remain disciplined around contributing an amount equal to at least the normal cost to mitigate the impact of any market downturns.
Of course, exploring the issuance of POBs involves key stakeholders at the state and municipal level, including its taxpayers. Doing so requires guidance and thoughtful input and planning from the plan’s actuary, bond counsel, investment consultant and the financial advisor. Stochastic modeling can provide insight and valuable information in assessing a range of potential outcomes, both good and bad, for the Plan Sponsor. Thorough and transparent due diligence keeps all stakeholders informed and creates a solid Fiduciary Trail® around the decision-making process.
For more information, please contact any of the professionals at Fiducient Advisors.