Benefit Bonds: What You Should Consider

The issue of funding an increasing pension liability is a lingering concern for many trustees and state officials. As employee contribution rates continue to increase, discount rates are declining, and municipal contributions are under pressure due to competing priorities, many plans struggle to properly manage and continue to provide benefits to employees.

Unfortunately, the investment outlook does not provide a respite from increasing liabilities in the near term, and global growth expectations continue to be ratcheted down. As a result, cities and counties need to get creative. This has led to consideration or issuance of- pension obligation bonds (POBs).

While it is better to fund retirement obligations with cash from the budget, in some situations, bond issuance, specifically “benefit bonds,” may make sense. These instances require significant preparation and evaluation —potentially years in advance — of the actual issuance. Some important items that municipalities, managers, administrators, and other professionals associated with public employee retirement systems should consider prior to the issuance of benefit bonds follow.

Stop the bleeding: Underfunded pension and Other Post-Employment Benefits (OPEB) plans do not materialize overnight; many factors contribute to a poorly funded plan.

As a viable solution, extreme plan reforms may involve closing the Defined Benefit (DB) pension or OPEB plan. Less draconian fixes include stronger funding policies or more risk sharing with employees. If the root causes for the declining funded status are unaddressed, issuing bonds is a short-term action that may result in an expensive long-term solution.

Prepare to issue when the benefit bonds window is open: Benefit bonds are most appropriately issued during a certain “window,” specifically, when interest rates are low and a solid intermediate- and long-term return outlook in the equity markets exists. This allows the bonds to be issued relatively inexpensively with a relatively higher likelihood of positive arbitrage when the proceeds are invested in a diversified portfolio.

While it is uncertain when and how long the benefit bonds window may be open making precise timing unlikely, it is vital to issue and reinvest under proper circumstances. Conversations with the authorizing body, preparation of legal or authorizing documents, and consideration of issuance structure and size in anticipation of the window can help expedite the process. Timing for this strategy typically occurs when the markets are stressed, so benefit bonds issuance should be prepared for in advance, when emotion is not part of the equation. Preparing does not mean the bonds need to be issued.

Structure the issuance appropriately: Debt structures can be issued on a “level debt service” basis, where the debt service is shaped similar to the current planned liabilities, or they may be structured for budgetary flexibility or “savings” in targeted years. Depending on market dynamics, issuance size, and risk appetite, components can include both fixed- and variable-rate debt. One must account for current and projected cost and budget dynamics to optimize the structure and to provide the greatest likelihood for positive results.

Sizing the benefit bonds issuance to increase the plan solvency without creating a potential “overfunding” problem is a key consideration. A significantly underfunded plan (which, in our view, is less than 80% funded at the recent June 1, 2021 equity market levels) should consider whether a multi-tranche approach to the debt issuance is cost effective. This “dollar cost averaging” approach to debt issuance can help mitigate the negative effects of unintended/unforeseen consequences.

Another consideration in the bond structure is the amortization schedule. The Government Finance Officers Association (GFOA) best practice warns, “The POBs are frequently structured in a manner that defers the principal payments or extends repayment over a period longer than the actuarial amortization period, thereby increasing the sponsor’s overall costs.” While the debt may be structured to provide budgetary savings, this benefit should be weighed against the downside of increasing total interest cost or unreasonably extending the time to pay off the liability. Issuers, managers or trustees considering benefit bonds can follow a level percent of pay amortization, which defers principal payments, and/or to have a relatively long remaining amortization period — i.e., over 20 years — so that this will not be an issue in many cases.

Protect the taxpayers: Since retirement plan contributions and debt service payments are met by the taxpayer, governments should protect the public where legally possible. This may include creating policies and/or debt covenants that limit the ability of future governing bodies to increase benefits while the debt is outstanding.

Ensure you have a current funding policy: Employers and plan sponsors should discuss the funding policy with their financial advisors and actuaries. Plans that have contribution requirements, amortization schedules, and other components governed by state law should also consider an updated funding policy tailored to their situation.

A pension or OPEB funding policy that is written and formally adopted by the plan sponsor should also ensure that the normal cost of the benefit is funded annually, that the Actuarial Determined Contribution (ADC) is clear and annually funded, and that the debt proceeds can be deployed in the most advantageous manner, without risk of the intent being degraded by a lack of consistent and adequate contribution funding.

Communicate your strategies: Pension funding explanations can be confusing to constituents. With a myriad of accounting and reporting standards, ratings agencies’ views, and segments of the actuarial community advocating for different ways to value pension liabilities, a tremendous amount of seemingly conflicting information is available for public consumption, making life more difficult for plan stakeholders.

Markets are unpredictable. Even a well-timed debt issuance may not appear successful during an outstanding debt’s entire term. With potential negative year-to-year financial implications, various assumptions, risk-mitigating features included in the issuance, and multiple scenarios should be discussed with the authorizing governing body and communicated to the public. A clearly defined outline of the strategy to manage/contain benefits growth, create funding certainty, and alleviate risks should take place, along with a discussion of exogenous variables that could negatively impact the strategy. 

About the Authors: 
Mallory Sampson, CFP, is Senior Managing Consultant at PFM Asset Management. She develops and implements investment strategy and recommends asset class and investment manager decisions for implementation. Sampson works with a select number of PFM’s institutional multi-asset class relationships in the South region, with a focus on pensions, OPEB trusts, endowments, foundations and higher education. Mallory serves as a member of PFM’s National Endowment and Foundation team and the PFM Foundation Committee.
Floyd Simpson III, CFA, CAIA, CFP, is Senior Managing Consultant with PFM Asset Management. He works with institutional clients to develop and implement multi-asset class strategies for their portfolios. Simpson serves on PFM’s Multi-Asset Class Investment Committee, as well as on the board of the CFA Society of Philadelphia. 
PFM is an Associate Member of TEXPERSThe views and opinions contained herein are those of the authors, and do not necessarily represent the views of PFM nor TEXPERS. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.
Follow TEXPERS on FacebookTwitter and LinkedIn as well as visit our website for the latest news about Texas' public pension industry.


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