Can Fiscal Alchemy Bolster Public Pension Funds?



One way to put a quick sheen on pension funds’ balance sheets is to issue municipal bonds at a lower rate of interest than the pension fund is expected to earn. These “pension obligation bonds” (POBs) have a long and checkered history. The first one was sold tax-exempt by the city of Oakland, Calif., in 1985. It stirred up a hornet’s nest at the IRS, which quickly realized that the lower tax-exempt interest rate was subsidized by Uncle Sam in a no-brainer for the pension fund that in theory could just invest in taxable bonds to make a profit, even without risking money in stocks. Congress was prodded to prohibit the use of tax-exempt debt where there is a profit-seeking investment “nexus,” and thus was born a thick book of IRS “arbitrage” regulations. Consequently, POBs must now be taxable, with a higher interest cost.

When interest rates are low, as they are today, the underwriters and many financial consultants come out of the woodwork to pitch their POB deals. The lure is always the same: “Over 30 years, you will save money because history shows it’s almost a certainty that stocks will outperform low bond yields,” even if they are now taxable. I’ve written extensively on the foreseeable cyclical risks of selling POBs when the stock market is trading at record high levels: The underwriters and deal-peddlers will sneak away with their fees from the deal, and public officials will be left holding the bag whenever an economic recession or stock-market plunge drives the value of their pension funds’ “new” assets below the level of their outstanding POBs. The Government Finance Officers Association (GFOA) has long opposed POBs for this reason, among others. POBs make sense to me only when they are issued in recessionary bear markets.

Author(s): Girard Miller

Publication Date: 16 March 2021

Publication Site: Governing