In what is the product of the sustained low-rate environment, many municipalities are considering addressing their pension position through bonds. This should be encouraged by policymakers and explored by pension systems.
Bond markets are offering municipalities the opportunity to exchange discount rates of 6, 7 and sometimes even 8 percent for bonds with yields below 3 percent. The spread between the discount rate and the bond yield is the root of the appeal of pension obligation bonds.
A natural question is “How do pension systems become underfunded?” The answer is a combination of issues. The two largest are underperforming investments and insufficient employee contributions.
The former is usually the result of overly optimistic assumed rates of returns: For example, if a retirement board votes to calculate their funding schedule based upon an 8 percent assumed rate of return and the system’s asset mix returns 7.5 percent, then the unfunded liability increases proportionally to the half a percent of underperformance.
The latter issue, insufficient employee contributions, has largely been addressed nationwide and most pension funds receive annual employee contributions that satisfy projected future payouts for those employees. It is important that retirement boards and municipalities that use pension obligation bonds remain vigilant that all future employees are contributing enough to cover their future pensions. If they do not, the unfunded liability will return, an important note for policymakers.
The benefits of these bonds include budgetary stabilization, long-term savings and short-term budgetary relief.
Pension obligation bonds stabilize budgets because funding schedules for addressing unfunded pension liabilities escalate year over year. When bonded, this annual escalation ceases and is replaced by a fixed annual payment. This inhibits growing pension costs from taking municipal funds away from spending on education, public safety and infrastructure.
Compositionally, these bonds often allow portions of the current year’s pension payment to be deferred. This deferred payment is often required to be diverted to reserve accounts to hedge against market downturns. This deposit bolsters a municipality’s unreserved fund balance, which strengths their basic financial statements. An increase in unreserved fund balance can also contribute to a credit rating increase, reducing future borrowing costs.
The most complex and important portion is the long-term savings. The variables are far more gradient and numerous, but they primarily revolve around three major points: unfunded pension liability, discount rate and bond yield.
Unfunded pension liability is the product of two variables: projected obligation and projected payout capacity. The projected obligation is the amount of the pensions that are guaranteed to the municipality’s retired and current employees. The projected payout capacity is the amount the pension fund can sustainably distribute relative to eligible pension system members. When the difference between payout capacity and obligation is negative the value is recorded as the unfunded pension liability.
The discount rate dictates the “interest” municipalities must pay on the balance of the unfunded pension liability. Municipalities must pay the unfunded liability as if it was earning the assumed rate of return. Assumed rates of return are usually voted on by retirement boards and certified by state agencies. They usually range between 6 and 8 percent. When bonded, the municipality no longer needs to raise its tax levy annually to mimic market returns. The proceeds from the bonds are generating the return.
As long as municipal bond yields remain far below the assumed rate of returns, municipalities can exploit this difference to address their pension liabilities. The high-quality corporate bond market mimics pension bond yields fairly well, as both are taxable and track entities with strong resilient revenue sources. The yield in this market is at an all-time low.
Moreover, taking on this debt does not change the liability profile of the municipality. The new debt replaces the liability of the unfunded pension. No new liability is being created. Instead, the municipality is addressing the liability with a lower-cost financing tool.
Pensions are a known liability that municipalities cannot avoid; no matter the economic or financial conditions, they will have to payout. Addressing the liability now, with rates at a historic low point, stabilizes pension funds and is a prudent financial solution.
Eric J. Mason is the Chief Financial Officer for the City of Quincy, Massachusetts. Quincy recently issued $475 million in bonds to address its unfunded pension liability.