To Bond or Not to Bond,
That Is The Question
Many public employer sponsors of pension and/or Other Post-Employment Benefit (OPEB) plans are considering issuing taxable Pension Obligation Bonds (POB) as a way of closing any funding gaps that might exist in their retirement plans. Not only does using the proceeds of such bonds for retirement plan funding immediately improve the funded status of that plan, but there exists the possibility of arbitrage – that is, proceeds from the bonds could, once deposited into the retirement plan, reap the expected rate of return on those plan assets in excess of the bond rate.
One obvious risk associated with such a funding strategy is the possibility that the targeted return on plan assets is not achieved. But how big is this risk and how significant is it? After all, wouldn’t a plan sponsor have to make up the shortfall whether or not a POB was used as a funding device?
A second, maybe not as dire but still of some consequence, risk would be investment returns significantly in excess of the targeted return. In such a situation, a contribution less than what is being required to repay the bond could be generated making the total cost to the employer higher if issuing a bond than it would have been had a bond not been issued and used for plan funding. In such cases, excess assets would be accumulating in the retirement plan and would not otherwise be accessible for other projects while bond financing continues.
As an example, suppose stochastic asset return modeling were done in conjunction with projecting plan liabilities in order to assess the risk that cash demands from the plan sponsor would be more or less if issuing POB in order to improve plan funding. Certainly, the likelihood that plan assets perform less well than the cost of financing the bonds would be of key importance. However, the risk associated with asset performance significantly higher than expected or needed could be valuable information as well. Having information about that risk could then lead to conversations about the proper level of risk-seeking assets in the plan if some value of excessive returns is lost when funding with a POB.
Another set of outcomes of interest to the plan sponsor would be worse case scenarios. That is, what is the largest shortfall scenario generated with and without a bond? Or, will funding patterns be more stable with a POB or is asset volatility exacerbated when bond proceeds are co-mingled with plan assets?
Having as much relevant information as possible when considering whether or not to fund one’s retirement plan using Pension Obligation Bonds serves not only the plan trustees and fiduciaries but is in the best interest of all stakeholders including plan participants, investment managers, taxpayers, and bondholders.
Are you wondering how POBs can potentially influence your public employer pension or OPEB plan? Connect with Watkins Ross today to receive a customized look into your individual plan details by one of our qualified actuaries:
Christian R. Veenstra, FCA, ASA, MAAA, EA
Troy A Schnabel, MAAA, ASA
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