An Update on Pension Obligation Bonds
Some state and local governments issued pension obligation bonds (POBs) to pay their required pension contributions. POBs are debt securities used to pay unfunded accrued actuarial liabilities in a public pension plan. Since 1986, state and local governments have issued around $105 billion in pension obligation bonds. The bulk of POB activity has centered in 10 states, including Illinois and California. In 2003, Illinois issued a single pension obligation bond worth almost $10 billion.
Pension obligation bonds provide governments with budgetary relief but carry a significant amount of risk. In order for POBs to make a positive gain, pension returns need to average more than the cost of financing debt. POBs are additionally inflexible in that they require annual payments and can’t be smoothed over time. POBs made positive gains during the stock market peak in 2007, but most issuers faced significant losses during the market crash in 2009. As of February 2014, the majority of POBs have had a positive return rate of 1.5 percent due to large gains in the stock market.
While POBs could be used responsibly, the authors find that has not generally been the case. Historically, pension obligation bonds tend to be issued by financially distressed governments that have had substantial debt or are short of cash.