I don't always agree with Alicia Munnell at the Center for Retirement Research, but when she talks about the pros and cons of pension obligation bonds, it's hard to ignore her warning: While POBs can deliver budget relief to cash-strapped states, they are fraught with risk.
Which is why, she says, "(POBs) are often inappropriately used by the desperate and irresponsible."
The cities of Detroit and Stockton, California, know this all too well. POBs played a role in both their bankruptcies.
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States that issue POBs invest the money in their under-funded pension systems, raising their funding ratios and potentially boosting their credit ratings while hoping to generate returns that cover their interest payments to debtholders.
It's the equivalent of a second mortgage of your home or business, which can provide breathing room in the short term but which can also make your long-term financial picture uncomfortable, if not unsustainable.
Financially ailing Kansas, which has one of the worst-performing pension funds in the nation, is now considering doing the same, for the second time actually. Kentucky is considering a similar gamble. Other states could follow suit soon.
POBs have paid off for Kansas in the past but there's no guarantee they will this time around, for the Sunflower State or any other municipal or state government that takes this approach.
Kansas Gov. Sam Brownback, a Republican, has been pushing the POB route. The legislature will need to sign off. I'm hoping it says no for a few reasons.
To start, with a market correction expected at any moment (by some people, anyway), the risk is just too high.
Even if equities continue to climb, there's always the very good chance Kansas won't be able to earn the 8 percent a year backers of the POB strategy promise.
As Munnell pointed out in a paper last year, the majority of POBs have produced positive returns, but that's only because of the market rebound that followed the 2008 financial meltdown.
Moreover, bonds issued at the end of the market run-up of the 1990s or right before the 2007 crash have continued to produce a negative return. Whether the next market downturn comes next week, next month or next year, it could be really hard for Kansas or anyone else to net a positive return on their POBs.
And, of course, positive returns or not, those annual payments are due to bondholders regardless, year after year after year. In other words, issuers who fail to make their payments could easily see their credit ratings take a big hit, making future borrowing even tougher and certainly more expensive.
The bottom line is that we're talking nothing less than a form of arbitrage here, folks, betting on the come that higher-risk investments will yield the returns required to pay off the debt and cover pension obligations.
Sorry, but that's no way to take care of our elders.
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