Posted April 1, 2007

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What's right with public pensions

Bonding with OPEB

Look Before You Leap

Some municipal bond underwriters are peddling the idea that public agencies should sell bonds now to “pre-fund” their promised retiree medical benefit plan liabilities. Now that the government accounting rules require disclosure of these so-called Other Post Employment Benefits liabilities, public managers will be looking for solutions and some will be bedazzled by the idea of bond finance.

Like pension obligation bonds, OPEB bonds are designed to raise cash to invest in a pension-fund-like portfolio of stocks and other securities, even including hedge funds, in hopes of earning a return higher than the borrowing cost. (These are taxable bonds because they will be sold to fund an arbitrage portfolio; the portfolio must outperform bond returns, and sinks underwater when market cycles turn downward, especially in the early years following the bond issue.)

The Government Finance Officers Association is wary, advising considerable caution. Not only is GFOA right, but now is a dicey time for issuers to be selling OPEB bonds, from a business-cycle standpoint.

GFOA’s recommendation gives several reasons why selling such bonds to pay for future retiree medical costs is a strategy that requires substantial research.

Selling bonds to buy a portfolio of market securities is risky business at any time. For a retirement trust fund, it’s the equivalent of buying a stock and bond portfolio in your IRA on 100 percent margin. It’s especially risky at the tail end of a business cycle as the odds of a recession increase with every passing month. To illustrate from the past, some plans that sold pension bonds in 1998, two full years before the last market peak, are just now above water after paying interest on their debts.

If you want to sell OPEB bonds, heed the words of Baron von Rothschild and “wait until there is blood on the streets.” Which means waiting until the bottom of the next recession. That is the optimal time in the cycle to sell OPEB bonds. In a recession, the stock market sells off as investors dump risky assets and fear overcomes greed. At the same time, bond yields go down, reducing issuance costs for municipalities, as investors shift their money from stocks into bonds in a “flight to quality.” Bond portfolio yield spreads likewise widen to the benefit of well-rated OPEB issuers. Simultaneously, the Federal Reserve cuts interest rates as it seeks to re-stimulate the economy and pump reserves into a recession-weakened banking system.

That sets up the ideal time to issue OPEB bonds: when interest rates are near their cyclical lows and stock prices are trading cheap at levels typically 25-30 percent below their cyclical peaks, with historically stronger prospects for superior long-term returns in the years to follow.

So unless you have a compelling fiscal reason that trumps the historical odds, should you take the chance to borrow now, as risks are mounting? Heed GFOA’s advice — begin the analysis and explore all alternatives. At least, scenario-test your OPEB bond results to model a typical 25 percent-down bear market slump within two or three years. Consider other plan designs, including Voluntary Employee Benefit Associations and governmental purpose trusts that may not even require borrowing: The unfunded liability can be amortized without bonds, after all. And make sure the bond component of investment portfolios you buy with your bond proceeds would actually generate higher risk-adjusted returns after expenses — otherwise, why borrow with bonds to buy bonds?

Don’t rely on financial markets to wallpaper over a management problem: If your plan awards lifetime medical benefits before employees finish 30 years and attain age 60, find ways to pro-rate or actuarially adjust the benefit for such early retirees. Consider splitting your retirees into a separate risk group, like Orange County, California, did recently. The county went back to the bargaining table before rushing into the bond market — a logical path. At the very least, OPEB bonds should not be sold without putting an inflation cap on future benefits to assure that the liabilities don’t outgrow the bond proceeds.

The best time to pull the trigger to sell pension and OPEB bonds is when the economy and the stock market look dismal. Of course, it’s impossible to pick an exact market bottom, and there will always be a risk of more declines after any issuance. But by funding the portfolio after a recessionary downturn clobbers the stock market, your odds of successfully launching a leveraged OPEB strategy, for decades to come, will likely be better than they are now. This is not short-term market timing; it’s simply picking the most sensible time to implement a long-term strategy that is, after all, market-dependent for its success.

Last month:
· The disability dilemma
· Sending underperforming funds to the doghouse

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Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net.
More biographical information.

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