RESEARCH BASED
Alex Fuller is accomplished in the realm of white papers and research-based SEO-friendly blogging.
Agency: Krative (Wallingford, CT)
Client: Odyssey Advisors
Blog Post #1
Pension Obligation Bonds: Pros, Cons, & Issues
A Pension Obligation Bond (“POB”) is a debt instrument issued by a municipal entity such as a Town to fund all or a portion of the Unfunded Actuarially Accrued Liability (“UAAL”) for its pension or OPEB plan.
A POB is designed to take advantage of an arbitrage opportunity whereby the Town can issue taxable debt at a lower rate than what can be earned by the pension fund. Access to this capital enables a Town to invest it and realize relatively strong profits. Ultimately, this can have the positive effect of reducing the long-term costs of the pension plan.
POBs carry with them a potential for risk and reward. It is important to evaluate how they will affect a Town’s financial viability, not just in the short term but in the long term.
Their overall effectiveness cannot be concretely demonstrated until the end of the loan cycle, which is typically 20 or 30 years.
Pension plans have a built-in element of flexibility to adapt to shifts in priorities and economic conditions, whereas POBs operate under stricter parameters. This introduces leverage to the Town’s balance sheet in that the flexibility of its annual required contributions under GASB 67/68 is largely converted to this fixed debt repayment schedule.
If the funds are invested well, a surplus may occur. This can lead to contribution holidays and/or pressure for increases in other benefits. Towns face such political pressure, while also having to keep an eye on the future. Market conditions are constantly changing, so it is best to prepare for lean times even during strong economic cycles.
Even if POBs are achieving strong returns, this positive uptick may have the unintended consequence of “crowding out” the Town’s ability to issue other debt for capital improvements.
Pension Obligation Bonds: Pros, Cons, & Issues
A Pension Obligation Bond (“POB”) is a debt instrument issued by a municipal entity such as a Town to fund all or a portion of the Unfunded Actuarially Accrued Liability (“UAAL”) for its pension or OPEB plan.
A POB is designed to take advantage of an arbitrage opportunity whereby the Town can issue taxable debt at a lower rate than what can be earned by the pension fund. Access to this capital enables a Town to invest it and realize relatively strong profits. Ultimately, this can have the positive effect of reducing the long-term costs of the pension plan.
POBs carry with them a potential for risk and reward. It is important to evaluate how they will affect a Town’s financial viability, not just in the short term but in the long term.
Their overall effectiveness cannot be concretely demonstrated until the end of the loan cycle, which is typically 20 or 30 years.
Pension plans have a built-in element of flexibility to adapt to shifts in priorities and economic conditions, whereas POBs operate under stricter parameters. This introduces leverage to the Town’s balance sheet in that the flexibility of its annual required contributions under GASB 67/68 is largely converted to this fixed debt repayment schedule.
If the funds are invested well, a surplus may occur. This can lead to contribution holidays and/or pressure for increases in other benefits. Towns face such political pressure, while also having to keep an eye on the future. Market conditions are constantly changing, so it is best to prepare for lean times even during strong economic cycles.
Even if POBs are achieving strong returns, this positive uptick may have the unintended consequence of “crowding out” the Town’s ability to issue other debt for capital improvements.
Blog Post #2
Underlying Assumptions of Pension Obligation Bonds
Pension funding can skew in the wrong direction if there is an imbalance between returns and expenditures. When managing assets and liabilities long-term, it is best to be cautiously optimistic about expectations. The best practice is to set levels of anticipation that err on the side of caution on both sides of the coin.
The wide spectrum of complex actuarial calculations is based on detailed data, both historical and current. The same is true for a municipality’s anticipated rate of return on investments. Actuarial accrued liability, a concrete monetary amount subject to annual re-calculation, is based on a number of assumptions. The following is a list of four such primary assumptions.
Regarding Projected Assets:
Investment Rate of Return – a rate of 7.75% (net of expenses) is common. For public sector plans, this is well within the range utilized by plan sponsors. The key issue would be to review your investment policy statement (“IPS”) to determine if that is consistent with this assumption. If not, you will want to either adjust your asset allocation to meet this 7.75% target or reduce the assumed rate of return to match the IPS.
Regarding Projected Liabilities:
Mortality Table – Projected mortality rates are obtainable through the RP-2000 Mortality Tables Report (projected 17 years by Schedule AA). While mortality continues to improve, it is unlikely to be a major source of loss for the plan.
Disability Rates – Disability rates used are consistent with those used by PERAC. In a poor economy, plan sponsors have seen significant increases in disability claims. Given the benefit structure and longer payout period, this can cause substantial plan losses. You will want to aggressively monitor disability retirees to ensure that they meet the plan requirements.
Salary increases – 3.5% per year is a cautious assumption. As of 2019, the national average salary increase is hovering at around 3%, and that figure accounts for both the private and public sector. Statistics from recent (post-recession) years are revealing stagnation in the private sector, as opposed to a trend toward steadily increasing benefits for public sector employees. Given the final average pay nature of the pension plan, salary increases beyond expected will cause actuarial losses. The 3.5% figure includes both cost-of-living, merit, step and other increases. As such, when negotiating contracts, you will want to measure the long-term pension impact as well as the short-term annual cash costs.
Underlying Assumptions of Pension Obligation Bonds
Pension funding can skew in the wrong direction if there is an imbalance between returns and expenditures. When managing assets and liabilities long-term, it is best to be cautiously optimistic about expectations. The best practice is to set levels of anticipation that err on the side of caution on both sides of the coin.
The wide spectrum of complex actuarial calculations is based on detailed data, both historical and current. The same is true for a municipality’s anticipated rate of return on investments. Actuarial accrued liability, a concrete monetary amount subject to annual re-calculation, is based on a number of assumptions. The following is a list of four such primary assumptions.
Regarding Projected Assets:
Investment Rate of Return – a rate of 7.75% (net of expenses) is common. For public sector plans, this is well within the range utilized by plan sponsors. The key issue would be to review your investment policy statement (“IPS”) to determine if that is consistent with this assumption. If not, you will want to either adjust your asset allocation to meet this 7.75% target or reduce the assumed rate of return to match the IPS.
Regarding Projected Liabilities:
Mortality Table – Projected mortality rates are obtainable through the RP-2000 Mortality Tables Report (projected 17 years by Schedule AA). While mortality continues to improve, it is unlikely to be a major source of loss for the plan.
Disability Rates – Disability rates used are consistent with those used by PERAC. In a poor economy, plan sponsors have seen significant increases in disability claims. Given the benefit structure and longer payout period, this can cause substantial plan losses. You will want to aggressively monitor disability retirees to ensure that they meet the plan requirements.
Salary increases – 3.5% per year is a cautious assumption. As of 2019, the national average salary increase is hovering at around 3%, and that figure accounts for both the private and public sector. Statistics from recent (post-recession) years are revealing stagnation in the private sector, as opposed to a trend toward steadily increasing benefits for public sector employees. Given the final average pay nature of the pension plan, salary increases beyond expected will cause actuarial losses. The 3.5% figure includes both cost-of-living, merit, step and other increases. As such, when negotiating contracts, you will want to measure the long-term pension impact as well as the short-term annual cash costs.
Blog Post #3
Pension Obligation Bonds and How They’re Viewed
A Pension Obligation Bond has a ripple effect. The key is to thoroughly investigate from the outset whether or not this financial instrument is the most suitable choice. It is a long-term commitment involving a fixed repayment schedule. The rewards forever hold the promise of outweighing the risk. Each municipality has a different degree of tolerance for such fluctuation. The issuance of a POB also comes under the radar of rating agencies.
How do rating agencies view Pension Obligation Bonds?
Moody’s Investors Service and the other two top agencies are effectively neutral on the issuance of POB’s. The reason is that existing pension debt is simply swapped out directly for a POB. However, if the debt incurred by a POB is structured merely to achieve short-term budget savings, the rating agencies would view this issuance negatively. The trade-off of the softer funding structure of the pension plan for a fixed debt POB repayment schedule can be a negative, but the potential interest savings over the long-term can outweigh this issue.
Moody's has recently announced they are considering changing their rating analysis to give more weight to debt and pension liabilities from 10% to 20% and decrease the weight for economic factors from 40% to 30%.
What is the appropriate size of a Pension Obligation Bond?
There is no “magic figure” for the proper size of a POB. This will be based on the Town’s ability to service the debt, its bond rating and issuing costs, the expected rate of return and the Town’s willingness to trade soft contributions for a fixed repayment schedule.
Let us break down an example in which the Town issued a POB for the entire unfunded balance of $33.8 million and all actuarial assumptions were realized as expected. In this case, the Town would still be required to fund the annual normal cost of approximately $700,000 for FY 2014 increasing by about 4.0% per year.
As the UAAL is based on a 20-year amortization and a 7.75% interest rate, the Town could potentially achieve an annual savings of approximately 2% or $675,000 (the ultimate savings will be based on actual issuance rates and returns achieved on investment of the issuance). The Town may decide on a lesser issuance (i.e., setting a goal of 80% funding) to preserve some budgetary flexibility.
What is required to begin a review & feasibility study?
Odyssey can perform a plan review and POB feasibility study to determine what a municipality’s best options are going forward. A pension obligation bond is a significant long-term undertaking. We offer the depth of experience you need in order to fully comprehend its potential for risk and reward.
The key issue is obtaining the pension data. It is our expectation that your retirement board maintains a database of plan participants (active, term vested and those in pay status). This would include salary history, contribution history, accrued benefits and related vitals. This is likely provided to the current actuary on a biennial basis. Additionally, we would ask for the current investment policy statement, a recent asset statement and the plan’s funding policy (if any).
Upon receipt of the necessary information, we would expect to finalize the plan review in 4-6 weeks and the POB feasibility study in an additional 4-6 weeks. It could certainly be done sooner and we will push to meet any deadlines the Town may have. However, given the need to interface with the Town’s retirement board, financial function and outside investment managers, it is difficult to give a more precise timeframe.
Pension Obligation Bonds and How They’re Viewed
A Pension Obligation Bond has a ripple effect. The key is to thoroughly investigate from the outset whether or not this financial instrument is the most suitable choice. It is a long-term commitment involving a fixed repayment schedule. The rewards forever hold the promise of outweighing the risk. Each municipality has a different degree of tolerance for such fluctuation. The issuance of a POB also comes under the radar of rating agencies.
How do rating agencies view Pension Obligation Bonds?
Moody’s Investors Service and the other two top agencies are effectively neutral on the issuance of POB’s. The reason is that existing pension debt is simply swapped out directly for a POB. However, if the debt incurred by a POB is structured merely to achieve short-term budget savings, the rating agencies would view this issuance negatively. The trade-off of the softer funding structure of the pension plan for a fixed debt POB repayment schedule can be a negative, but the potential interest savings over the long-term can outweigh this issue.
Moody's has recently announced they are considering changing their rating analysis to give more weight to debt and pension liabilities from 10% to 20% and decrease the weight for economic factors from 40% to 30%.
What is the appropriate size of a Pension Obligation Bond?
There is no “magic figure” for the proper size of a POB. This will be based on the Town’s ability to service the debt, its bond rating and issuing costs, the expected rate of return and the Town’s willingness to trade soft contributions for a fixed repayment schedule.
Let us break down an example in which the Town issued a POB for the entire unfunded balance of $33.8 million and all actuarial assumptions were realized as expected. In this case, the Town would still be required to fund the annual normal cost of approximately $700,000 for FY 2014 increasing by about 4.0% per year.
As the UAAL is based on a 20-year amortization and a 7.75% interest rate, the Town could potentially achieve an annual savings of approximately 2% or $675,000 (the ultimate savings will be based on actual issuance rates and returns achieved on investment of the issuance). The Town may decide on a lesser issuance (i.e., setting a goal of 80% funding) to preserve some budgetary flexibility.
What is required to begin a review & feasibility study?
Odyssey can perform a plan review and POB feasibility study to determine what a municipality’s best options are going forward. A pension obligation bond is a significant long-term undertaking. We offer the depth of experience you need in order to fully comprehend its potential for risk and reward.
The key issue is obtaining the pension data. It is our expectation that your retirement board maintains a database of plan participants (active, term vested and those in pay status). This would include salary history, contribution history, accrued benefits and related vitals. This is likely provided to the current actuary on a biennial basis. Additionally, we would ask for the current investment policy statement, a recent asset statement and the plan’s funding policy (if any).
Upon receipt of the necessary information, we would expect to finalize the plan review in 4-6 weeks and the POB feasibility study in an additional 4-6 weeks. It could certainly be done sooner and we will push to meet any deadlines the Town may have. However, given the need to interface with the Town’s retirement board, financial function and outside investment managers, it is difficult to give a more precise timeframe.
WHITE PAPER
Liability Driven Investing (“LDI”) and Qualified Retirement Plans
While asset liability matching (“ALM”) has always had an appeal in the qualified retirement plan arena, it has become more popular and timely in the Pension Protection Act (“PPA”) era. In the pre-PPA period, plan sponsors enjoyed a period of contribution stability along with the flexibility to utilize “Credit Balances” built up from prior contributions.
With the PPA now in place, plan sponsors have witnessed severe contribution volatility. They also have seen restrictions on the usage of Credit Balances, and on benefit distributions and accruals. On top of this, PPA guidelines have compelled them to provide increased disclosures to participants on the funded status of the plan.
Pre-PPA: The calm before the storm
Prior to the implementation of PPA, most sponsors of qualified retirement plans would utilize a long-term investment strategy with a policy of earning 7.5% or 8.0% per year. That rate would determine how they valued the liabilities of the associated plan.
Pre-PPA, most plan sponsors also utilized an asset smoothing method. This would allow the actuarial valuation of plan assets to differ by up to 20% from the market value of plan assets with the 80%/120% corridor allowed under IRS rules. This permitted the plan sponsor to minimize year-to-year asset volatility, thus ensuring that any losses would be relatively modest.
PPA: A perfect storm of lower interest rates, the financial crisis and contribution volatility
With PPA implemented, plan sponsors were now faced with an entirely new landscape of liability valuation strategy, participant disclosures and a reduction in asset smoothing options.
PPA was designed with many targeted purposes. One was a stronger plan-funding scheme to increase benefit security. The intention of this was to limit the risk of potential losses backed by the Pension Benefit Guaranty Corporation (“PBGC”). PPA also set out to provide more useful disclosures to plan participants as to the financial health of their plan.
This was to be accomplished through the use of a “mark to market” approach on plan liabilities utilizing the yield curve of high-grade (“AA” rated) corporate bonds rather than the prior long-term methodology of discounting all liabilities at one rate (i.e., 7.5% or 8.0%).
PPA was passed in 2006 and went into in effect in 2008, however Congress did not see the financial crisis coming. It brought with it the problematic combination of much lower interest rates (thus increasing plan liabilities) and a large drop in equity prices. This inevitably served to greatly increase unfunded plan liabilities, which were now to be funded over a shorter period.
PPA 2008 to today
Over the last several years, Congress has passed several patchwork “fixes” including the most recent Moving Ahead for Progress in the 21st Century (“MAP-21”) Act. They are only treating the symptoms rather than the underlying causes and issues.
While plan assets may have performed very well (i.e., 10% or higher returns for a year), plan liabilities may have increased by even more. This can be attributed to either a reduction in discount rates or a shift in the shape of the yield curve from year to year.
In the era prior to PPA, treating plan assets and liabilities as independent silos may have been a stable enough strategy. With PPA now in place, however, such an approach is likely to result in wide swings in the funded status of the plan.
Why LDI?
Under PPA, plan liabilities are valued as a fixed income investment. Ultimately, this valuation reflects that they will serve as a stream of predictable payments in the future. As such, in order to stabilize unfunded plan liabilities and minimize contribution volatility, plan sponsors should look at matching their assets to that underlying stream of payments.
A traditional LDI approach would utilize a 100% fixed income portfolio that matches all expected payments from the plan to a laddered set of investments. Under this approach, assets and liabilities are expected to have comparable changes in value as the yield curve changes.
This allows the plan sponsor to remove changes in asset values and the yield curve from the equation. Actuarial gains or losses are only based on plan demographic and are usually very small. This will yield much lower contribution volatility, but often from a higher contribution amount as equities are removed from the portfolio.
Modified LDI
Under a modified LDI approach, the plan sponsor would seek to match plan asset income to the expected payment stream for the first 6-10 years and may use dividend-paying stocks as part of that match.
This allows the plan sponsor to maintain a comparable beta of plan assets and plan liabilities while still allowing them to seek alpha returns from their long-term equity component.
Given that long-term equity performance is expected to be positive and that fixed income rates are at historic lows, this would lead to much lower contribution volatility but also a lower total contribution than would be expected from a traditional LDI approach.
Summary
As of September 2019, the funded status of qualified defined benefit pension plans has increased to 88%, per a study from Aon Hewitt.
We’ve survived the crisis and plans have gotten back to reasonable funding levels. Now is the time to buy stability so as to avoid going backwards.
Your actuary and investment professional can work to develop an LDI approach that meets your needs. This will allow you to maintain reasonable plan funding and to plan your cash flow budget better. It will also minimize negative reaction on participant disclosures. And lastly, it will improve pension disclosures under FASB 87/158.
Liability Driven Investing (“LDI”) and Qualified Retirement Plans
While asset liability matching (“ALM”) has always had an appeal in the qualified retirement plan arena, it has become more popular and timely in the Pension Protection Act (“PPA”) era. In the pre-PPA period, plan sponsors enjoyed a period of contribution stability along with the flexibility to utilize “Credit Balances” built up from prior contributions.
With the PPA now in place, plan sponsors have witnessed severe contribution volatility. They also have seen restrictions on the usage of Credit Balances, and on benefit distributions and accruals. On top of this, PPA guidelines have compelled them to provide increased disclosures to participants on the funded status of the plan.
Pre-PPA: The calm before the storm
Prior to the implementation of PPA, most sponsors of qualified retirement plans would utilize a long-term investment strategy with a policy of earning 7.5% or 8.0% per year. That rate would determine how they valued the liabilities of the associated plan.
Pre-PPA, most plan sponsors also utilized an asset smoothing method. This would allow the actuarial valuation of plan assets to differ by up to 20% from the market value of plan assets with the 80%/120% corridor allowed under IRS rules. This permitted the plan sponsor to minimize year-to-year asset volatility, thus ensuring that any losses would be relatively modest.
PPA: A perfect storm of lower interest rates, the financial crisis and contribution volatility
With PPA implemented, plan sponsors were now faced with an entirely new landscape of liability valuation strategy, participant disclosures and a reduction in asset smoothing options.
PPA was designed with many targeted purposes. One was a stronger plan-funding scheme to increase benefit security. The intention of this was to limit the risk of potential losses backed by the Pension Benefit Guaranty Corporation (“PBGC”). PPA also set out to provide more useful disclosures to plan participants as to the financial health of their plan.
This was to be accomplished through the use of a “mark to market” approach on plan liabilities utilizing the yield curve of high-grade (“AA” rated) corporate bonds rather than the prior long-term methodology of discounting all liabilities at one rate (i.e., 7.5% or 8.0%).
PPA was passed in 2006 and went into in effect in 2008, however Congress did not see the financial crisis coming. It brought with it the problematic combination of much lower interest rates (thus increasing plan liabilities) and a large drop in equity prices. This inevitably served to greatly increase unfunded plan liabilities, which were now to be funded over a shorter period.
PPA 2008 to today
Over the last several years, Congress has passed several patchwork “fixes” including the most recent Moving Ahead for Progress in the 21st Century (“MAP-21”) Act. They are only treating the symptoms rather than the underlying causes and issues.
While plan assets may have performed very well (i.e., 10% or higher returns for a year), plan liabilities may have increased by even more. This can be attributed to either a reduction in discount rates or a shift in the shape of the yield curve from year to year.
In the era prior to PPA, treating plan assets and liabilities as independent silos may have been a stable enough strategy. With PPA now in place, however, such an approach is likely to result in wide swings in the funded status of the plan.
Why LDI?
Under PPA, plan liabilities are valued as a fixed income investment. Ultimately, this valuation reflects that they will serve as a stream of predictable payments in the future. As such, in order to stabilize unfunded plan liabilities and minimize contribution volatility, plan sponsors should look at matching their assets to that underlying stream of payments.
A traditional LDI approach would utilize a 100% fixed income portfolio that matches all expected payments from the plan to a laddered set of investments. Under this approach, assets and liabilities are expected to have comparable changes in value as the yield curve changes.
This allows the plan sponsor to remove changes in asset values and the yield curve from the equation. Actuarial gains or losses are only based on plan demographic and are usually very small. This will yield much lower contribution volatility, but often from a higher contribution amount as equities are removed from the portfolio.
Modified LDI
Under a modified LDI approach, the plan sponsor would seek to match plan asset income to the expected payment stream for the first 6-10 years and may use dividend-paying stocks as part of that match.
This allows the plan sponsor to maintain a comparable beta of plan assets and plan liabilities while still allowing them to seek alpha returns from their long-term equity component.
Given that long-term equity performance is expected to be positive and that fixed income rates are at historic lows, this would lead to much lower contribution volatility but also a lower total contribution than would be expected from a traditional LDI approach.
Summary
As of September 2019, the funded status of qualified defined benefit pension plans has increased to 88%, per a study from Aon Hewitt.
We’ve survived the crisis and plans have gotten back to reasonable funding levels. Now is the time to buy stability so as to avoid going backwards.
Your actuary and investment professional can work to develop an LDI approach that meets your needs. This will allow you to maintain reasonable plan funding and to plan your cash flow budget better. It will also minimize negative reaction on participant disclosures. And lastly, it will improve pension disclosures under FASB 87/158.