MuniLand: Pension Obligation Bonds or Pension Obligation Bombs?

Last week the City of Houston came to market with a $1.0 billion voter-approved pension obligation bond or POB. As a refresher, POBs are issued in the taxable market by local and state governments for the purpose of paying unfunded pension liabilities. Key to the success of POBs is the ability to arbitrage the cost of debt versus the returns for the pension assets and reasonably managing future pension costs. If the issuer cannot earn enough relative to the cost of the debt, as well as manage the pension plans in a manner that reduces the pension liability, then the outcome will likely be credit underperformance and potential rating downgrades.

Enter the City of Houston and its notable pension reforms and POB bonds. Houston pension reforms are notable because of the implementation of “cost corridors” on pension benefits for current and retired fire, police and municipal employees. In Houston’s case, market risk was transferred from the City of Houston to the retirees and employees. There was also a reduction of the assumed rate of return on pension assets to 7.0% from 8.0% or 8.5%, the implementation of a fixed 30 year amortization period and, finally, the City’s request of its voters (through a ballot referendum) for a $1.0 billion bond to stabilize the pension plans. The level of compromise between voter, employee, retiree and the city can only be described as impressive.

Two key provisions of Houston’s pension reforms are guided by the “cost corridor” concept, which means if pension assets grow slower than pension liabilities, current employees and retirees could receive benefit reductions because the city’s cost would be fixed. This represents a transfer of market risk to the pension plans from the city. These reforms could be used as a national model for pension reform because they ask all stakeholders to give and take.

Even with all of the compromises and the potential stabilization of the City of Houston’s finances, S&P Global Ratings warns in its December 6, 2017 report titled “Pension Obligation Bonds’ Credit Impact On U.S. Local Government Issuers,” POBs are a negative credit factor if issued in an environment of fiscal distress or as a mechanism of short-term budget relief. Generally, local governments do not need to issue POBs if their pension systems are well funded, return assumptions are conservative and if the city or county is fully funding its annual required contribution. Clearly, if a local government is issuing a POB something has gone wrong. Houston’s problems started with poor funding and the miscalculation of its pension liability. The result was a quick deterioration in funding ratios and significant fiscal stress.

S&P is correct that POBs alone do not fix pension issues. There are many cases where aggressive return assumptions or poor timing lead to unfortunate outcomes. S&P cites the New Orleans, LA 2000 POB and Stockton, CA 2008 POB as examples of POB risk. Nevertheless, we do not view Houston in the same light as New Orleans or Stockton because of the major and far-reaching pension reforms the city enacted, its diverse and thriving economy (anchored but not dependent oil and natural gas activity) and its significant taxing authority. These credit factors help defuse potential Houston pension obligation bombs.

Source: S&P Global Rating