Pension Obligation Bonds: Not as Bad as They Sound

Insufficient pension funding and opaque accounting rules creates angst for public pension recipients, budgetary stress for states and uncertainty for public debt investors. While there are other options, pension bonds address two central deficiencies in the management of state pension systems: highly variable and inconsistent funding and the lack of transparent accounting. 

Here in the State of Washington, Governor Inslee’s proposed fiscal year 2015-17 budget allocates $210.0 million for K-12 pension funding. If fiscal year 2014 is any indication, the new biennium’s budgeted contribution for the Teachers and School Employees Retirement Systems will fall short of the required pension payment contribution. The Public Employees Retirement System was also underfunded in fiscal year 2014 receiving only 68.5% of the annual payment required. Recent underfunding by the State has resulted in these pension plans having only 83.9% of the assets needed to pay future pension benefits. The underfunding of the State’s pension plans should concern public employees because it jeopardizes their future pension payments. State lawmakers should also be concerned because underfunding can quickly erode aggregate pension funding ratios and creates greater budget uncertainty. Eventually, variable and inconsistent pension funding can lead to significant budgetary stress. Just look to Illinois and New Jersey as current examples. Each of these states neglected their required annual pension payments and now must reduce benefits, curtail public services and/or raise taxes in an attempt to catch up. Pension obligation bonds limit the uncertainty of pension funding due to their transparent and stable payment timeline.

Financial transparency is integral to fixing pension liability mismanagement. Estimates of future pension costs are almost always much larger than current pension liabilities. As such, current governmental accounting standards mask future pension costs because the total pension liability disclosure is not required. Issuance of pension bonds comes with clear accounting and would be preferable to the current system. Better financial disclosure applied to pension bonds is a win for both bondholders and pensioners because it improves their chances of receiving future payments and forces politicians to be more honest about the State’s source of pension funding. Specifically, pension bonds provide funding for the investments that are needed to fully satisfy current and future pension entitlements. Moreover, pension bonds do not increase total debt outstanding but convert existing off balance sheet liabilities from a footnote in a State’s financial statement to a line item on the balance sheet and income statement that fully reflects the true cost of the obligation. This transparency can reduce budgetary pressure, which could otherwise weaken the financial health and negatively impact funding for K-12 schools, roads and bridges and public universities.

Public employees who are promised a pension and holders of public debt who are promised a full return of money loaned should be asking the same question: What is the likelihood of receiving future payments in full, and just as promised?  Public pension recipients and bond investors should work together in demanding an end to nondisclosure and highly variable and inconsistent funding of pension plans, which pose a risk to our shared future. Ultimately, the public will benefit from stable service delivery, improved financial health of states and greater public involvement through more transparency.