US - The issuance of pension obligation bonds by cash-strapped governments is a risky move that can increase pension costs, a new report by the Center for State and Local Government said.
Pension obligation bonds (POB) are issued by governments to fund annual pension contributions as an alternative to tapping cash reserves. But after the financial crisis, most POBs issued since 1992 have led to losses, the Center said.
The use of POB's peaked in 2003 with issuances topping US$16bn, driven mainly by one large issuance by the state of Illinois worth over $10bn. The state issued another round of bonds this year worth $3.5bn.
The Center argues POB's contain risks.
"The success of POBs depends on the premise that pension returns are on average more than the cost of financing the debt. However, these assumptions may not turn out to be correct, as the recent financial crisis has shown," the report said. Interest costs can outpace asset returns.
Timing is also a problem, with some saying these should only be issued during recessions, which requires a sense of market timing.
It could also cause political problems, with the pension fund appearing to be fully funded after it receives the proceeds of the bond sales, when it's not.
This "may create the political risk that unions and other interest groups will call for benefit increases, despite the fact that the underfunding still exists," the report said.
But the Center does not completely discount the use of POBs.
"Issuing a POB may allow well-heeled governments to gamble on the spread between interest rate costs and asset returns or to avoid raising taxes during a recession. Unfortunately, most often POB issuers are fiscally stressed and in a poor position to shoulder investment risk."
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