Pension Obligation Bond (POB)

How It Works

POBs are among the most controversial tools in municipal finance. The arbitrage strategy works if the pension fund's investment returns exceed the bond's interest rate over its 20-30 year life, but if investments underperform, the city has added new debt without solving the pension problem, a double loss. Unlike traditional GO bonds issued for capital projects, POBs are typically taxable because IRC Section 103 tax-exempt status is unavailable for arbitrage transactions where proceeds fund an investment portfolio expected to earn at a higher rate than the bond cost. Taxable rates are typically 100-150 basis points higher than tax-exempt, raising the break-even required return. Many financial advisors and the Government Finance Officers Association (GFOA) have published formal advisories recommending against POBs except under very narrow circumstances. Several cities that issued POBs before 2008 saw disastrous results when the financial crisis cratered pension fund investments by 25-35% in 2008-2009 while the bond debt remained. Stockton, California issued $125 million in POBs in 2007 and filed for Chapter 9 bankruptcy in 2012. Detroit issued $1.4 billion in POBs in 2005-2006 via pension certificates of participation (COPs) structured to evade debt limits; the resulting litigation was central to the 2013 bankruptcy with bondholders ultimately receiving pennies on the dollar. Illinois alone carries roughly $140 billion in unfunded state and local pension liabilities, and multiple Illinois municipalities have considered POBs. POB issuance is flagged in the CitySpend pension funding factor (20%) and debt burden factor (20%) of the Fiscal Health Score.

Related Terms

• Unfunded Liability, The difference between a pension plan's projected liabilities (what it owes to current and future retirees) and its current assets. Also called the unfunded actuarial accrued liability (UAAL).
• Funded Ratio, The percentage of a pension plan's projected liabilities that are covered by current assets. A plan with $80 in assets for every $100 in liabilities has an 80% funded ratio.
• Municipal Bond, A debt security issued by a city, county, state, or other government entity to finance capital expenditures. Interest income is generally exempt from federal income tax.