A Pension Obligation Bond is issued by a state or local government to fund its payment obligations to its pension plan, and hinges on the general concept of arbitrage. Best practices in fiscal management require an entity to fund its pension plan each year by contributing a portion of payroll costs for its current employees using currently available funds. It is anticipated that these contributions will grow with investment income all of which are available to pay benefits for those employees when they retire.
Governments generally contribute their own revenues, i.e. taxes to their pension plans. Pension obligation bonds, however, are an alternative way to finance current pension funding obligations: the government issues bonds and contributes the bond proceeds to the pension plan in addition to, or in lieu of, its own revenues.
Federal law specifies that pension obligation bonds must be taxable; while the issuer therefore pays more interest to bondholders than it would with tax-exempt bonds, the bond proceeds are not subject to arbitrage restrictions or earning restrictions.
After the bonds are issued, the proceeds are invested along with the rest of the pension plan. Although most governments invest their idle cash in low-risk, low-yield investments, pension plans often invest in a wider range of potentially riskier securities, such as stock, that may earn a higher return.
In some environments, stock or other pension investments may generate a higher return than the interest the government is required to pay on its pension obligation bonds. Thus, the government “makes money” off the difference, which may further reduce its unfunded pension liability and its required annual contribution. For example, a government may issue taxable pension obligation bonds that pay bondholders 6 percent interest, while the government’s pension plan may have a target 7.5 percent return on its investments.
In practice, pension obligation bonds may not ultimately save the government money, as the investments of the bond proceeds may not perform as well as anticipated. Furthermore, pension obligation bonds are often structured to postpone paying principal in early years, increasing overall borrowing costs.