ANDOVER, MA — A new study examines the risks with using bonds to fund pension systems, as is the case in three Massachusetts municipalities. Andover, Brockton, and Quincy all use pension obligation bonds (POBs) to top up their pension plans.
Typically, towns and cities must either raise taxes or reduce benefits to retirees to fully fund their pension plans. However, POBs offer an alternative.
The government borrows money, but instead of simply paying those funds into the pension plan, they use the borrowed money for investments.
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Mark Davidson, a professor and associate director at Clark University’s Graduate School of Geography, said that cities and towns should think twice before using POBs.
“The research shows that, even when cheap (low interest) debt is available, the risks of POBs to city finances are not insignificant,” Davidson said.
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Davidson is the author of “Is it worth a punt on pensions? A case study of three municipalities’ use of pension obligation bonds.”
He said that municipalities tend to use POBs when interest rates for borrowing are low, thereby taking advantage of the gap between interest rates and expected investment returns. However, POBs are inherently associated with risk.
“There is always a chance that the cost of borrowing (i.e. interest rates) exceeds the investment return,” he said. “This relates to the need to ‘time the market’ – i.e. pick the right time to invest. Given the world is a volatile place, this is an impossible task.”
But Andover Town Manager Andrew Flanagan said the town’s use of POBs was carefully considered. He said “what has made Andover’s approach to POBs both responsible and successful so far is the engagement of stakeholders,” such as having residents engaged in shaping outcomes.
“Prior to seeking authorization for the pension obligation bond, the town held 60 public information sessions in order to inform the public about our financing plan, while also receiving feedback and input that helped shape our decisions,” Flanagan said.
The town also established an advisory committee consisting of residents who are experts in relevant fields and performed stress tests and simulations. Andover voters also overwhelmingly approved a POB plan at a special election.
“All of this contributed to what we consider a fiscally responsible plan,” Flanagan said.
The alternative would have involved $350 million in total appropriations over 18 years.
Andover, Brockton, and Quincy – the three municipalities in the study – all invested just before COVID hit, an unpredictable event. Davidson said that when cities and towns fail to generate the revenue from POBs they expected, they may then seek out greater returns from riskier investments.
“Another way to look at this is that the speculative risks of POBs can easily compound over time,” Davidson said. “By assessing the relative risk of POBs to each city’s budget, even prosperous communities like Andover will require major budgetary reforms if their POBs do not work out.”
However, Flanagan said that Andover “focused our pension obligation bond plan around risk mitigation.” He said the long-term expected rate of return at 5.75 percent is among the lowest in the country.
The town also has a Pension Obligation Bond Stabilization Fund, which “creates a source of funding to resolve future unfunded liabilities that may occur as a result of market downturns,” according to Flanagan.
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Davidson said that to avoid the risks with POBs, municipalities can reallocate budget expenditures to pension payments; raise taxes to fund pension payments; negotiate with retirees, workers, and unions to reduce pension obligations; or lobby state and federal legislators to fund pension plans.
But these are “all highly political decisions” compared to speculating with POBs.
“The solution for each city will likely be different, and will often be a combination of the above,” Davidson said. “The great problem with pensions is that the can has, for a long time, been kicked down the road. The longer the problem is left unresolved, the greater the problem becomes.”
Flanagan said that Andover made meaningful efforts in addressing unfunded pension liabilities “prior to, and in concert with, our pension obligation bond plan.” These efforts included the town appropriating funds in excess of required annual contributions in the years leading up to the POB issuance.
The town also worked with the Retirement Board to make reforms to member eligibility and service attainment. Andover also partnered with employees to create the Unfunded Liability Offset, an additional contribution employees make in the form of a payroll deduction to help fund the pension liability.
“While these efforts were meaningful to the overall plan to address our liability,” Flanagan said, “leveraging low interest rates to provide a sustainable and predictable funding schedule through the POB has positioned the town to maintain services while also significantly reducing costs to taxpayers.”
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