All of the talk surrounding pension reform and unfunded liabilities is causing municipal governments to become increasingly interested in pension obligation bonds.

Whether one finds them good or bad, most disagree with passing them without voter approval, which is precisely what the City of Houston is planning to do. State Sen. Paul Bettencourt  (R-Houston) filed Senate Bill 151 ahead of the session which, if passed, would remove local governments’ authority to pass these bonds without going to voters first.

While that would be good governance, many taxpayers are still wondering what exactly a pension obligation bond is.

Pension obligation bonds, or POBs, are a financial mechanism that allows state and local governments to reduce their current unfunded liabilities by borrowing against future tax revenue. They are only allowed to borrow to pay for current unfunded pension liabilities and, in Texas, government entities can borrow up to the amount they owe without voter approval.

The money borrowed is then invested into high-yield investments where, hopefully, returns on those investments will exceed the interest on the bonds, therefore earning money for the pension fund.

Since higher yielding investments often come with more risk, these bonds are inherently precarious. Although unreliable, many governments take advantage of this tool because of its ability to immediately reduce the reported unfunded liabilities, making a city or state’s finances look more optimistic than they are.

But when they go bad, they go very bad.

POBs are often sold to the public as an ability to “refinance debt” and will provide “savings for taxpayers,” which could be true, but they are more of a bet than a sure thing. Both San Bernardino and Stockton in California went bankrupt, in part, because of overly generous pensions that were being supplemented by POBs. When the anticipated returns dropped below the interest rates, the cities’ unfunded liabilities increased to unsustainable levels. These bonds were issued just before the market dropped. Their only enemy was timing.

The use of POBs is currently incentivized by Rule 68, issued by the Government Accounting Standards Board a little over a year ago.

Simply put, Rule 68 – or GASB 68 as it is called – is aimed at increasing the accuracy and transparency of accounting and financial reporting by state and local governments. The rule requires that pension plan liabilities be measured as the current and future liabilities minus the plan’s current net position.

To give an idea of the significance of the change, before the rule was enacted Houston was reporting its unfunded pension liabilities at $1.2B. After the rule change, the reported liabilities skyrocketed to $5.6B. Forced to publicly report billions in increased unfunded liabilities, governments are looking for ways to reduce that net pension liability, which is where POBs come in.

Despite their uncertainty, POBs remain popular because it allows government officials, usually elected, to immediately claim they reduced pension liabilities and paint a rosy picture for taxpayers and voters.

When put in a tight budgetary position, politicians would undoubtedly rather borrow money against the future than tighten the budget, reduce municipal employees’ benefits, or raise taxes. As is all too often the case, the politically expedient thing to do isn’t always in the best interest of the taxpayers.

Timing can be the savior or the death knell for POBs. As long as there are no downturns, all is well. But if there are, taxpayers are the ones left holding the bag as officeholders move on to future offices and pension boards have already collected and doled out that money. Ultimately, taxpayers are assuming all of the risk and that makes this municipal finance tactic the least taxpayer friendly.

Charles Blain

Charles Blain is the president of Urban Reform and Urban Reform Institute. A native of New Jersey, he is based in Houston and writes on municipal finance and other urban issues.