As many states and municipalities struggle with the increasing pension costs, many are exploring the issuance of pension obligation bonds (POBs), particularly following a recent Illinois Supreme Court ruling that rejected the state’s attempt to overhaul its severely depleted pension system and lower costs by cutting its public sector employee retirement benefits. While the Illinois ruling is not binding upon other states, it may influence lawmakers elsewhere to look for alternative methods of pension funding reform, aside from cutting pension benefits.

Faced with restrictions on the changes that can be made to already-promised benefits, pension obligation bonds may present a tempting alternative. POBs allow governments to issue debt, and then take the proceeds from that debt issuance and invest it directly into the assets of pension funds. The governments would be required to pay interest on that debt, but POBs are issued with an assumption that high-yield investment returns will more than cover the obligation.

However, a recent issue brief from the Center for State and Local Government Excellence and the Center for Retirement Research at Boston College found that for many state and local governments, the richer returns promised by POBs – particularly attractive to governments that, because of unfunded liabilities, face higher borrowing costs – also carry a greater risk. In order for pension obligation bonds to add value without increasing liabilities, they would have to meet projected annual returns in the eight percent range. The assumptions behind these investments don’t always turn out to be correct.

The brief finds that POBs could potentially be used responsibly by fiscally sound governments that understand the risks involved or could play a role as part of a broader pension reform package for fiscally stressed governments. Unfortunately, the results from the brief suggest that POB usage to date has not followed this formula, rather, POBs have played a role in the fiscal woes of municipalities such as Detroit, which issued the bonds just as the market was reaching its peak.