Just Say No:
Financial Products and Strategies to Avoid
May 24, 2016
2:00 to 3:15 p.m.
1.5 CPEs
Moderator: Gary Donaldson, Chief Financial Officer, Orange County, NC
Speakers: Kathleen Clarke Buch, Town Administrator, Town of Darien, CT
Michael de Leon, Specialist Leader, Deloitte Consulting
Justin Marlowe, Professor, University of Washington
o Pension Obligation Bonds
– GFOA Advisory 01/2015
o OPEB Obligation Bonds
– GFOA Advisory 01/2016
o Employer Owned Life Insurance
– Government Finance Review Article 12/2015
o DROP Plans
– GFOA Advisory 06/2005
o Social Impact Bonds
Pension Obligation Bonds (POBs)
o POBs are taxable bonds that some
governments may issue to fund all or a part
of their unfunded pension liability, on the
assumption that interest earned on the
proceeds will exceed the interest due on the
bonds.
Pension Obligation Bonds (POBs)
o “The Government Finance Officers
Association recommends that state and local
governments do not issue POBs…”
Why not?
o Invested proceeds might not earn an interest
rate greater than the interest owed on the
bonds
o Structures may be complex, including swaps,
derivatives, etc and may carry serious risk
o Increases government’s debt burden
o May not be viewed as credit positive by
rating agencies
Connecticut law
o Municipality must notify the state of intent to issue and
provide:
– Actuarial valuation
– Actuarial analysis of planned funding of any benefit
obligation NOT funded by the POBs
– Investment strategic plan for Pension Plan
– 3 year financial plan including financing plan for POBs
– Comparison of funding via POBs v through the annual
actuarially defined contribution
– Documentation of ordinance or resolution requiring
municipality to appropriate funds sufficient to meet
the ADC
Connecticut law continued
o As long as the POBs (or any refunding of the
POBs) are outstanding, municipality must
appropriate funds sufficient to meet ADC and
actually contribute that amount
o After issuance, the plan must maintain the
funded level that it had immediately following
the issuance of the bonds. If the funded level
drops, the entity must take action to restore the
funded level over a “short period of time”.
How’s that working out?
o One city that issued suffered losses in 2009,
causing its funded level to drop. They are still
working on getting it back to 100%. And the
gap is growing. The relative net position
dropped over 4% last year.
Other Post-Employment Benefit (OPEB)
Obligation Bonds
o OPEB bonds are taxable bonds that some
governments may issue to fund all or a part
of their unfunded OPEB liability, on the
assumption that interest earned on the
proceeds will exceed the interest due on the
bonds.
OPEB Bonds
o “GFOA Recommends that state and local
governments do not issue OPEB bonds….”
OPEB Bonds – Risks
o The actuarial liability for OPEB is even more
volatile than that of Pension benefits
– Costs and utilization are difficult to project
– Health care trends are more volatile than pension
inflation rates
OPEB Bonds – Risks
o “Soft” liability vs “Hard” liability
– Unlike pensions, retiree health benefits can often
be reduced, capped, or eliminated
– State and Federal healthcare changes could
further impact benefits
– Bonds reduce/eliminate contribution flexibility
– Trust assets can be used for limited purposes
OPEB Bonds – Risks
o Short-term volatility
– Increases exposure to investment performance
following bond issuance
– Poor returns will exacerbate financial challenges
OPEB Bonds – Risks
o False sense of security
– Improved funded ratio is not real – the liability still
has to be paid
– Overfunded plan may trigger benefit
improvements
OPEB Bonds – Case Studies
o
Wisconsin School Districts:
–
–
–
–
o
o
Five districts issued OPEB bonds in 2006 to avoid raising property taxes
Invested the proceeds in Certified Debt Obligations (CDOs)
Collapse of the subprime market caused the CDOs to become worthless
Districts had to raise property taxes to cover debt service, while still not
addressing their OPEB liability
Peralta Community College District:
– Issued $150 million OPEB obligation bonds in 2005
– Multiple restructuring to defer debt service and relieve general fund
pressures
Minnesota School Districts:
– Legislature temporarily allowed school districts to issue OPEB bonds
without voter approval
– 93 school districts issued $705 million in OPEB bonds (2007-2009)
Benefit Obligation Bonds – Market Timing
• Small window in which
benefits bonds are
advantageous
• Market returns must
exceed taxable bond
borrowing costs
• Do you feel lucky?
The PRM Group, “Benefits Bonds” and Their Place in Today’s Market, August 2014
S&P 500 Nominal Returns 1926-2015
60.00%
40.00%
20.00%
0.00%
-20.00%
-40.00%
2013
2010
2007
2004
2001
1998
1995
1992
1989
1986
1983
1980
1977
1974
1971
1968
1965
1962
1959
1956
1953
1950
1947
1944
1941
1938
1935
1932
1929
1926
-60.00%
Government Owned Life Insurance
o AKA “Dead Peasant Insurance”
o What is it?
– Employer takes out life insurance on employee
and/or retiree
– Employer is the beneficiary of the life insurance
– Upon death of employee, proceeds of the
insurance go to the Pension Fund and/or OPEB
fund
Issues with GOLI
o How do you fund the premium payments
– Under current tax law, if you bond it, those would
be taxable bonds
o Risk of cost exceeding benefit
o Besides interest cost (if bonded) there could
be premium taxes, admin costs, etc
o Counterparty risk – how sound is the
insurance company
Issues with GOLI
o Does the government have an insurable
interest
o Is this an allowable investment for your
pension plan under your local and/or state
regulations
o Does this assist in maintaining a balanced
asset allocation for your plan?
DROP Plans
o Deferred Retirement Option Plans
– Employee begins receiving pension benefits, but
continues to work
– Employee’s pension benefits are paid into a separate
account, which may or may not earn interest
– Employee no longer accrues pension credit for service
or increased compensation
– After set number of years, employee retires and
receives balance in separate account and benefits
proceed as normal
DROP Plans
o “GFOA recommends that governments
exercise extreme caution in considering
DROP Plans…”
Proceed with caution…
o Transparency is key
– Public participation, open discussion and public
decision making
– Watch for potential conflicts of interest among
decision makers
– Document the process
– Make the process comprehensive
Proceed with caution…
o Set and communicate explicit goals up front
– What do you expect the DROP plan to do for your
government
– Should not be designed to reward a select group
– Should be consistent with other provisions of
retirement plan
• don’t offer a DROP and early retirement
Proceed with caution…
o Design your DROP Carefully!
– Eligibility Parameters
• If not set carefully, you may lose more or retain more
employees than intended
– How long is your DROP period
• How long do you need/want to keep key employees for
a transition
– How long will you offer the DROP
• Have a sunset provision
Proceed with caution…
o Financial Risks
– Changing interest rates may cost the government
• Be conservative
• Link to risk and return of the investments supporting
the DROP
– Actuarial Impact
• Look for cost neutral/balance
• Test the sensitivity of the assumptions
– Is your portfolio ready for the cash flow needs of a
DROP?
Social Impact Bonds (“SIBs”) Defined
o Most SIBs follow a basic formula:
1. Private investors pay a government to launch a new social
program designed to achieve a measurable result.
2. If the program works, funders get their money back, and
some or all of the savings attributable to that result.
3. If it fails, the funders lose most or all of their investment.
4. Most SIB programs are usually delivered by non-profits
who want to try innovate approaches to solving social
problems.
Social Impact Bonds - Mechanics
Source: Adapted from Liebman and Sellman
(2013); hks-siblab.org
Recent SIB Examples
o Juvenile Recidivism – Rikers’ Island, NYC; greater
Boston
o Chronic Disease Prevention – Fresno, CA; South
Carolina HHS
o Early Childhood Education – Salt Lake County, UT;
Chicago
o Workforce Development – Massachusetts DOL,
New York State DOL
o Dozens of other SIBs under consideration or in
development
Main Advantages of SIBS
o Emphasis on impact, not outputs or throughputs
o Emphasis on prevention and long-term impact
o Opportunity to “backfill” federal and state funding
cuts
o Advances evidence-based policy - proof of concept
(or ineffectiveness) for new service delivery models
Main Concerns about SIBS
o
o
o
o
o
It’s difficult to measure impact. How do we define impact?
How do we get the data to measure it?
Does “pay for success” imply we’ve been paying for failure?
What are “cost savings”? Is reducing marginal costs alone a
compelling reason for SIBs?
Upside Risk. If a SIB reduces costs more than expected, is
there “gain sharing” for governments?
Are SIBs sustainable without philanthropy?
Why Finance Professionals Should Care
o
o
o
o
o
Headline Appeal; What elected official doesn’t want to
“leverage private sector and philanthropic investment to
transform the lives of children?”
Feasibility analysis for SIBs = performance-based budgeting/
zero-based budgeting
Evaluation and evidence-based policy are increasingly the
domain of the budget/finance office
Potential for broader government “risk sharing” in SIBs
Broader trend of "impact investing" – SIBs, social
entrepreneurship, corporate social responsibility, etc.
Thank you for attending!