Using Pension Obligation Bonds to Feed our Spending Addiction

Thursday, July 22, 2010

Several recent news reports have indicated that Illinois is planning on selling pension obligation bonds in order to come up with the cash to make its contributions to the five state public retirement systems for the next fiscal year. This is by no means the first time that the state has used POBs: In 2009 it issued just under $3.5 billion of bonds to fund its pension contributions for 2010. Back in 2003, it issued about $10 billion in bonds for the same purpose.

So, are issuing such bonds a good idea or not? The answer depends on who you are, and what you are trying to achieve.

If you are a participant in one of the five public plans, the issuance of these bonds sure beats another year of having the state fail to make its contributions. While I have written before that public employees have little to worry about given the nature of the constitution benefit protections that are in place, any lingering concerns about the state’s inability to make good on pension promises ought to be at least partially mitigated by having additional contributions made into the pension funds. This is true regardless of whether the funds came from higher taxes, reduced spending, or borrowed funds.

If you are a politician, this is really a good plan because it allows you to – once again – avoid behaving like a responsible adult and making the difficult fiscal choices that ultimately need to be made.

If you are a current taxpayer, it also looks pretty good. First, we avoid raising taxes now. Second, we are essentially converting implicit debt (money owed to pensioners) into explicit debt (money owed to bondholders), with the key difference being that it is actually somewhat easier to default on the explicit debt than it is to violate the constitutional non-impairment clause (this is precisely the opposite for Social Security, in which it is easier to reduce benefits than to default on U.S. government debt).

If you are a beneficiary of other government spending programs, you are also pretty happy. After all, borrowing to fund the pensions puts less pressure on politicians to cut your favorite spending program.

So far, so good. Sounds like everyone is a winner. So, what is the catch?

The catch is that issuing these bonds takes the pressure off of our elected officials to exert fiscal discipline. It is like trying to cure a spend-a-holics debt problem by giving them a credit card.

As such, the losers are all the future generations of taxpayers and program beneficiaries who are going to be saddled with several additional billion dollars worth of debt that must be serviced because we gave today’s politicians an “easy out” from facing their responsibilities today. This reduction in fiscal discipline is made all-the-more dangerous when these bonds are portrayed as a way to magically reduce our obligations by more than the amount of the debt issuance. All too often, one hears proponents of these bonds make statements about how the state can borrow at a low rate and invest at a high rate, and thus make money on the difference. Invariably, such statements ignore the risk differences in the investments, and are akin to try to create a free lunch where none exists.

Thus, the biggest downside to the use of these bonds is that they are an “enabler” for politicians who are addicted to deficit spending. The direct effect of this resulting debt burden will be to increase the pressure to raise future taxes and cut future spending on education, health care, roads, state police and every other spending program that people may value.

The indirect effect is that higher future taxes will turn Illinois into an unattractive place for businesses to invest or for our most talented young people to build careers, homes and families. Who wants to invest in a state that is saddling future generations of businesses and workers with debt?