THE PROS AND CONS OF OPEBOB’s September 25, 2007 APPA Business & Financial Conference.
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Transcript of THE PROS AND CONS OF OPEBOB’s September 25, 2007 APPA Business & Financial Conference.
THE PROS AND CONS OF OPEBOB’s
September 25, 2007
APPA Business & Financial Conference
PAGE
OPEB FUNDING OVERVIEW 3
PROS 6
CONS 9
STRUCTURING & ISSUANCE CONSIDERATIONS 14
TAX-EXEMPT AND CALLABLE OPEBOBS? 19
ADDRESSING ALM ISSUES VIA OPEBOBS 20
3
OVERVIEW
GASB does not require the funding of a qualified OPEB Trust. But it allows entities that establish these trusts to discount future benefit payments using a higher rate (a rate that reflects the assets being held in the trust v. the Authority’s general investments). That is a strong incentive to pre-fund since it reduces the size of the UAAL and the amortization component of the ARC.
Funded on either a Pay-as-you-go (PAYGO) or pre-funded basis.PAYGO:
ANNUAL PAYMENT
A GASB FUNDED PLAN:ARC
UAAL AMORTIZATION
NORMAL COST
ANNUAL PAYMENT
BENEFIT PROVIDER
AUTHORITY/AGENCYQUALFIED HEALTHCARE TRUST
BENEFIT PROVIDER AUTHORITY/AGENCY
ARC CAN BE MANY TIMES LARGER THAN ANNUAL BENEFIT PAYMENT UNDER PAYGO.
4
PAYGO v. Funded Plan Amortization
-
50,000,000
100,000,000
150,000,000
200,000,000
250,000,000
300,000,000
350,000,000
400,000,000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Term
Level Percentage of Payroll Payment Level Payment PAYGO
GASB Amortization Methods:
•Level Payment
•Level % of Payroll
PAYGO and the amortization methods allowed under GASB place the burden of these obligations at different points along the term structure.
Level Payment Less Level Percentage of Payroll Method
(80,000,000)
(60,000,000)
(40,000,000)
(20,000,000)
-
20,000,000
40,000,000
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Level Payment Less Level %
OVERVIEW
5
The larger the gap between the UAAL’s carrying charges and debt service on the OPEBOB, the greater the estimated savings.
OPEBOB FUNDED PLAN:
RESIDUAL AMORTIZATION
NORMAL COST
OPEBOB PROCEEDS
ANNUAL PAYMENT OPEBOB Proceeds Debt Service
OPEBOB BONDHOLDERSBENEFIT PROVIDER
QUALIFIED HEALTHCARE TRUST AUTHORITY/AGENCY
OPEBOB Savings (Level ARC v. Level DS)
0.00
50,000,000.00
100,000,000.00
150,000,000.00
200,000,000.00
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Term
Level Payment Level Debt Service
OPEBOB debt service
UAAL’s carrying charges
OVERVIEW
6
Estimated savings appear substantial:
OPEBOB’s effectively refund a more expensive “debt-like” expense with one that is lower.
The UAAL that is being refunded has an effective coupon equal to the actuarial rate of return assumption of the qualified trust’s assets.
v.
The All-In-TIC of the OPEBOB.
Budget relief:
In addition to uniform savings, some issuers may be able to shape OPEBOB’s debt service to provide a “ramp-up” period that is different to the level percentage of payroll alternative provided by GASB.
PROS
7
Actuarial and Accounting Benefits:
By issuing an OPEBOB and funding a qualified trust issuers reduce:
• The size of the accounting liability on their books by using a higher discount rate, and
• Their ARC and increase the likelihood of not reporting a Net OPEB Obligation as an on-balance sheet item.*
HR Benefits:
A fully funded plan enhances the security of an important component of an employees total compensation.
*: The Net OPEB Obligation is not the same as the UAAL. The NOPEBO represents the shortfall between the actual contribution and the ARC and interest on the same. Importantly, fully funding a qualified trust does not guarantee that a UAAL will not develop in the future should assets under-perform or liabilities over-perform.
PROS
8
OPEB Management Benefits:
Organizations, so as to facilitate other components of the OPEB Management Strategy, may accede to fully fund the qualified trust.
Plan Asset Allocation and Portfolio Risk Reduction:
Improves the ability of the fund to recuperate from periods of under-performance.
PROS
9
Savings depend on prospective asset returns:
Estimated savings may prove to be dis-savings should the qualified trust realize returns below the All-In-TIC of the OPEBOB’s.
$6,711
47.9%
$1,424
10.2%
$3,067
21.9%
$4,469
31.9%
-$513
-3.7%
-$2,812
-20.1%
$5,672
40.5%
-4000.0 -2000.0 0.0 2000.0 4000.0 6000.0 8000.0
4.50%
5.50%
6.50%
7.50%
8.50%
9.50%
10.50%
$ Million
Savings Sensitivity Analysis
CONS
10
Assets may over-perform:• An over-funded trust does not benefit issuer directly and may
create pressure to expand benefits or modify other elements of an OPEB management strategy.
Provides incentives to take on risk and shift costs across generations:
• Since savings are driven by the spread between the actuarial rate of return and the All-In-TIC, sponsors are incented to expand the amount of risk/expected return in the trust.
• Back-loaded OPEBOB’s (and ARC determined as level percentage of payroll) provide immediate budget relief but have the effect of shifting current costs to future generations and postponing the “day of reckoning” to future budgets.
Concentrates market-timing risk:• Large lump-sum is invested in trust at one time instead of
dollar averaged. • Issuers are also exposed to the risk that a national solution
develops (a wait and see approach before funding an irrevocable trust may prove less risky).
CONS
11
ALM Issues:
• Trust assets and OPEB liabilities may appear to be correlated retrospectively but may prove to be poorly correlated prospectively.
• Pension Obligation Bonds are well suited to their task. A pension obligation is similar to a bond; there are third party suppliers of long-term annuity products. There are no healthcare equivalents. Moreover, the historical out-performance of medical inflation over most investment indices suggests that a funded trust can only be part of the answer. Medical Inflation v. Domestic Stock Index
-
50.00
100.00
150.00
200.00
250.00
1998 1999 2000 2001 2002 2003 2004 2005 2006
Kaiser Medical Inf lation Index SPX Midcap Index Russell Index
CONS
12
Loss of flexibility:
• Addressing OPEB obligations results in higher costs. Depending on the size of the obligation these costs can be significant.
• ARC v. Bonded Debt; o Contributing less than the ARC results in “reporting”
consequences, but failure to pay debt service is a default under the bond indenture.
• Proceeds are invested in an irrevocable trust;o Should national health-care or other solution develop the
irrevocable trust may prove difficult to un-do.
CONS
13
An OPEBOB is only part of the OPEB Management Strategy:
• UAAL can resurface if;
o Qualifying trust does not achieve the actuarial rate of return,
o Benefits are expanded, and
o Actuarial assumptions are revised.
• In these cases the Authority will have to make the normal cost payment, the D/S payment on the POB’s and an additional payment to amortize the new UAAL.
Financial theory:
• Appropriate rate to discount cash flows is the applicable risk adjusted rate of return not the funding source used.
CONS
14
Larger and back-ended issues may be marketed to not only domestic but also international investors. These bonds should be structured to support assignment of low BIS risk weights. Expect significant drop off in foreign demand for BIS “ratings” above 20%.
Background on BIS
• The BIS standards on capital adequacy provide guidelines to national banking supervisors on minimum capital requirements for banks;
o Banks must have regulatory capital in an amount equal to 8% of its risk weighted assets.
• Classification of assets are often determined by each bank with the approval of its supervisor.
• The lower the risk weight the greater the investor’s return on invested capital (reduces the amount of capital set aside). The amount of regulatory capital drives ROIC, as the generic example below illustrates:
Risk Weight Return on Capital*
100% 4.69%
50% 9.37%
20% 23.44%
0% infinite*operational risk, capital floor, and scaling factor not considered
Coupon 5.875%
Funding Cost 5.500%
Spread 0.375%
Structuring
15
• Authority obligations would be classified as claims on non-central government public center entities
• Qualify under the two options for banks (only one option applies within a country, we illustrate Option 2 below) or subject to national discretion as claims on sovereigns. Guidelines provide different sovereign categorization criteria, these include:
o Revenue raising power, and
o The nature and amount of guarantees provided by the central government.
• Consider cost benefit of obtaining Corporate Equivalent Ratings
o Banking supervisors are responsible for mapping External Credit Assessment Institution ratings to the standardized framework.
o Credit Mapping may permit institutions to lower risk weights:
— Muni Baa3 maps to Aa2 CER— Muni Aa3 maps to Aaa CER
Claims on Banks (Option 2)
Credit Assessment AAA to AA- A+ to A- BBB+ to BBB- BB+ to B Below B- Unrated
Risk Weight 20% 50% 50% 100% 150% 50%Risk Weight for Short Term Claims 20% 20% 20% 50% 150% 20%
Structuring
16
Ratings not only will impact the demand from domestic investors but also be a key driver of BIS Risk Weights. Consider cost benefit of structuring to specific ratings and BIS Risk Weights. Consider cost benefit of obtaining Corporate Equivalent Ratings. This may permit certain institutional investors to lower risk weights.
Insurance: depending on revenue source and structuring, may require the use of bond insurance which may not be available in large quantities.
• Hire underwriters early in the process to provide continuing market assessment and structuring input.
• Hold meetings with the insurers to discuss capacity issues and develop a clear understanding of capacity constraints.
Call Features: Most buyers prefer non-call structures or require a make whole call provision. Consider pro-rata versus random draw calls on term bonds with sinking fund provisions.
ALM: Consider issuing a portion of the bonds as floating rate obligations.
Structuring
17
Execution Team
Tackling OPEB should involve a broader team consisting of not only the issuer’s finance team members, financial advisor and underwriters, but also folks involved in managing OPEB’s: plan consultants, attorneys, human resources professionals, and actuaries. The team can assist the finance team in deciding:
• Are OPEBOB’s in your financial toolbox?
o Legally authorized,
o Can you afford to use it (size, impact on financial flexibility).
• If it is a tool in your toolbox, when should you use it?
o Synchronized with other components of OPEB management strategy.
Disclosure:
Issuers should plan to provide significant disclosure to stakeholders and seek their vetting of the funding plan: including bond structuring, and the allocation of savings. PSI also recommends communicating and managing expectations on savings by using a range of savings estimates (using different discount rates or confidence interval, etc.).
Issuance Considerations
18
Marketing Plan Characteristics:
• Larger issues should include international investor marketing
• Road show should not only include typical domestic (NYC, Boston, Chicago and LA) but also certain international locations (London, Frankfurt)
• Internet road show especially for Asian accounts
• Investor tours/conferences
Issuance Considerations
19
Many authorities’ capital budgets include a component that can be financed with tax exempt debt but is actually financed with Authority Revenues/equity (PAYGO).
These Authorities may be able to generate savings to the extent that it is able to –
• Reallocate these Paygo revenues to fund a qualified OPEB Trust
• Finance its capital investments with tax exempt borrowings.
• The net effect is that higher cost debt (UAAL carrying charges) is retired and replaced with lower cost tax-exempt debt and the capital program is fully funded.
• It may also be possible to bond finance past PAYGO capital investments if the authority previously disclosed that it planned to use bonds to refinance these investments at some point in the future.
• Such a program would be subject to opinion of counsel.
Qualifying Healthcare Trust Funding Requirements
Component of capital program funded with pay as you go
revenues
Fund with T/E debt
Fund with revenues
High cost UAAL carrying charges are replaced with lower
cost debt
CIP Paygo components funded
as planned
Tax-Exempt & Callable OPEBOB’s?
20
An ALM Perspective:• The combination of falling long bond yields and poor returns on
broad market indices impacted the funding status of most DB pension plans in 2001-2003. Pension plan funding status and ARC have been on a roller coaster ride since the early ’90’s.
• Changes in private sector accounting may signal future changes in public sector accounting for pensions. FAS 106 and 87 will have sponsors show net deficit or surplus on the balance sheet (using market prices) and over time changes in this line item will flow through the income statement. FAS is also moving away from using expected returns to actual realized returns.
• FASB already measures plan liabilities using a much lower discount rate o FASB discounts rate - high quality corporate bonds,o GASB discount rate - assumed return on assets.
• Prospectively, with more stringent accounting and pension funding law sponsors face the risk of sharply higher ARC’s and volatile funding status ratios.o Standard Deviation of one-year forecasted funding ratios is 12.4%*
*: Source PIMCO, Pension Update: Slip Slidin’Away, March 2006
Floating Rate OPEBOB’s
21
An ALM Perspective:
• As a result plan sponsors are:
o Cognizant of the sharp differences in duration between the assets it is long and the liabilities it is short.
o Increasingly focused on managing relative returns (Assets – Liabilities), not absolute returns (Assets).
• In an effort to reduce ARC and funding status volatility increasing numbers of plan sponsors have adopted ALM techniques.
• ALM techniques seek to dampen or eliminate changes in the funding status/gap by better matching characteristics of the plan’s assets and liabilities.
Floating Rate OPEBOB’s
22
An ALM Perspective:• Seen from an integrated ALM perspective variable rate
OPEBOB’s are attractive for two reasons:o Reduced Duration Impact:
— Adding a short position in a long-term bond would further increase the net-short duration exposure of the plan’s sponsor.
— Issuing a component of their OPEBOB’s as variable rate obligations with a close to zero duration however, would reduce the growth in the sponsor’s net short duration position.
o A portion is naturally hedged: — A portion of the variable rate bonds will closely match
the portion of fund’s assets that are invested in money-market instruments and other short term fixed-income assets (more typical of mature plans with large relative numbers of beneficiaries).
• Plan sponsors may integrate the OPEBOB into their ALM plan by considering the OPEBOB issue and plan liabilities as short positions. Thus post-issuance:o Assets increase by the OPEBOB net proceeds, ando Liabilities now include a short position in the OPEBOB.
Floating Rate OPEBOB’s
23
Contact Information Investment Banking
Popular Securities, Inc.
120 Broadway, 15th Floor Suite SE-1, New York, NY 10271
Carlos Desmarás
Vice President
Tel: (212) 417-6903
E-mail: [email protected]