Jan. 21 (Bloomberg) -- The new growth area of the U.S. municipal market is going to be pension obligation bonds.

These are the bonds that states and municipalities sell to cure, or help to cure, the ``unfunded liabilities'' in their public pension funds.

States and localities sell pension obligation bonds in the taxable market, because they are prohibited by tax law from selling debt at tax-exempt yields and investing the proceeds in higher-yielding investments.

In 1999, taxable municipal issuance totaled $15 billion, according to the Bond Buyer. It rose to $20 billion in 2002 and to $41 billion in 2003. In 2004, it declined to $24 billion, an amount that can easily double this year.

These sales used to be fairly rare, and done only by those issuers in desperate straits or those in need of a quick budget fix (they sell pension obligation bonds and skip a year or two of contributing money to the pension funds). Today such bonds are sold every week.

This isn't a good thing. What it demonstrates is a failure of political will to come to grips with a situation that requires some fiscal discipline. States and localities have to put aside enough money to pay for their retirees' benefits. They also have to stop promising more and more in the way of benefits.

Easy Way Out

Bonds are the easy way out -- at least for a short time. The easy way out is also, unfortunately, usually the avenue of choice for most politicians.

How we got here is the subject of a new report by Parry Young, an analyst with Standard & Poor's, titled, ``Managing State Pension Liabilities: A Growing Credit Concern,'' published yesterday.

``The rapid growth and significant magnitude of these liabilities has become an increasing credit concern for many state ratings,'' writes Young, ``reaching crisis proportions in some cases.''

There aren't a whole lot of options, either. ``Even with adequate investment returns, the pension funding problem will be in the forefront for at least a few more years, and possibly much longer if the markets don't cooperate,'' writes Young.

And as if the business of ``unfunded pension liabilities'' were not enough, states and localities also have to deal with post-employment benefits like rising health-care costs.

What Happened

It wasn't always this way. On June 30, 2000, the average funding ratio for public pension funds in the U.S. was just above 100 percent, higher for state funds.

``The party to celebrate the final defeat of unfunded pension liabilities was short-lived,'' writes Young.

Three things happened. The first two occurred over time, the last, it seemed, in a heartbeat.

One is pernicious. States and localities started making improvements to pension benefits. They added more and more goodies. Nor have they stopped. It seems that every week we read about another state or municipality, somewhere, enhancing the package of benefits for its retirees -- this at a time when the private sector is drastically cutting back.

Once these ``enhancements'' are made, it's difficult to get them back. ``From a liability standpoint,'' writes Young, ``most states have constitutional or statutory pension benefit protections that preclude any reductions in benefits already promised to existing employees.''

The other thing that happened over time is that people started retiring sooner, and living longer. Let's call that a good thing, but it still costs money.

Negative Returns

The biggest component in the return of unfunded pension liabilities was the stock market crash.

``The investment return assumption requirement for most public funds to maintain actuarial balance, about 8 percent, could not be sustained when the average allocation to domestic equities stood at 40 percent to 50 percent, and the annual returns of the S&P 500 Index was negative 16 percent, negative 19 percent, and positive 2 percent, in fiscals 2001, 2002 and 2003,'' writes Young.

Well, there's your problem. During the good times, states and municipalities promised more to retirees. They cut back on annual contributions. Then the market turned against them. Public pensions are now 80 percent to 90 percent funded.

Some, of course, are in worse shape. In Illinois, for example, the funded ratio for the combined pension systems is 57 percent. And that's after the state borrowed a record $10 billion to help fix the problem, according to Young.

Fiscal Rectitude

The prospect ahead isn't pleasant. The safe and sane way to deal with it would be to make sure that states and localities put aside the right amount of money every year to ensure that their retirees won't go hungry.

They would also keep a lid on promises made for the most short-term political gains (the next election), so these same retirees don't eat filet mignon every night.

There is never a bull market in fiscal virtue. That's why we are going to see places sell bonds to reach actuarial Nirvana, at least for a year or two, and count on their investments making 8 percent or 9 percent a year -- itself unlikely unless they diversify into riskier assets.

Have pension obligation bonds been a success or a failure? It's too soon to tell. You can't judge whether selling such bonds and investing the proceeds in the hopes that the returns exceed debt service costs and pension contributions until the last bond matures, and the politicians who authorized them are long gone.

``The best that can be said to date is that POB results have been mixed,'' says Young. That's not going to stop issuers from selling a bumper crop.

To contact the writer of this column: Joe Mysak in New York jmysakjr@bloomberg.net

Last Updated: January 21, 2005 00:05 EST