Pitchbook US template

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J A N U A R Y   2 0 0 6
O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
S T R I C T L Y   P R I V A T E   A N D 
 C O N F I D E N T I A L
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This presentation was prepared exclusively for
the benefit and internal use of the JPMorgan
client to whom it is directly addressed and
delivered. This presentation is for discussion
purposes only and is incomplete without reference
to, and should be viewed solely in conjunction
with, the oral briefing provided by JPMorgan.
Neither this presentation nor any of its contents
may be used for any other purpose without the
prior written consent of JPMorgan. The
information in this presentation may be based
upon any management forecasts provided to us and
reflects prevailing conditions and our views as
of this date, all of which are accordingly
subject to change. In preparing this
presentation, we have relied upon and assumed,
without independent verification, the accuracy
and completeness of all information available
from public sources or which was provided to us
by or on behalf of the State or which was
otherwise reviewed by us. In addition, our
analyses are not and do not purport to be
appraisals of the assets, stock, or business of
the State or any other entity. JPMorgan makes no
representations as to the actual value which may
be received in connection with a transaction nor
the legal, tax or accounting effects of
consummating a transaction. Notwithstanding the
foregoing (but subject to any applicable federal
or state securities laws), JPMorgan and the State
may disclose to any and all persons, without
limitation, the tax treatment and tax structure
of any transaction contemplated hereby and all
materials (including opinions or other tax
analyses) relating thereto, so long as such
disclosure is not made prior to the earlier of
(x) public announcement of discussions relating
to the transaction or of the transaction itself
and (y) the execution of an agreement to enter
into the transaction. JPMorgans policies
prohibit employees from offering, directly or
indirectly, a favorable research rating or
specific price target, or offering to change a
rating or price target, to a subject company as
consideration or inducement for the receipt of
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prohibits its research analysts from being
compensated for involvement in investment banking
transactions except to the extent that such
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investors. JPMorgan is a marketing name for
investment banking businesses of J.P. Morgan
Chase Co. and its subsidiaries worldwide.
Securities, syndicated loan arranging, financial
advisory and other investment banking activities
are performed by J.P. Morgan Securities Inc. and
its banking affiliates. JPMorgan deal team
members may be employees of any of the foregoing
entities.
O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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Funding plan options
OVERFUNDED PLAN BENEFIT High level of security
for benefit payments. (105 funded) DRAWBACKS Pr
essure to provide new benefits leads to
funding holidays, followed by gen fund budget
pressure when surplus has been drawn
down. FULLY FUNDED PLAN BENEFIT High level of
security for benefits payments (80-100
funded) DRAWBACKS Could cement liabilities if
not required by contract. Reduces flexibility
to change benefits in the future. Difficult for
most public entities to fund quickly. PARTIALLY
FUNDED BENEFITS Good security for benefit
payments in medium term. Indicates fiscal
responsibility to rating(20-60 funded) rating
agencies, bondholders, etc. Insulates general
fund from fluctuations in medical
costs. DRAWBACKS May result in annual
contributions that are higher than
pay-as-you-go costs in the short run. PAY AS YOU
GO BENEFITS Lower short run contributions in
many cases no need to create or join OPEB
trust. (0 funded) DRAWBACKS Could affect
credit ratings, balance sheet. Strongly rising
costs over time. Long term cost accruals
higher than funded plans.
O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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What is the impact of NOT funding OPEB
liabilities at all?

• Accounting Unfunded plans generate greater
  liabilities than funded plans
• Public entity will be required to calculate the
  present value of OPEB liabilities at a lower
  interest rate, e.g., 3.5 - 4.5 instead of 6.5
  - 8.0
• In many cases, over time the large unfunded OPEB
  accruals can consume all net assets, or even
  become larger than all assets of all kinds
  (investments, capital assets, receivables, etc.)

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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What is the impact of NOT funding OPEB
liabilities at all? (continued)

• Cash flow differential
• Funding some portion of the liability results in
  investment earnings which reduce future
  expenditures. There are good reasons why
  completely unfunded pension plans are rare.
• Unexpected increases in medical costs directly
  affect the current years budget.
• Labor relations
• Completely unfunded plans leave labor and
  retirees worried about the security of their
  benefits.
• Ratings
• Rating agencies have already identified
  management of OPEB liabilities as a significant
  issue which may affect credit ratings going
  forward.

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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What is an OPEB Bond?

• A bond whose proceeds are used to partially or
  fully fund payments for Other Post-Employment
  Benefits
• Most likely used to fund a shortfall which
  already exists, rather than to finance current
  year costs over many years
• It might have a single direct issuer, use a
  conduit issuer, or even be issued by a joint
  powers authority

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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States where pension bonds have been issued
O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
Yellow 1 Billion in State GreenOther States
With POBs
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OPEB bonds overview Some similarities to
pension bonds

• OPEB bonds are similar to Pension Obligation
  Bonds in many ways
• Bonds are issued by a public entity, with net
  proceeds going to an OPEB trust, pension fund, or
  retirement association
• Proceeds are used to reduce or eliminate an
  unfunded liability
• It is hoped/expected that long-term investment
  returns on proceeds will be greater than cost of
  borrowing
• Bond interest is very likely taxable
• The bonds would typically be long term, 15 years
• Synthetic fixed interest bonds, capital
  appreciation bonds, current interest bonds, and
  variable rate bonds are possible
• In California, validation proceedings might be
  used to verify authority for issuance (other
  methods might also be used, e.g., statutory
  authorization)

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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OPEB bonds overview Some potential differences
from pension bonds

• Potential differences include
• Many public entities do not yet have an OPEB
  trust or retirement system which is willing and
  able to manage investments
• OPEB bond proceeds may be going to new OPEB
  trusts or JPAs investment strategies/policies
  will need to be defined in advance
• Most OPEB bond issuers will have funding ratios
  near zero percent before issuance
• Authority for OPEB bond issuance may come from
  different sections of the code than pension bonds
• The GASB accounting incentives for moving away
  from a completely unfunded OPEB plan are stronger
  than for pensions
• In some cases, the estimates of future OPEB
  liabilities may not be as precise as estimates of
  pension liabilities
• In some cases, the commitment to make OPEB
  payments is very clear (e.g., written into state
  law or city charter) in other cases the
  commitment is not so clear

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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Potential advantages of OPEB bonds

• Can increase funding levels for OPEB liabilities
  in a very short time, resulting in lower booked
  liabilities and annual accruals than
  pay-as-you-go or level amortization
• Lower expected out of pocket cash flow and net
  present value cost than amortizing the unfunded
  liability in 30 level payments
• Flexible debt service structures, potentially
  including interest-only or capital appreciation
  bonds
• A lower chance of disruption to benefits to
  current and future retirees
• Long-term taxable interest rates in early 2006
  are lower than historic averages

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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Potential disadvantages of OPEB bonds

• OPEB bonds can only benefit those employers who
  have, or obtain, authority to issue such bonds
• There must be a retirement system, OPEB trust, or
  other entity in place to receive and invest the
  bond proceeds
• All other things being equal, lower-rated issuers
  will have higher borrowing costs, and may want to
  look at alternatives to bonds which have lower
  credit charges/credit spreads. JPMorgan has
  developed certain products as alternatives to
  OPEB bonds.
• There is a chance that long term investment
  returns could be lower than borrowing costs for
  OPEB bonds
• Overfunding

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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Should an OPEB bond be sized to fund the entire
shortfall?

• Probably not, for several reasons
• Debt service is higher on larger bond amounts
• If investment returns are especially good, OPEB
  could quickly become overfunded
• Short-term overfunding of pension funds in the
  late 1990s led to long-term changes in benefits
• Funding holidays caused budget fluctuations
• Estimates of liabilities from the first actuarial
  study may be more uncertain than subsequent
  studies
• Public entities are allowed to amortize the
  funding shortfall over a period of up to 30 years
• Funding a significant portion of the shortfall
• Provides more assets to earn investment returns
  on than level amortization
• Has a lower booked OPEB liability, and lower
  annual accruals than being completely unfunded

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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Prefunding annual required contributions at ANY
level significantly reduces total contributions
by the Public Entity
Annual Required Contributions (ARC) ( billions)
O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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and result in a cushion against medical
inflation and rising costs
Percentage funded
O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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15
How have pension obligation bonds performed
historically?

• Comprehensive data on pension bond performance
  had not previously been published, so JPMorgan
  conducted a study of the 76 pension bonds with
  more than 100 million in par value issued from
  1986 through 2004
• JPMorgan compared borrowing costs to asset
  returns of CalPERS from date of issuance to
  2/28/05

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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Notes on pension bond performance

• While most POBs were profitable to their issuers,
  the margins tended to be higher for more highly
  rated issuers
• Issuing bonds in times of low interest rates
  improved results
• Most unprofitable bonds were issued between
  1999-2001, and encountered a major investment
  downturn shortly after issuance
• Future returns averaging in the 7 - 9 range
  would ultimately make most of those bonds
  profitable.
• This is a caution about evaluating results after
  only 1-5 years on bonds with ultimate maturities
  of 15-30 years
• Past performance does not guarantee future results

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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What about future investment returns?

• Pension funds commonly publish assumed
  investment returns
• For example, CalPERS currently assumes 7.75
  annual returns
• In its 2005 Report on State Retirement Systems,
  Wilshire Group forecasts a long-term return on
  state pension assets equal to 7.5 per annum
• January 24, 2006 yields for 20-year taxable bonds
  with different ratings were
• AAA (insured) ____
• AA ____
• A ____
• BBB ____

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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CalPERS historic annual returns, mean return
CalPERS Historic Annual Returns, Mean Return

• Instructions
• Enter annotation values in datasheet (Column Q)
  where needed. Activate the column in order for
  the markers to appear. Deactivate the column
  when finished if markers are not desired.
• Position text and lines where needed on top of
  the chart (outside of MSGraph)
• Text boxes w/ fill background (from JPMorgan
  colors)
• 8pt. font size (increase/decrease as needed)
• Left alignment
• Use black lines (0.5pt)
• No bold (only when necessary)

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
Source JPMorgan Securities, CALPERS Annual
Report, The Wilshire Group
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Comparison of interest costs and expected
investment returns
Comparison of Interest Costs and Investment
Returns

• Instructions
• Enter annotation values in datasheet (Column Q)
  where needed. Activate the column in order for
  the markers to appear. Deactivate the column
  when finished if markers are not desired.
• Position text and lines where needed on top of
  the chart (outside of MSGraph)
• Text boxes w/ fill background (from JPMorgan
  colors)
• 8pt. font size (increase/decrease as needed)
• Left alignment
• Use black lines (0.5pt)
• No bold (only when necessary)

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
Source JPMorgan Securities, CALPERS Annual
Report, The Wilshire Group
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Conclusion

• If you intend to set aside any prefunding at all,
  regardless of the source of the prefunding, make
  sure you have an entity which is willing, able,
  and authorized to invest that money
• Creating a new OPEB trust takes time, start early
  if you think you will need one
• There are many good reasons not to immediately
  try to fund 100 of the estimated liabilities
• Pension bonds have usually been profitable to
  their issuers, and OPEB bonds are expected to
  have similar characteristics, but past
  performance does not guarantee future results
• Analysis of the effects of various alternatives
  usually includes both bankers and actuaries

O P E B   F U N D I N G      O P E B 
 T R U S T S      O P E B   B O N D S
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