Concern over the state of America’s infrastructure—highways, mass transit, rail, aviation, water transportation, water resources, water supply, and wastewater treatment facilities—has become widespread. The nation’s interstate highway system has nearly been completed, but highway, air traffic, and other transportation and environmental problems are mounting. However, the federal budget deficit has made it increasingly difficult to fund infrastructure improvements either directly through federal grants or indirectly through tax exemptions. Consequently, the Congress and the administration have explored additional financing methods—including some that involve America’s pension plans, which were estimated to have over $4 trillion in assets in 1994—to expand federal, state, and local financing of infrastructure projects. Substantial grant funding for infrastructure projects, including highways, wastewater treatment facilities, and mass transit began between 1956 and 1964. Spending on these programs as a share of total federal spending peaked in the 1970s. But by the late 1970s, the growth of federal infrastructure spending had slowed and continued to slow into the 1990s. According to CBO, the share of all federal spending that was devoted to infrastructure declined from over 5.4 percent in 1977 to less than 3 percent in 1992. For example, in the area of environmental infrastructure, the Congress began to reduce funding for constructing wastewater treatment facilities in the late 1970s and decided in 1987 to phase out federal capitalization grants by 1995. The decline in infrastructure investment as a share of federal spending—coupled with a growing backlog of infrastructure development and repair projects, and federal, state, and local budget deficits—led to a widespread perception of an infrastructure crisis in the 1980s and 1990s. Estimates of how much investment was needed to resolve the crisis varied widely. A 1991 Office of Technology Assessment study estimated that federal, state, and local governments spent about $140 billion annually on building, operating, and maintaining infrastructure facilities, but others estimated that $40 billion to $80 billion more was needed each year. However, some experts and economists believe that the infrastructure problem has been overstated. They argue, for example, that the U.S. stock of “public capital” (that is, infrastructure) rose steadily between 1949 and 1991. Some also contend that past spending on infrastructure means less can be spent now; the interstate highway system is about 98-percent complete, for instance, and Americans have the highest quality drinking water in the world. The debate over infrastructure investment has been extensively explored in the economic literature. Although there is no consensus on the magnitude of any infrastructure gap, federal, state, and local officials have begun seeking new and innovative ways to finance development for the 1990s and beyond. For example, the Congress included the “toll provisions” in section 1012(a) of the Intermodal Surface Transportation Efficiency Act of 1991 (ISTEA) to allow tolls to be charged on new, reconstructed, or renovated federal highways other than interstates. The revenue streams from the tolls make participating in financing highway projects more attractive to private investors. Another provision of ISTEA, section 1081, established the Commission to Promote Investment in America’s Infrastructure (the Infrastructure Commission) “to conduct a study on the feasibility and desirability of creating a type of infrastructure security” that would attract pension plan investors. Creating securities that would encourage pension plans to invest in public facilities was a novel idea because private pension plans do not generally invest in public projects within the United States. Public projects at the state and local levels are commonly financed through bonds for which the interest income is exempt from federal taxation. Tax-exempt bonds pay lower interest rates and, thus, hold down the cost of borrowing for state and local governments while providing a return to investors comparable with the after-tax return of taxable securities. At the same time, to encourage the development and growth of private pensions, the federal government exempts pension plans’ earnings from taxation. However, since plans are subject to fiduciary rules under the Employee Retirement Income Security Act of 1974 (ERISA), which obligate them to seek the highest return (taking risk into account) on their investments, they do not normally invest in lower-yielding, tax-exempt bonds. The bipartisan Infrastructure Commission, which was appointed by the President and congressional leadership, made three major recommendations in its February 1993 report designed to increase institutional investment, including pension plan investment, in infrastructure projects: Create a National Infrastructure Corporation (NIC) to leverage federal dollars and boost investment in infrastructure projects; NIC would have the capacity to become self-sustaining through user fees or dedicated revenues. Create new investment options to attract institutional investors, including pension plans, as new sources of infrastructure capital. Strengthen existing infrastructure financing tools and programs by making federal incentives more consistent and by providing uniform treatment for investment in infrastructure projects. Given continuing congressional interest in infrastructure and pension issues, and at the request of the Chairman and the Ranking Minority Member of the House Committee on Transportation and Infrastructure, we initiated a study to identify the role that current federal policies play in providing incentives for private pension plans to invest in infrastructure projects and analyze the Infrastructure Commission’s 1993 proposals relating to pension plan investment to determine how pension plans might respond. In addressing these objectives, we reviewed relevant laws, policies, reports, Infrastructure Commission hearing testimony, and various economic analyses. We also interviewed former Infrastructure Commission officials, corporate executives, government officials, and experts on infrastructure financing or pension plan issues. For further details on our scope and methodology, see appendix I. To ensure the accuracy of our information, we provided a draft of this report to several outside experts, who generally agreed with our findings. We incorporated their technical comments where appropriate. We conducted our review between January 1994 and June 1995 in accordance with generally accepted government auditing standards. Current federal tax and pension policies are inconsistent with the goal of having pension plans invest in infrastructure projects to any significant extent. Fiduciary requirements state that pension plans must invest their assets for the exclusive benefit of their participants by earning the highest risk-adjusted return possible. Federal law also exempts the plans’ earnings from taxation. At the same time, the Internal Revenue Code and current federal grant and revolving fund programs encourage infrastructure project sponsors to finance public projects at lower interest rates through the municipal bond market. As a result, infrastructure projects do not attract pension plan investment. However, the Infrastructure Commission did not propose to substantially change the long-standing tax and pension policies, which together translated into more than $60 billion in indirect federal subsidies in fiscal year 1994. Federal law does not prevent private pension plans from investing in infrastructure, but the plans’ investments must meet certain standards. Private pension plan managers may only make investments that comply with various fiduciary standards found in ERISA, Taft-Hartley Act restrictions, Internal Revenue Code provisions, and common law. These fiduciary standards require plan managers to, among other things, carry out their duties with the same care, skill, and diligence as a prudent person. These standards have been interpreted to mean that managers should obtain market-rate returns on their investments. DOL, which is responsible for enforcing the fiduciary standards in ERISA, interprets the standards as permitting infrastructure investment. DOL’s Solicitor testified before the Infrastructure Commission that nothing in ERISA’s fiduciary provisions specifically prevents pension plans from purchasing a security created to encourage investment in infrastructure facilities. Specifically, a pension plan must act solely in the interest of the participants and beneficiaries, and for the exclusive purpose of providing benefits and defraying reasonable expenses; act prudently; diversify plan investments; and not engage in certain kinds of transactions that may create conflicts of interests or result in self-dealing. This guidance generally means that private pension plans may invest in infrastructure projects only if the investments offer an equal or higher rate of return, adjusted for risk, as other potential investments. However, a pension plan can, according to the Solicitor’s statement, consider “noneconomic” factors even though it is required to act solely in the interests of its participants. For example, DOL advised a pension plan that it could invest in a mortgage pool that included only construction projects built by union labor because the mortgages had to meet rigorous financial criteria, and the investment was competitive with comparable investments available in the marketplace. However, according to the Solicitor’s testimony, DOL has consistently opposed pension plan investments designed to achieve socially beneficial objectives at the expense of yield or security. A key ERISA requirement is that pension plan managers “act prudently.” Specifically, ERISA requires that a fiduciary use the care that “a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” In fact, the Counsel to the Infrastructure Commission said that only large pension plans are likely to want to bear the cost of the “due diligence” work to determine whether an infrastructure investment is prudent. In Interpretive Bulletin 94-1, issued on June 22, 1994, DOL reiterated its position that the fiduciary standards applicable to infrastructure are no different than the standards that apply to other investments. DOL stated that it issued its bulletin because “a perception exists in the investment community” that ETIs, including infrastructure, “are incompatible with ERISA’s fiduciary obligations.” The bulletin stated that sophisticated long-term investors, including pension plans, may invest in assets designed to create benefits to third parties in addition to their returns to investors. That would be possible even though less information about the investment may be readily available and the investment may be less liquid, may require a longer time to generate significant investment returns, and may require special expertise to evaluate. Federal tax laws were designed to help lower the costs to states and localities for developing and financing public projects. The Internal Revenue Code exempts the earnings on municipal bonds from federal taxation; thus, states and localities financing infrastructure projects can hold down their costs by paying lower interest rates and still attract investors who do not have to pay taxes on the interest they collect. Typically, the interest rate paid on tax-exempt bonds is about 15 to 20 percent lower than that paid on taxable bonds of comparable risk and maturity. Given the high capital costs of some infrastructure projects such as environmental facilities, the interest savings can be considerable. Although tax-exempt bonds help states and localities hold down the cost of public projects, the comparatively low interest rates they pay make them relatively unattractive to pension plans, whose earnings are already tax exempt. The difference between yields on tax-exempt and taxable bonds changes over time, but we found that taxable bonds consistently pay a higher rate of return. CBO, for example, found that the yields on 30-year AAA-rated tax-exempt general obligation bonds (or bonds that are issued for state and local projects) have been an average of 1.4 percentage points lower than those on 30-year Treasury bonds since 1989. Our work shows that the yields on the tax-exempt bonds were lower than those on the Treasury bonds every month during the 11-year period, as shown in figure 2.1. The lower return on tax-exempt municipal bonds means that the securities cannot compete effectively for pension plan assets. Consequently, infrastructure developers have little incentive to seek financing from private pension plans, and private pension plans have little incentive to seek infrastructure investment opportunities. Only 0.1 percent of the assets held in private pension plans were invested in such securities at the end of 1992, according to CBO. Federal agencies assist infrastructure projects through programs that involve direct, as well as indirect, federal expenditures. We reviewed several recent initiatives that used federal funds to help infrastructure developers obtain financing from traditional sources, such as tax-exempt bonds. Actions taken to increase private investment in infrastructure have included establishing the State Water Pollution Control Revolving Fund Program under the 1987 amendments to the Clean Water Act to leverage, and eventually replace, federal capitalization grants; permitting states to lend federal funds to toll road projects under section 1012(a) of ISTEA in 1991; and issuing Executive Order 12893, Principles for Federal Infrastructure Investments, on January 26, 1994, which directed federal agencies to seek private sector participation in their infrastructure programs. These initiatives generally use the tax-exempt market and do not target pension plan investment. The tax exemptions for private pension plans and for bonds that finance infrastructure projects involve large, indirect federal subsidies in the form of foregone federal revenue, referred to as a “tax expenditure.” Recent estimates show that exempting pension plan earnings from taxation resulted in foregone revenue of about $48.8 billion in fiscal year 1994.Nearly $12 billion in revenue was foregone by subsidizing interest on tax-exempt bonds. Although current policies are costly and have the effect of discouraging pension plans from investing in public projects, the Infrastructure Commission did not propose changing these basic federal laws substantially. However, research suggests that it might be less costly to pay interest subsidies directly to state and local governments than it is to exempt state and local bonds from taxes. Paying interest subsidies directly to state and local governments might also eliminate the disincentive for pension plans to invest in state and local government bonds because the bonds would presumably pay investors competitive interest rates. The Infrastructure Commission recognized, though, that both the tax exemption for pension plan contributions and the tax exemption for municipal bonds are long-standing federal laws. The Congress tasked the Infrastructure Commission with conducting a study on the “feasibility and desirability of creating a type of infrastructure security to permit the investment of pension assets in funds used to design, plan and construct infrastructure facilities in the United States,” including examining other methods of encouraging public and private investment in infrastructure facilities. In short, the focus of the Infrastructure Commission’s inquiry was on developing a new investment instrument that could attract private money, with a particular concentration on pension plans. The Congress has not acted on the proposals contained in the Infrastructure Commission’s 1993 report, although a bill based mainly on the proposals was introduced in the 103rd Congress. The Infrastructure Commission found that there is a significant need to facilitate investment in the repair, renewal, and development of domestic infrastructure. The Infrastructure Commission’s report argued that budgetary constraints will prevent federal, state, and local governments from increasing either grant expenditures or tax subsidies sufficiently to eliminate the nation’s projected shortfall in infrastructure investment. The Infrastructure Commission’s Counsel told us that there is a “limited appetite” for state and local tax increases to pay for roads, environmental facilities, and other infrastructure projects. Furthermore, the Infrastructure Commission’s report noted that the legal limits on federal tax subsidies for municipal bonds, issued to finance projects that involve private sector participation, constrain the availability of financing and increase the cost of financing such projects. As grant funds from the federal government decrease, states and localities need to find new ways to leverage their limited resources. The Infrastructure Commission’s 1993 report recommended that the Congress establish two new corporations to provide credit assistance and insurance to state and local issuers of debt to finance infrastructure. The Infrastructure Commission recommended the establishment of a National Infrastructure Corporation (NIC) that would purchase and bear the credit risk of obligations issued to finance transportation and environmental facilities, including both governmental and public-private sponsored projects. NIC would also insure project sponsors against a portion of the risk of developing new facilities. Also, the Infrastructure Commission recommended the establishment of an Infrastructure Insurance Corporation (IIC), initially an NIC subsidiary, that would insure infrastructure bonds. In general, the Infrastructure Commission’s proposals are aimed at providing credit assistance to public and private sponsors seeking financing for infrastructure projects. Borrowers may have difficulty securing financing because their projects may be judged as too risky given the rate of return they promise to investors. When an entity assumes some of this risk (that is, by providing credit assistance or bond insurance) the investment becomes more attractive to the investor. At the same time, the state or locality seeking to obtain financing may do so on more favorable terms. The ability to bring borrowers and investors together by having an entity assume risk may involve the provision of a subsidy on the part of the federal government. The Infrastructure Commission proposed that NIC and IIC provide three forms of credit assistance. First, NIC would purchase “subordinated” bonds sold by state and local governments to finance new infrastructure projects. The payment on these bonds would be legally subordinated to, or not due before, payments on the remainder of the debt, called “senior” debt. The subordinated debt purchased by NIC typically would be for projects that are not eligible for investment-grade credit ratings (ratings BBB and above) in the marketplace. Second, NIC would insure private firms against a portion of the risk associated with developing new facilities, such as the risk of environmental lawsuits and voter disapproval of the issuance of bonds to provide long-term financing. NIC would be legally obligated to cover up to 70 percent of any losses incurred by developers if the projects were never completed. Third, IIC would bear a portion of a project’s credit risk by insuring or reinsuring senior infrastructure bonds. IIC would insure or reinsure only those bonds that private municipal bond insurers would not insure or that could not obtain other forms of credit enhancement, such as a bank letter of credit. It was also proposed that in the long run, NIC would purchase senior infrastructure bonds, including bonds insured by IIC. The Infrastructure Commission proposed that the federal government initially capitalize NIC and IIC through a grant of $1 billion per year over 5 years. Later on, NIC would raise additional funds by issuing debt to the public and creating and selling securities backed by the infrastructure bonds that it had purchased (that is, providing securitization). The Infrastructure Commission’s report did not specify the legal and organizational status of NIC. It noted that NIC’s ability to borrow from the public would benefit from a “limited line of credit” from the U.S. Treasury, but it did not foresee a need for a “full faith and credit guarantee” from the federal government. IIC would be established initially as an NIC subsidiary and would operate as a private corporation similar to the College Construction Loan Insurance Association (Connie Lee)—a private, for-profit municipal bond insurer that insures bonds for construction at institutions of higher learning and teaching hospitals. The Infrastructure Commission noted that pension plans historically have not participated in financing infrastructure in the municipal bond market because of their tax-exempt status as well as the relative complexity of infrastructure credit. The Infrastructure Commission identified three options to encourage pension plans to participate: Pension plans could invest in the equity of the proposed bond insurer, IIC. Pension plans could buy taxable project debt insured by IIC or purchase securities directly issued by NIC. Pension plans could act as lenders directly funding taxable project debt through purchasing public benefit bonds. The first option would involve pension plans by having them provide capital to start up IIC. Since it is assumed IIC would generate a revenue stream of its own through fees paid by those seeking insurance for their bonds, the pension plans could earn a return. The size of such a return is not clear. Furthermore, the experience with Connie Lee suggests that those providing capital typically would invest only modest amounts. Thus, the potential equity participation in IIC by pension plans is likely to be of limited magnitude. The second option involves two parts. First, pension plans could directly purchase taxable project debt insured by IIC. Second, NIC could use its capital to purchase taxable project debt, some of which may have been insured by IIC. When a large volume of debt has been acquired, NIC could create a new security backed by the project debt that would then be sold to the market with NIC’s guarantee. It is thought that this security would create a secondary market for project debt and reduce the risks of investing in specific project debt. Since it is presumed that this security would offer a competitive, taxable, market rate and be more liquid than specific project debt, pension plans might be attracted to it. Pension plans might, for example, support pollution control projects that are not eligible for tax-exempt financing because they benefit private businesses. However, this could only occur after some time, since NIC would need to develop a quality portfolio of loans over time as a precondition to issuing its own debt or securitizing its loans. In its third option for increasing pension plan investment in infrastructure, the Infrastructure Commission recommended modifying federal tax law to allow all or part of the earnings on a municipal or “public benefit” bond to be distributed tax free upon retirement to workers who participated in defined contribution pension plans, such as 401(k) plans and individual retirement accounts (IRA). Defined contribution plan participants would be willing to invest in such a bond because its after-tax rate of return would be comparable to a taxable market return. This would allow the localities issuing the bonds to finance projects at rates comparable to those in the municipal bond market while attracting direct investment from pension plans. The Infrastructure Commission’s Secretary told us that he considers the public benefit bond proposal to be the “cornerstone of the Infrastructure Commission’s proposals related to pension plans.” However, the Infrastructure Commission’s Executive Director said that much of the investment in infrastructure would come from public, and perhaps union, pension plans—not from corporate pension plans. He estimated that about 1 percent of U.S. pension plan assets might be ultimately invested in infrastructure. One approach to evaluating the proposals is to examine the economic justification for an expanded federal role in establishing entities and incentives to entice pension plan investment into infrastructure. We reviewed a number of economic analyses related to the justification for a federal role, and a discussion is contained in appendix II. Here, we summarize that discussion, focusing on a recent CBO analysis that specifically addressed the Infrastructure Commission’s proposals. CBO made the following key points regarding the Infrastructure Commission’s proposals: The premise that greater investment in infrastructure will increase overall economic output is questionable, and only a few projects that would be supported through NIC would have returns higher than alternative private investments. The proposed new federal incentives may result in further distortion of investment choices by displacing other investments, which in turn could result in economic inefficiency. The municipal bond market already receives a large federal subsidy and is generally considered to be functioning well. The market imperfections that affect the municipal bond market were not addressed by the Infrastructure Commission’s proposals. Measuring and controlling the impact of new federal financial entities are influenced importantly by the organizational form of the proposed corporations. Establishing NIC as a government-sponsored enterprise carries high risk (through contingent liability) to the federal government. Concerning the specific incentives for pension plan involvement mentioned earlier, CBO made several additional points. With regard to pension plans investing in IIC’s equity, CBO noted that the proposed IIC has little justification on efficiency grounds since the municipal bond insurance industry appears to be competitive. Hence, this first avenue for pension plans may not be necessary or attractive. The second avenue—having pension plans buy debt securities issued directly by NIC—is problematic because infrastructure projects are heterogeneous and, thus, are not likely to be easy to pool into securities to create a secondary market. The third avenue for pension plan investment—having pension plans invest directly in funding infrastructure project debt through public benefit bonds—also was questioned by CBO. It noted that the public benefit bonds might subsidize projects that are not really public in nature. This provision might circumvent the legal restrictions put in place during the 1980s to prevent the excessive use of tax-exempt municipal debt to finance private activities that were crowding out state and local spending and raising costs for public projects. CBO also noted that administrative costs may be associated with implementing a public benefit bond that gives a tax break to pension plan participants. Internal Revenue Service regulations would have to be put in place to require individuals to separate income from investing in infrastructure securities from other asset income. The CBO analysis concluded that the interaction of existing federal tax subsidies for pension plans and municipal bonds is the main cause of the low level of direct investment in infrastructure. It noted that existing subsidies for municipal debt could be reduced and that this could induce pension plans to invest in infrastructure. A similar effect could result from taking away the tax exemption for pension plans. However, the Infrastructure Commission did not advocate either approach. In reviewing other analysis and commentary on the Infrastructure Commission’s proposals, we found substantial skepticism among economists as well (see app. II). The basic view was that there seems to be little reason to put new incentives in place to reallocate capital from its existing uses. Moving beyond the economic analysis framework implies that the issue becomes one of competing political values about how to allocate resources. In our discussions with Infrastructure Commission officials, it was noted that the rationale for the proposals was based more on “policy” considerations than on a strictly economic justification. In this regard, the Infrastructure Commission’s rationale seems more rooted in the view that capital should be reallocated to public investment (in infrastructure), and the proposed entities and incentives are justified as an effort to implement that objective. This means that the justification for an expanded government role to encourage investment in infrastructure can depend on the values expressed by the voters. In other words, if individuals perceive a problem with infrastructure and want it to be addressed, then government may be chosen as the means to meet this demand. The institutions and public processes for making infrastructure investment decisions should then be the focus of analysis and debate. Private pension plan managers and financial market experts we spoke with confirmed that private pension plans are not active investors in the domestic infrastructure finance market for many of the reasons that the Infrastructure Commission and others cited. For example, they noted the lack of available investment opportunities at competitive rates of return. Some market participants suggested a role for defined contribution pension plans and the desirability of finding “niches” for pension plan investment in infrastructure. Their points seem broadly in line with some of the proposals that the Infrastructure Commission made. Other market participants expressed concern about efforts to induce a reallocation of pension capital. Some pension plan managers were concerned that pressures to invest in infrastructure or other ETIs would ultimately affect their ability to comply with their fiduciary responsibilities under ERISA. They believed that even DOL’s Interpretive Bulletin 94-1 (which states that the selection of an ETI will not violate ERISA rules if the general fiduciary standards are met) did not provide any new information and that DOL’s interpretation would simply subject the private pension plans to a higher level of government scrutiny. Other experts noted there are alternative mechanisms that do not involve pension plans but may help increase infrastructure investment. Earlier, we discussed the fundamental disincentive for pension plan investment in infrastructure that results from the tax-exempt status of the plans and the use of tax-exempt municipal bonds as a common vehicle to finance infrastructure. The financial return to the pension plan is simply too low, which leads to concerns, as the Counsel to the Infrastructure Commission noted, in evaluating whether these investments meet fiduciary standards. In our discussions with market participants, other disincentives for pension plan involvement were noted. In many respects, the Infrastructure Commission’s proposals attempt to respond to these concerns. While pension plan managers told us that they are unlikely to invest in infrastructure projects, one investment manager noted that he could consider including infrastructure projects in an “alternative investment portfolio” if the projects provide a rate of return that is competitive with taxable securities. However, he believed that managers of alternative portfolios are still unlikely to invest pension plan assets in infrastructure projects because alternative investments, such as venture capital and foreign securities, are available. At any rate, alternative investment portfolios are small. Project finance experts told us that infrastructure projects are often large and complex, with long development and construction phases. These types of projects are not standardized and, thus, are difficult to make into securities, in contrast to home mortgages. Unlike mortgage-backed securities, pooling of infrastructure projects does not have a track record that investors can assess. That situation is not advantageous to pension plans, particularly in light of their fiduciary requirements concerning safety, liquidity, and yield. It is difficult for investors to estimate the rate of return or risk of a proposed infrastructure project. The chief investment officer of a communications firm that has a large pension plan told us that the pricing of public infrastructure projects is not driven by cost of capital but by political considerations. Predicting long-term cash flows is, therefore, difficult. In addition, a project developer who served as Secretary of the Infrastructure Commission said that he had been unable to attract pension plans to proposed projects because of the difficulty in estimating the rate of return. Proposed projects have not yet demonstrated competitive returns. Our discussions with market participants highlighted several key points regarding pension plan involvement in infrastructure. One is that pension plans seek diversification in their portfolios but must have investments that provide competitive returns within fiduciary standards. In addition, liquidity and standardization of investments are important. The securities that may be backed by infrastructure projects would not possess these characteristics, and it may be more difficult to use information about them in evaluating securities for future projects. Even if these problems could be overcome, the potential amount of pension capital that could be invested in infrastructure is probably significantly smaller than the vast pool of available capital sometimes suggested. Defined contribution pension plans (primarily 401(k) plans) represent the fastest-growing portion of pension plan assets. These plans, managed by the mutual funds and life insurance industry, represent a potential source for financing infrastructure. According to data that an investment firm provided to the Infrastructure Commission, private defined contribution plan assets represented almost 47 percent of all privately sponsored pension plan assets in 1991. According to the chief economist at a private bond-rating agency, the managers or the participants of these plans might not want to invest in infrastructure bonds. However, if the same bonds were sold as part of a “government bond fund” they might buy them, he said, because the public thinks of government bonds as safe investments. Also, investing a small portion of their assets in infrastructure might help diversify risks in a defined contribution pension plan’s portfolio of investments if the value of infrastructure assets goes up when the value of other assets is going down. One mutual fund industry lawyer told us that defined contribution pension plans cannot be expected to finance infrastructure projects since they do not “pass through” the tax advantage to beneficiaries. Also, infrastructure investments may lack the liquidity that defined contribution plans require in order to repay beneficiaries. These views suggest a possible role for the Infrastructure Commission’s proposed public benefit bond, which would pass through tax benefits to retirees. An advantage of tapping defined contribution assets is that a portion of these funds are self-directed by workers and, hence, these workers can make a voluntary choice to invest these funds in infrastructure securities. Since pension plans, by virtue of their tax-exempt status, would prefer fully taxable bonds over tax-exempt bonds, the way to entice them into funding public projects, some experts suggested, is to find niches where their capital can be put to fruitful uses at competitive rates of return. Projects that meet this criterion might include “stand-alone” toll roads constructed by private developers for which there is adequate demand and that can generate identifiable revenue streams. Furthermore, according to the Infrastructure Commission’s Secretary, toll roads that lacked a track record when they were initially financed could attract pension plans when they are refinanced based on a history of generating revenue. Economic research suggests that user fees could provide a revenue stream to finance a large share of many public works facilities such as transportation, water supply, wastewater treatment, and solid and hazardous waste systems. Because these facilities largely serve identifiable consumers, their use can be measured and priced, and the beneficiaries can be charged directly for the cost of services. If financing is linked to use, revenue can become steadier and more predictable, encouraging better maintenance, rehabilitation, and replacement. Unless these niches are found, pension plans will not be significant investors in America’s infrastructure, according to a managing director of a municipal bond-rating firm. Pension plans are not investing in infrastructure because “the deals aren’t out there.” One way to identify a niche, the managing director suggested, would be to establish a pilot program on one kind of project, such as highways or mass transit, so that pension plan managers would “learn to walk before they run.” Once these niches are found, then government incentives—such as the development of industrywide standards for evaluating projects, and tax credits—might help attract private capital. A transportation consultant said that any governmental actions to encourage investment in infrastructure must move in the direction of assisting the private sector’s efforts in infrastructure investment, establishing standards for project evaluation, and pooling and securitizing private sector projects. We were also told that while government guarantees, by reducing risk, enable state and local governments to obtain lower interest rates, they also lower the return to investors. The view that niches must be found suggests the need for exploring alternative financing schemes but also seems to be broadly consistent with the notion of a government corporation that would work with localities to find projects and help make them attractive to pension plans. Creating NIC and IIC to attract pension plan capital to finance public projects may not be necessary, according to the pension plan representatives and experts we met with. They pointed to the vast market for privately insured tax-exempt municipal bonds that already exists for financing such projects. Other concerns included the potential for increased federal direction or scrutiny of pension plan investments. Pension plan managers are concerned about the possibility that the federal government will mandate certain investments, or classes of investments, said a managing director of a financial services company that manages assets for large corporate pension plan clients. In addition, partners in a global investment management firm that advises pension plans told us that they believed DOL’s interpretive bulletin will subject private sector pension plans to a higher level of government scrutiny than they receive now. They believed that pension plan managers will become more circumspect about the possibility of investment losses in ETIs. State and local officials are unlikely to seek investment from private pension plans because it would increase their cost of borrowing, the chief economist of a bond-rating agency told us. An official of a private bond insurance company noted that NIC’s insurance proposals would also be more costly than private insurance. Instead, she recommended that projects obtain low-interest loans and grants from the federal government. In financing infrastructure projects, pension plans would require a competitive rate of return as well as a government guarantee backed by the full faith and credit of the federal government. Thus, pension plan capital would be expensive for states and localities to borrow. Municipalities could finance their projects more efficiently by improving their bond credit ratings instead of relying on government guarantees or pooling of assets, according to a managing director responsible for municipal bond ratings. In this view of the capital markets, plenty of capital is available to finance creditworthy infrastructure projects. Moreover, the bond insurance function envisioned for IIC would compete with the functions currently being performed by private insurance companies. One insurance industry official stated that IIC could not do any more than the private insurance industry does. The managing director of a bond-rating company told us that IIC may not significantly increase infrastructure investment by offering bond insurance because municipal bonds are already privately insured. A project finance expert at an investment bank told us that by offering insurance to projects with more risks than the private sector would normally accept, IIC would encourage the development of financially infeasible projects. We found that some market participants and experts were skeptical about the need for the government to intervene by creating NIC to reallocate capital. They were not sure whether the complex NIC mechanisms would work in the marketplace and questioned whether specific incentives to attract pension plans are the best way to spur infrastructure investment. They pointed out that other mechanisms for infrastructure financing already exist, such as municipal bonds, state revolving funds, user fees, and private bond insurance for creditworthy projects. In transportation finance, for example, some pointed out that ISTEA could be amended to allow states to create state revolving fund loans or to provide credit enhancement (such as guaranteeing local government bonds) with federal highway money. Some state officials and industry experts remain skeptical about the viability of state transportation revolving funds. One concern, for example, is whether even densely populated areas will generate many revenue-bearing projects with the capacity to repay loans. Despite these concerns, however, state transportation revolving funds could serve as an alternative to NIC and IIC, and may help expand infrastructure investment if key barriers to their effectiveness can be overcome. There has been long-established general agreement on the need for infrastructure to be funded by tax dollars and on a federal role in supporting infrastructure projects. Nevertheless, debate continues on the amount of infrastructure investment that is needed, the role of infrastructure in fostering future economic growth and higher productivity, and the appropriate degree of federal involvement. There is also a continuing effort to explore innovative and efficient ways to finance projects. The idea of attracting a portion of pension plan capital to infrastructure investment has become popular, and the proposals of the Infrastructure Commission offer an ambitious attempt to put that idea into practice. Our review of the Infrastructure Commission’s proposals suggests that they could play a role in encouraging more infrastructure investment by pension plans. The government can foster marketplace innovations and has done so in the past. But this comes at a cost to the federal government. We found strong reservations among economists and market participants about the need for new federal entities and subsidies to encourage a reallocation of pension capital when significant existing tax subsidies discourage pension plans from investing in infrastructure projects. If the primary goal is increasing infrastructure investment, then there are many ways, including initiatives currently under way, to address this goal. Encouraging localities to make projects more creditworthy through the provision of adequate revenue streams could foster investment that is more in line with the demand from the public. Techniques to leverage grants at the state level seem promising. Establishing NIC and IIC might aid these efforts, but the evidence is insufficient to conclude that such entities are required to attain an adequate level of infrastructure investment. The goal of attracting pension capital to infrastructure is problematic. Advocates for new federal entities to encourage direct pension capital flows to infrastructure recognize that the subsidies accorded to pension plans and municipal bonds are well established and serve important policy objectives. Advocates also need to recognize that fostering significant pension plan investment in infrastructure would probably require a reevaluation of existing tax policy.

Summary: Pursuant to a congressional request, GAO provided information on the role that pension plans play in expanding public investment in infrastructure projects. GAO found that: (1) pension plans have not been investing in domestic public infrastructure because of the combined effects of federal law, which requires plans to seek the highest rate of return on investments and encourages growth by exempting earnings from taxation; (2) to encourage public investment in infrastructure, federal law provides a tax exemption on interest income to those who invest in municipal bonds; (3) pension plans have no incentive to invest in lower-interest municipal bonds, since plan earnings are already tax exempt; (4) although the Infrastructure Commission recommended creating two federal financing entities to attract pension plans to invest, the share of plan assets that might go to infrastructure would likely be small; and (5) the federal capitalization of state revolving funds may be an option to expand infrastructure investment without relying on pension plans.