Can Social Impact Bonds Fix Your State's Budget Crisis?

Can Social Impact Bonds Fix Your State's Budget Crisis?

Imagine if, as a taxpayer, you only paid for programs with a proven track record. That is the promise of a new type of government debt called a "social impact bond."

Here's how it works: Private investors put up the money to fund a new social program, such as a preschool for low-income families. The program is monitored by an independent evaluator and the government pays investors based on whether the program meets its goals. If the program fails to produce results, investors will not be compensated.

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Can These New Bonds Save Your State?

Ideally, social impact bonds, also known as pay-for-success bonds, allow local and state governments to receive more financing to innovate and expand successful programs. For investors, the bonds offer an opportunity to provide better returns in a low-rate environment and a chance to fund programs that benefit their communities.

Cities and state governments are still strapped for cash. According to the Center on Budget and Policy Priorities, while state governments' revenues have improved recently, reserves need to be replenished and program funding remains below pre-recession levels. The National League of Cities reports American cities have experienced annual revenue declines in their general funds since 2006. Could social impact bonds help governments fill these budget gaps, especially in hit-hard areas like education?

Social impact bonds have gained momentum in a short time. These types of bonds started in the U.K. in 2010. Last August, New York City issued the first social impact bond in U.S., which raised $9.6 million to fund a new four-year program that aims to reduce the incarceration rate of repeat-offender teens at Rikers Island. Salt Lake City received $4.6 million for a preschool education program in June. Investment bank Goldman Sachs was the manager of both bond offerings.

“Social impact bonds are an entirely new way of financing things that have been paid for by philanthropy or taxpayer dollars.”

“Social impact bonds are an entirely new way of financing things that have traditionally been paid for either through philanthropy or by taxpayer dollars,” Alicia Glen, head of Goldman Sachs' urban investment group, told The New York Times.

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A Boom in Social Impact Bonds

More states and municipalities plan to offer social impacts bonds in the future:

  • The New York state government issued plans last year to develop a project that will offer transitional employment services to adults released from state prisons, and sought additional suggestions for programs to be funded by social impact bonds.
  • The Massachusetts state government wants to set up two projects funded by social impact bonds—one to lower the prison incarceration rate of 900 teens released from the juvenile justice system over three years, and another project to provide housing for 400 chronically homeless people.
  • The U.S. Department of Labor recently solicited projects that would fund up to $20 million of pay-for-success contracts. President Obama has proposed initiatives funded with social impact bonds in his past three annual budgets.
  • The Rockefeller Foundation and the Social Impact Bond Technical Assistance Lab at the Harvard Kennedy School held a national competition this year to help states and municipalities issue more social impact bonds. The contest received 28 entries from state and local governments. Six winners were named in June: Colorado, Connecticut, Illinois, New York, Ohio and South Carolina. The winning projects ranged from early childhood education to senior housing.

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“Social impact bonds provide an innovative way to encourage smart and cost-effective solutions to social problems," said New York Governor Andrew Cuomo when his state was selected as a winner in the Rockefeller Foundation and Harvard Kennedy School contest. "By attracting private investment to fund programming, this approach also ensures that solutions that work can be brought to scale."

The Potential Downsides

Social impact bonds are unproven. Governments will eventually have to pay investors if programs are successful, as well as independent evaluators to measure the effectiveness of each program. Critics say that social impact bonds have not demonstrated that they can actually save governments money, lead to more innovation or create new capital for social programs.

"Given the costs of attorneys, consultants and program evaluators, the potential for a return on investment to third-parties, and a second tier of program managers, using [a social impact bond] relative to direct financing will therefore increase pressure on the budget, as the government must set aside more funds than even the investors provide to the program," Kyle McKay, a policy analyst who evaluated social impact bonds for the Maryland General Assembly, wrote in the Stanford Social Innovation Review.

Still, none of the projects funded by social impact bonds have been around long enough to draw definitive conclusions about the success or failure of financing.

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Can You Invest in a Social Impact Bond?

The small number of social impact bonds has limited investors to large institutions and wealthy individuals. No mutual funds have invested in social impact bonds. But if this type of financing continues to grow at a rapid clip, social impact bonds will become more mainstream.

The returns from these bonds could attract more investors if the programs prove successful. The first-ever social impact bond, issued for the Peterborough Prison in the U.K., will pay up to 13% annually if the prison can meaningfully reduce the re-offending rates of its prisoners. The payout will be proportional to the results of the program.

On the flip side, investors will get nothing if the program fails. For the New York City social impact bond, investors raised $9.6 million and stand to make $2.1 million if the teen recidivism rate at Rikers Island drops by more than 10%. But investors will lose $2.4 million if the recidivism rate doesn't fall by at least 10%.

It's early days for social impact bonds. They might not be coming to your portfolio soon, but your state or local government could be using them to test whether they can ease your tax burden. And that may be worth the risk.

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