September 27, 2016—While headline stories of troubled states and municipalities have been constants for several years now, we are seeing a pickup in the interest of the growing strain that pension funding – or non-funding, to be more accurate – is placing on these entities. While our credit staff has been keenly aware of the issues surrounding public pension funding and factor those findings in their credit opinions, we thought it valuable to keep you up-to-date on some of the most pressing concerns.
One of the triggers of this escalating issue is a chronic underfunding of pension liabilities. As states and local municipalities find they are short on revenue, long on spending needs, and loathe raising taxes, the decision to not meet the Actuarial Required Contribution for pensions (ARC) has been an easy way to “find” new revenue. This is exactly how IL and NJ dug themselves into severe underfunded status. Another, less obvious, impact is a potential crowding out of public municipal debt. As investors take account of the pension funding obligations – like we do – when evaluating an entity’s overall debt burden, you find resistance to growing burdens from both the public debt and the pension obligation.
Aggressive Expected Returns
To this day, most states and municipalities use 7-8% return assumptions to discount future pension obligations. How is that going for them? Many public funds in the last fiscal year earned less than 2%. One recent study by Stanford’s Institute for Economic Policy Research, shows the dramatic increase in pension debt if the discount rate is lowered to more realistic levels. In the study the total U.S. Public Employee Pension debt in fiscal 2014, applying the actuarial discount rates used by the pension systems (again averaging 7.5%), is estimated to be $1.0 trillion. However, this economic research group applied a market based discount rate (based upon 20-year Treasury rates, 3.0% in 2014) and the pension debt liability ballooned to $4.8 trillion. For perspective, the entire public municipal market is $3.6 trillion.
Changing Financial Reporting Standards
There are several changes in the way states and municipalities will be reporting pension and other post-employment benefits (OPEB), none of which make the situation any easier. Just to highlight a few:
- Governmental Accounting Standards Board (GASB) 67 strictly limits the discounting rate, the impact of which is highlighted above in the Stanford study.
- GASB 68 will force local municipalities that participate in “cost-sharing” plans (those often managed by the states on behalf of local governments) to show the net pension liability on their balance sheets. For many major cities, this could raise their unfunded liabilities to nearly 100% of their annual revenue base.
- GASB 74 & 75 will have similar impacts, but focused on OPEB obligations.
The level of “debt” from pension and OPEB liabilities is meaningful. Below is a chart showing the total debt of states and cities broken down between public, pension, and OPEB obligations. In both cases, the largest percentage at nearly 41.0% is the pension liability.
Percentages of total debt
(Public, Pension, OPEB, and Negative General Fund Balances)
Source: Loop Capital Markets
Bondholder Legal Standing
Historically, bondholders, particularly for unlimited general obligation bonds, have been considered to be priority lienholders, with the states and municipalities required to take all steps, including raising taxes, to cover this liability. However, recent history, driven by political realities has questioned this standing vis-à-vis the pension-holder. In various CA municipal bankruptcies (Stockton, Vallejo, and San Bernardino), pension obligations were left untouched while bondholders (in these cases, mostly lease backed debt) were impaired. In Detroit, unlimited GO was impaired by 26.0% while pension obligations were only impaired by 4.5%. We note here that OPEB liabilities were severely impaired in Detroit, by 90.0%, which highlights that OPEB benefits are often held with less legal backing than pension contracts.
The standing of Puerto Rico bonds vs. pension obligations has yet to be determined. However, when one pits the interests of “Wall Street” investors vs. those of the hard working public employee, the politicians to date have favored the pension-holder.
We expect this issue to continue to be a hot button and investors in this asset class can expect more headlines. In our core narrative, we emphasize the value of research in fixed income investing – not only for high yield, but for investment grade as well. Our strong emphasis on internal research opinions, for both initial investments and for surveillance of existing positions, is a key component of the municipal investment process.
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