Public employee pensions, over time, are moving to the forefront of the municipal credit analysis process and lately there have been many stories in the media about the pension fund liabilities of state and local governments. Many municipalities rely on actuarial assumptions as a guideline to show what amount of money needs to be set aside every year to fund future retirement benefits. Recent stories reflect the fact that many states and municipalities have not made these regular payments or have made payments less than the requirements due to budget constraints, and now potentially owe the pension funds a lot of money.
There are many reasons for the current state of affairs. Public employee unions have negotiated retirement and medical benefits from willing politicians who may not have been as cost conscious as they should have been. In addition, investment earnings on existing plan assets have not lived up to expectations due to overly high return assumptions. Friendly assumptions enabled state contributions to be reduced, while the asset allocation of invested funds trended to more risky vehicles. This simultaneously limited inherent asset growth while making returns more susceptible to market volatility. Lastly, medical costs have skyrocketed and life expectancy has increased. Nevertheless, I do not view the pension funding deficit as insurmountable.
According to the National Conference of State Legislatures (NCSL), between 2009 and 2015, almost all states enacted some type of pension reform, such as requiring higher employer and employee contributions. Despite some successful reforms, there have been legal roadblocks along the way. As recently as March 2016, the Illinois Supreme Court ruled that changes to pension funding rules sought by the City of Chicago were unconstitutional, citing the State of Illinois Constitution which prohibits the impairment of public employee pensions. Not all states are in agreement with Illinois. In 2015, the New Jersey Supreme Court ruled that the state’s payments into its pension system are not a constitutionally protected right.
Without examining the concepts of “ability” and “willingness,” it becomes clear that governments and employees will both have to make sacrifices in order to correct the current deficit. Options to make up current funding shortfalls include, but are not limited to: employees increasing their contributions, employers increasing contributions, extending retirement ages, reducing or eliminating cost-of-living adjustments, changing asset allocation strategies, and converting from defined benefit to defined contribution plans.
Underfunded pensions are not something that I see leading to defaults, but rather to selective downgrades or negative rating outlooks – with local governments more sensitive than states. States have revenue raising capabilities that local units of government simply do not have. However, each state must be examined individually, as each has its own credit variables that need to be assessed.
In assessing individual names, it is important to note that a strong correlation exists between pension funding and credit quality. The states with the greatest unfunded pension liability have started to receive negative credit outlooks by the rating agencies. Conversely, those that have the highest funding ratios have maintained higher ratings with stable outlooks. Currently, the average US state and local pension funded ratio is 71.2%. The data below from a Standard & Poor’s study (Standard & Poor’s: “US State Pension Roundup, 2015”, “Outlooks” Apr. 2016) shows the top and bottom five states’ funded ratios and illustrates the point regarding rating outlooks:
In addition, two other states that have gained credit notoriety in the municipal bond market recently are New Jersey and Pennsylvania. While both have funded ratios in the low 60% range and are not in the bottom five states, their current shortfall is certainly one of the key concerns for both investors and rating agencies evaluating the credit.
Looking forward, some current realities must be noted. In the United States, life expectancy has risen to 76 years for men and 82 years for women. This means that pension funds will have to fulfill their obligations for longer periods of time. Further, the older segments of the population are growing at a faster rate than the younger segments. For the public employment portion of the economy this could mean that as the wave of “baby-boomers” retires, there will be less employees to back-fill and replace their production. This could result in potentially less contributors to retirement plans.
Going forward, governments, employees, and unions will have to be willing and able to reach compromises and make the necessary changes in order for public pensions to survive.
Although I believe that there are several viable solutions to continued pension funding issues, it may be a rocky road until those solutions are agreed. For municipal bond investors, the lesson is simple: always look to the pensions when assessing a credit.
(Sources: National Conference of State Legislatures, Standard & Poor’s)
Gary Binkiewicz serves as the municipal bond analyst on the Seelaus institutional municipal bond trading desk. Over his 35 years in the industry, he has worked in the municipal bond credit research, rating agency, and bond insurance businesses. email@example.com.
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