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Fixed-Income Insights

Troubled plans may draw headlines, but most have sufficient flexibility to adjust. Astute analysis should turn up buying opportunities.

[Note: This article is from the upcoming edition of The Muni Quarterly.]

Underfunded U.S. state and local government pension plans continue to dominate media coverage of the tax-exempt bond market. Although the low funding levels are creating headwinds for some entities, the impact to municipal-bond issuers is not uniform, and we believe that most have sufficient resources and the flexibility to cover both bond obligations and pension payments.

In this commentary, we discuss the nature of pension liabilities themselves in order to provide context around when pension risk is sufficient for us to underweight a particular credit, versus when concerns about pensions may be overblown. In general, a credit-oriented approach to pensions requires a nuanced understanding of how pension liabilities are calculated and what a large pension liability actually means for a municipality. We believe that active and attentive management is key to identifying investment opportunities in the muni-bond market.

Recent rule changes around the information that must be reported in municipalities’ audited financial statements served as the catalyst for increased concern over pension liabilities from credit ratings agencies and investors. We believe that the increased transparency these changes provided has been a net positive for our industry; understanding how pension liabilities are calculated is the first step toward a more nuanced analysis of the risks associated with underfunded pensions.

In 2014, the Governmental Accounting Standards Board (GASB) issued its Statement 68, which required audits to present pension liabilities on municipalities’ balance sheets rather than including them only in the notes, as they were under prior rules. Bringing long-term pension liabilities to the forefront of entities’ financial statements made net asset positions look significantly weaker than they had previously appeared.

One year prior to that, GASB 67 changed the way governments calculate the size of a municipality’s pension liability by altering the discount rate used to calculate the present value of future benefits they owe to their employees. Discount rate assumptions have a massive impact on pension liabilities: the higher the discount rate, the more a government expects its assets to appreciate over time, meaning that larger discount rates lead to lower liabilities, but open the door to risk if plan assets underperform their assumptions.

With GASB 67, governments must use a low discount rate for the portion of the liability that cannot be covered under the current rate of return assumptions.

The financial statements for Colorado’s PERA (Public Employees' Retirement Association) represent an illustrative example of the impact that accounting rules can have on pension plan discount rates. Under prior rules, the state would discount its entire pension liability at the plan’s expected rate of return, in this case, 7.25%. Under GASB 67, Colorado continues to use that discount rate for future years, up to 2039, when the fund’s assets are projected to be depleted. Any promised benefits to be paid out after this date must now be discounted by the Bond Buyer General Obligation 20-year Municipal Bond Index, which, as of the time of its last audit, was 3.86%, arriving at a “blended rate” of 5.26% 

This change makes PERA look more poorly funded than it had been previously, even though the plan experienced five years of positive investment returns from 2012 to 2016, and net position increased by a cumulative $6.16 billion. Instead, the change of the discount rate and the resultant increase in the net pension liability was due to the shift in accounting assumptions. On the positive side, with a depletion date of 2039, Colorado has sufficient time to make needed reforms to PERA, and we do not expect pension cash flow issues to have a significant impact on creditworthiness in the near to medium term.

Chart 1. GASB 67 Example of Dual Discount Rates for a Plan Projected to Run Out of Assets in 2025

Source: Milliman. For illustrative purposes only.

The power of the discount rate also colors other independent evaluations of municipal pension liabilities. For instance, The Pew Charitable Trusts uses entities’ own reported pension data and discount rates as reported in audited financial statements. Moody’s discounts entities’ pension liabilities using a high-grade, long-term taxable bond index, while other observers, such as the Hoover Institution, have advocated using average Treasury yields as an even more conservative pension asset discount rate. As a result, the conclusions of these organizations are not necessarily consistent with each other, making it occasionally challenging to compare pension research across the sector.

How Do We View Pensions?
1)  Because of the way that reported pension liabilities can be affected by differing discount rate (and other) assumptions, measures of pension stress that rely on the size of the liability, including common measures such as the funded ratio (total plan assets/plan liabilities), are not always particularly useful for understanding the size or urgency of an unfunded pension plan. We prefer to use standardized and conservative discount rates in our analysis, and focus on the budgetary impact of potentially escalating pension costs combined with an entity’s capacity to manage those costs.

2) While the calculation of the long-term liability depends on discount-rate assumptions that may change over time, the contribution a municipality must make to its pension plans occurs annually, and is the primary way that pensions can have an immediate negative effect on an entity’s financial strength. These expenses are calculated from the liabilities themselves—that is to say, they are also dependent on discount-rate assumptions. As pension-plan funding levels worsen, expenses associated with amortizing the associated pension liability grow, putting pressure on operating balance. This pressure is exacerbated by accounting policies such as GASB 67—once an entity’s pension performance weakens to the point where a lower blended discount rate must be used, expenses can grow exponentially. Over the long term, rising pension expenses will hurt the creditworthiness of municipalities that see dwindling pension assets, as these costs force governments to cut expenses elsewhere or raise revenues. Kentucky is a good example here: a large part of the commonwealth’s budgetary imbalance heading into the most recent legislative session had to do with pensions. In fiscal 2015, the commonwealth’s actual contributions to its Teachers’ Retirement System and Kentucky Employees Retirement System-Non Hazardous were around $550 million and $500 million, respectively. In 2017, after underfunding forced the commonwealth to start increasing contributions in order to reduce asset depletion, contributions to these same plans rose to almost $1.2 billion and a little more than $800 million, respectively. 

3) Despite the challenges described above, municipalities usually have the flexibility to address underfunded pensions, and we believe pension-related credit pressure tends be manageable, or at least relatively easy to forecast. Entities have multiple options at their disposal to manage pension risk, including reducing benefits, making changes to discount rates, adding assets through the dedication of a revenue stream or the issuance of pension obligation bonds, and, for states, pushing pension costs down to other branches of government. Thus, even places with poorly funded pension plans tend to have some time and capacity to make changes that can help preserve their long-term viability. Some good examples of this are Dallas and Houston, each which got changes to their pension plans passed through the legislature, preserving their creditworthiness in a moment of high pressure. Jacksonville, Pittsburgh, and New Jersey have each identified new streams of revenue to go toward funding pensions, creating a present-day pension “asset” used to reduce the net pension liability and lower the expense burden on the general fund in the current year.

In addition, pension expenses grow over time in a way that is relatively predictable based on investment returns, employee retirements, and mortality rates. We can see when changes need to be made to pensions relatively far in advance of a true stressed scenario, and we can make decisions as investors about how much and what maturities to buy. This is particularly true when it comes to credits like New Jersey and Kentucky that are forecasting that they will run out of pension assets at some point in the future. Ultimately, there may be opportunities to purchase bonds issued by municipalities with weak pension plans when we believe the headline risk associated with weak funded ratios is overstated relative to the actual degree of credit risk present.

We believe that careful and comprehensive credit analysis will help investors evaluate the materiality and immediacy of pension risk in the municipal market. Although some plans may weaken in the years to come, analysts with a broad perspective and an understanding of pension rules should still be able to find good buying opportunities.

 

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