Coping with Unfunded Pension Liabilities
June 15, 2010
By Howard J. Cure
Director of Municipal Research
Summary
Unfunded pension liabilities are an increasingly onerous obligation for the states, amounting to more than twice the sum of all state debt outstanding. Many states have underfunded their annual contributions amid equity market declines while after having enhanced pensions for their workers — a recipe for unsupportable financial obligations. The rating agencies cite pensions as a major reason why the state of New Jersey and Illinois general obligation credits face significant downgrade pressure. Yet even these two states are beginning to come to grips with the issue. With the private sector stingier in compensating its employees, taxpayers are aware of the generous benefits public employees enjoy. Public resentment and unprecedented budget deficits may finally prod state governments to act. These liabilities have serious negative credit implications, but there are ways to continue to invest in municipal bonds and avoid the most pension-burdened issuers.
The Causes
How did so many state and local governments get into this mess? The causes are mostly selfinflicted:
• Failure to make annual payments for pension systems at levels recommended by state actuaries;
• Expanding benefits (particularly when pension plans appeared overfunded or in lieu of salary increases) without fully considering the long-term price tag or how to pay it;
• Reluctance to stand up to powerful public employee unions; and
• Overly optimistic actuarial assumptions
The Governmental Accounting Standards Board grants states considerable discretion in computing pension obligations. (The Financial Accounting Standards Board, by contrast, is more restrictive and requires corporations to follow more uniform criteria.) States thus vary greatly in how and when they recognize investment gains and losses — their so-called smoothing practices — and in their assumptions for investment returns, retirement ages, and life spans. For example, state-administered plans commonly assume 8% returns. Based on the past decade's experience and average investment losses of 25% for public pension plans in 2008, this does not seem reasonable for states to count on over time.
Selected State Pension Data
Source: The Pew Center on the States: "Unfunded State Retirement Systems and the Roads to Reform" February 2010
The Situation Today
The last decade has been difficult for public pension funds. In 2000, slightly more than half the states had fully funded pension systems. By 2006, that number had shrunk to six states. By 2008, only four — Florida, New York, Washington, and Wisconsin — could make that claim. States are struggling to balance their budgets. Economically sensitive revenues have shrunk, and states must provide more services for the unemployed and uninsured. Losses in more speculative pension fund investments have been meaningful, and the methods of recognizing these losses mean annual deficits for many pension systems for years to come. Meanwhile, some 90% of public sector employees enjoy defined benefit plans with guaranteed pension payments (see definitions for more detail), compared with only 20% of private sector employees. The growing resentment of taxpayers who largely lack these benefits but must support them through their taxes is thus understandable.
There are several reasons why the problem has been so hard to fix:
• Public employees are influential constituencies;
• Pension programs for existing state employees are usually constitutionally or legislatively protected, and so cost reductions would only affect new employees and not provide fiscal relief for the state until well into the future;
• Underfunding often occurs when states must relieve general operating budget pressures, thus deferring an even larger problem to future taxpayers, and
• The pension issues are complex, and many politicians prefer simple solutions.
There are some signs of hope, however. Two of the worst offenders in underfunding their pension responsibilities, Illinois and New Jersey, are beginning to address some of the most costly, burdensome, and generous benefits. Two other states, Colorado and Minnesota, are attempting to reduce cost-of-living adjustments for existing retirees.
Illinois is curbing benefits for incoming employees by raising the retirement age to 67 (from as low as 55), preventing retirees from double dipping (drawing benefits under one state plan while accruing more benefits under another), and setting constraints on salary figures used to calculate benefits. As noted above, while this lowers future pension liabilities, the near-term effect on state finances is not likely to be significant. Nevertheless, taking action on this long-standing issue is a credit positive.
New Jersey now excludes new part-time workers from the pension system, instead requiring parttimers who make more than $5,000 to join a defined contribution plan. Pensions for future full-time hires will also be less generous, as the state is rolling back a 9% increase granted in 2001, limiting pension payments to one job, and limiting accrued sick leave for future workers to $15,000. The laws do not affect those already retired. The Governor is using the $3 billion of estimated savings from these changes upfront to avoid making this year's pension contribution. He argues that the state may realize savings now from pension reforms that reduce the system's underfunding.
Colorado and Minnesota have legislatively reduced annual cost-of-living increases for retired workers, not just new employees. Retirees have responded with lawsuits claiming that the changes violate state law. The question is whether financial commitments made to retired public workers are sacrosanct, as many employees have long assumed. If Colorado and Minnesota prevail, it could embolden other pension funds to make similar cuts, though the laws vary from state to state.
Issuers with Lower Unfunded Pension Burdens
Some municipal bond investments that limit the potential credit risks associated with unfunded pension liabilities include the following:
• Debt secured by specific revenue streams, such as sales or personal income taxes: These issues are typically gross revenue pledges where monies are used first to pay debt service, with the remainder remitted to the city, county, or state for general use. For example, the New York City Transitional Finance Authority can issue debt secured by NYC personal income and sales tax with a strong legal structure that separates the revenue streams from the general credit risks of the city and state.
• Many essential-purpose revenue systems, such as water, sewer or electric utilities: These entities are less labor-intensive than more general government agencies such as school districts or state governments. These utilities' budgets are largely dedicated to commodity purchases, capital equipment, and debt service. Utilities that are primarily distribution systems have even lower unfunded liability risks. These entities buy electricity or treated water or send their sewage elsewhere for treatment. They don't directly employ personnel in treatment or generation facilities and so have fewer employees.
• Private Colleges and Universities: The soft economy and competition from established and cheaper public institutions make us cautious about many private colleges and universities. But instead of defined benefits, many of these institutions have defined contribution plans, which give workers more mobility and appeal to many instructors who want the flexibility to move to other institutions across state lines. Well-endowed universities with a broad draw of students and a defined contribution plan provide ample bondholder protection.
• States with better pension funding: The State of New York has many economic and political issues, but it continues to maintain strong funding levels for its pension liabilities. When the state began its painful economic declines and budgetary imbalances in the 1970s and 1980s, it instituted tiered pension plans for new employees that were much more affordable for the state. In the face of extreme budgetary woes, however, even New York State is not immune from potentially shortchanging its pension fund. A tentative agreement would allow the state and municipalities to borrow nearly $6 billion from the state pension plan to help them make their required annual payments to it. The state and municipalities would borrow to reduce their pension contributions for the next three years, in exchange for higher payments over the following decade. They would begin repaying what they borrowed, with interest, in 2013. The agreement excludes New York City, which has its own pension plan.
Now that Illinois and New Jersey have finally begun to address this issue by tiering their pension systems, and Colorado & Minnesota are challenging existing retiree benefits, there is hope for progress in other states as well. In the meantime, we will continue to heavily weight the pension burden in our municipal investment decisions.
Howard joined Evercore Wealth Management with over 24 years of experience in analyzing taxexempt municipal securities. He can be contacted at cure@evercore.com.
Some basic definitions:
Defined Benefit Pension Plan: An employer promises a specified monthly benefit on retirement that is predetermined by a formula based on an employee's earnings history, tenure of service, and age rather than on investment returns. The employee, the employer, or both may make contributions, but the employer bears the investment risk.
Defined Contribution Plan: The employer's annual contribution is specified, but only employer contributions to the account are guaranteed, not future benefits, which fluctuate with investment earnings. One type of defined contribution plan is the 401(k) program.
Annual Required Contribution (ARC): Employers that pay the full ARC set aside sufficient money to cover the cost of currently accruing benefits as well as a portion of the unfunded liability from previous years. Failure to pay the ARC by a material amount means the unfunded liability will likely grow.
Download: Coping with Unfunded Pension Liabilities (PDF)
Important Notice. Evercore Wealth Management, LLC ("EWM") is registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. EWM prepared this material for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. EWM may make investment decisions for its clients that are different from or inconsistent with the analysis in this report. EWM clients may invest in categories of securities or other instruments not covered in this report. EWM obtained this information from multiple sources believed to be reliable as of the date of publication; EWM, however, makes no representations as to the accuracy or completeness of such third party information. EWM has no obligation to update, modify or amend this information or to otherwise notify a reader thereof in the event that any such information becomes outdated, inaccurate, or incomplete. Specific needs of a client must be reviewed and assessed before determining the proper allocation for a client and must be adjusted to market circumstances. The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Any opinions and analysis herein reflect our judgment at this date and are subject to change as there are changes in relevant economic, legal or political circumstances. Upon request, we will furnish a list of all securities recommended to clients during the past year. This material does not purport to be a complete description of our investment services. This material may not be sold or redistributed without the prior written consent of EWM.