Could Public Pensions Sink Your Muni Bond Portfolio?
- The cost of paying for public pensions can be a challenge for state and local governments, but a manageable one for those taking action now.
- Many municipal governments are making adjustments to current plans, strengthening their financial position and credit quality.
- However, there are differences among issuers that investors should be aware of in an increasingly varied muni bond market.
There's no shortage of challenges to state and local governments as we continue to emerge from the worst economic downturn since the Great Depression. For many analysts and pundits, public-employee pensions top the list. Words like "insolvent," "bankruptcy" and "time-bomb" increasingly drive the public debate.
We think it makes sense to put these problems into perspective—not dump your municipal-bond portfolio. While we believe the challenges are real, the trend of pension reforms since 2008 has been encouraging.
Putting pensions in perspective
Currently, more than 27 million employees and retirees are covered by state and local pensions, funded by each of the 50 states and thousands of local authorities. Corporate pensions may be a quaint historical memory, but governments in developed economies worldwide still grant these benefits—and they're struggling to reconcile the cost of paying for generous benefits promised during boom times now that revenues are falling.1
We see pensions as a long-term challenge, with some notable exceptions we'll discuss below. The issue many governments face is the discrepancy between what they promise and how much they set aside to pay for those promises.
How do pensions work?
Social Security is the biggest, most-watched public retirement plan. The payments to retirees are paid, for the most part, directly from contributions from current workers. There's a Social Security Trust Fund, but it's not the source of payments to retirees today. Social Security is a "pay-as-you-go" system, not a savings account with funds built up for when they're needed later.
State and local government pensions are funded differently. These plans generally hold prior contributions from a public employer and employees, and invest them to fund and pay current and future costs. Annual contributions are added and invested to fund the estimated cost of future benefits. If the estimated future costs rise, or the value of assets falls, greater contributions are needed—and that's where we are now.
Current funding levels generally sufficient to meet current needs
Today, most state and local government pension plans aren't fully funded. In other words, they don't have enough money set aside to fund all of their future estimated costs. This is hardly a shock: How many other institutions or individuals currently have fully funded the cost of obligations they've incurred for years to come?
This isn't meant as an excuse for public officials; to stabilize credit quality for municipal governments, the cost of any promises must be anticipated and paid for. But, for most muni governments with funded plans, it's not a question about solvency today.
A report from the Government Accounting Office (GAO), Congresses' non-partisan analytical arm, concluded in March that despite significant investment losses, most state and local pension plans "have sufficient assets to cover their benefit commitments for a decade more." Funded plans have money to pay current retirees—as of 2009, according to the GAO report, total assets held in state and local government pension plans totaled more than 12 times the annual expenditures to pay current retirees.2
For most state and local governments, the challenges are adding additional funds to these pension accounts, and managing the investment of those funds to pay future retirees. According to the GAO, the "funded ratio"—the amount available in state and local government plans—has fallen from more than 100% of estimated future costs to just more than 75%, even after including projected investment returns and future contributions. This is in aggregate, however; the funded ratio varies significantly by state.
Funded Status of Major State Pension Plans Varies Widely
Source: Standard & Poor's, "US States Pension Funded Ratios Drift Downward", March 31, 2011. Note: The funded ration equals the ratio of plan assets to actuarially estimated liabilities.
In total, the balance of estimated future benefit liabilities not prefunded by the trillions of assets held already in state pension plans was just more than $660 billion in 2009, compared to $429 billion in tax-supported state debt, according to Standard & Poor's. Clearly this will be an ongoing financial and political challenge.
Crisis forces action
What are municipalities doing now to address these problems? Governments are notorious for promising more than they can pay for during boom times, and then scaling back during bad times. "Normal" cycles may not drive much in the way of change.
But the depth of the recent crisis, and pain felt by state and local governments that have cut billions in costs, may be a turning point. The politics of the Tea Party movement and general belt-tightening tone of Washington, as well as many new cost-cutting officials elected since the recession, has encouraged some municipalities to undertake serious reform.
In 35 states, pension benefits for public employees have been scaled back or reformed since 2008, according to the GAO report mentioned above. Meanwhile, 25 states have increased employee contributions, transferring some retirement costs from governments to employees.
Several states have made significant recent reforms, including Virginia, Utah and Georgia. It's not a coincidence, in our view, that each of these states are currently rated AAA/Aaa from both S&P and Moody's. Michigan, a lower-rated state, has made adjustments as well. Even New York has made progress. Moody's recently noted that pension reform passed in March of this year would save the state and local government $80 billion in pension costs over 30 years, a short- and long-term credit positive.
"Pension reform is a favorable development for New York State and its municipalities, as spiraling pension costs have been one of the leading expenditure drivers putting strain on state and local government budgets," according to Moody's. We expect these reforms to have a trickle-down effect, impacting pension-funding costs for local municipal employees as well.
There are always exceptions
In January 2012, the state of Illinois, a recurrent violator of the "prudent and proactive management" rule, was downgraded by Moody's from A1 to A2 due to "outsized pension deficits" coupled with "lack of progress… in the implementation of long-term solutions to pension underfunding and payment deferral challenges."
Even states that have made the least progress seem willing to consider changes, when forced. In April, Illinois Governor Pat Quinn proposed a plan to overhaul the pension system, including a proposal to increase the retirement age. The proposal, noted Moody's in a follow-up comment, is a "credit positive," if enacted.
Stockton, California is the latest (and largest) municipality to make headlines, largely due to pension costs. The city sold bonds during boom times to fund the future cost of rich benefit increases, including pensions. It's proven to be a bad decision, and the sharp reversal in the economic and financial fortunes of the city has shed light on the city's funding problems.
Are these exceptions a problem for muni investors? It depends on your comfort level with the credit risk of the issuers of any bonds you may hold, but most types of state and local muni bonds enjoy strong protection in terms of legal commitments to use available revenue to make payment on bonded debt before other government costs.
In Illinois, a $1.8 billion bond offering from the state in May attracted "big interest," according to a recent headline in The Wall Street Journal. Investors demanded compensation for the risk in the form of higher yields, roughly 1.75% above the yield for a benchmark of AAA-rated muni bonds. In Stockton, the jury's still out. But bondholders in many cases of bankruptcy or distress have continued to enjoy certain legal protections.
How might you invest?
So what's the bottom line? To us, the $3.7 trillion muni market defies broad generalizations, though rising entitlement costs are unquestionably a concern for the sector overall. There are as many differences as there are institutions. However, bad news about budgets that leads politicians to touch the political "third-rail" of public pensions may be good news for investors.
- Due diligence. For individual bond investors, we suggest choosing carefully and monitoring the political climate surrounding any bonds you own. If you own state and local bonds, are government leaders tackling pension problems, or postponing action? This diligence may require some work: Schwab clients can find recent disclosures and financial statements, which generally include the funded ratios for the issuer's pension plans, either here on our site or at emma.msrb.org. If you do own bonds from issuers who've been less proactive in addressing pension or other budget issues, you should generally receive, and demand, higher yields in exchange for the higher risk.
- Diversify. If you choose 10 or more individual issuers, at minimum, the diversification should help limit idiosyncratic, individual credit problems. We don't expect to see a significant increase in defaults or distress caused by pension or post-employment costs. Try to avoid too much exposure to any single issuer, but if you do hold any outsize positions, we believe you should focus even more on the quality of those bonds.
- Consider outsourcing to professionals. Investors without the desire and interest to monitor individual credit conditions are not alone. We believe professional muni bond fund managers can help manage idiosyncratic issuer-specific risk.
A key principle that professionals generally follow is to look more closely at differences in individual muni issuers, along with the similarities. This is especially true today, as we see increasing differences in individual issuers. The vast majority of issuers in the market have the time and flexibility to adjust to their pension-funding challenges, in our view. But there will also be outliers who have benefits they can't pay for, or who don't make adjustments.
For more help choosing bonds or looking at your portfolio, please talk to your financial consultant or call a Schwab fixed income specialist at 877-563-7818.
1. According to US Department of Labor data, only 18% of private sector employees participate in pension (also known as "defined-benefit") plans, compared to 78% of state and local employees.
2. Government Accountability Office, State and Local Government Pension Plans: Economic Downturn Spurs Efforts to Address Costs and Sustainability, March 2012.
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