Download the Schwab app from iTunes®Get the AppClose

  • Find a branch
To expand the menu panel use the down arrow key. Use Tab to navigate through submenu items.

Do Pensions Pose a Risk to the Municipal Bond Market?

Key Points
  • We believe under-funded pension obligations pose a burden to some issuers in the municipal market, but the burden—and the ability to address these challenges—varies widely.

  • We expect to see more news of pension troubles, but in general most municipalities have been taking steps to address problems, and are able to regularly fund their pension obligations.

  • We suggest that investors who are concerned about unfunded pension liabilities focus on higher-rated (A or better) issuers and, when investing in individual bonds, diversify among 10 or more issuers with different credit risks—or consider professional management.

U.S. states have a combined pension shortfall of $760 billion1. Although that number is staggering, we don’t believe that the muni market, as a whole, has a pension problem. We do, however, believe that some municipal issuers are struggling with large unfunded pension liabilities that could negatively affect their credit ratings and potentially the prices of their bonds. Investors shouldn’t avoid munis because of pension issues, but we do think investors should be aware of the red flags that warrant additional caution.

The good news is that most municipalities are able to regularly fund their pension expenses. A large majority are generating enough income to make current payments to bondholders, and many have taken steps to address the future shortfalls.

How do pensions work?

Many municipalities—both state and local—offer pensions as a benefit that will provide a lifetime stream of income to public employees after they retire. The state or local government must contribute and invest funds to pay for future benefits (the employees usually also have to contribute). Future benefits are based on a variety of factors such as projected retirement dates, growth in salaries and life expectancies.

Municipal pension plans vary by municipality in terms of funding levels, annual expenses and their ability and willingness to fully fund their plans. If the value of a plan’s assets falls, or the future retirement benefits promised become more expensive, the municipality generally must contribute more. Those costs must compete with other costs, such as other public services or debt payments. Each plan has a different “funded ratio,” which offers a snapshot of the amount of future assets available to meet projected future needs.

Most state and local government plans haven’t set aside all of the assets required to meet 100% of the needs of future retirees, as the map below shows. Not having a fully funded plan isn’t an immediate concern, in our view. Some plans are better funded than others, though. The median funded ratio is 68.1%, according to S&P.

Mind the pension funded gap

Funded ratio (%) for states’ pension liabilities

Pension plans are funded at 80% or more to meet the needs of future retirees in state including New York, Florida, Tennessee, Oregon and Utah. At the other end of the spectrum, Illinois, Kentucky, Connecticut and New Jersey are funded at 50% or less.

 

Source: S&P, as of 10/18/2017

Pension expenses compete with payments to bonds and other expenses

If a pension liability grows too large, the state or local government may have to increase contributions or attempt to reduce the benefits that were promised, which can be legally challenging. Large payments to pensions can take away from payments to other resources—such as keeping the municipality operating, or making payments to bondholders. If pension expenses become too burdensome, the municipality risks defaulting on its bonds.

The good news is that payments to bonds are a generally low portion of state governmental revenues. On average, states have the financial resources to make payments to both their pension plans and bondholders. However, as shown in the map below, this ability varies by state.

Payments on debt account for a low portion of governmental revenues for many states

Debt service ratio based on fiscal year 2016 own-source revenues

Payments to bond holders account 2% or less of revenues in Alaska, Idaho, Montana, Wyoming, North Dakota, Nebraska, Iowa, Oklahoma, Indiana and Tennessee. But they account for 8% or more in Illinois, New York, Massachusetts, Connecticut and New Jersey.

Source: Source: Moody’s Investors Service, as of 4/24/2018.

“Debt service” is debt services costs (usually interest and principal) as a percent of own-source governmental revenues

Note: Additional adjustments have been made by Moody’s to own-source revenues for Delaware, Massachusetts and Washington to reflect inclusion or exclusion of certain funds.

We don’t believe investors should avoid all issuers in a state with a large unfunded liability, such as Illinois, New Jersey or Connecticut. Although a state, and even some of its local governments, may be struggling with unfunded pension liabilities, some issuers in those states have more financial flexibility than others. As shown in the table below, the largest local governments exhibit a wide range of variability in their pension expense.

The 50 largest local governments exhibit large variability in total fixed costs as a percent of revenues

Chicago’s pension expenses were 51% of revenue at the end of 2017, while Dallas’ were 46% and Houston’s were 42%. On the other hand, the District of Columbia’s costs were 10% of revenue and Los Angeles County’s costs were 12% of revenue.

Source: Moody’s Investors Service, as of 12/14/2017.

Many states and local governments have been taking action to reduce expenses

Overall, 74% of state plans and 57% of local government plans have made changes—such as reducing benefits or increasing contributions—to their pensions since the financial crisis2. The most common reform is to reduce the cost-of-living adjustment (COLA) for retirees, which in turn reduces the projected liability. Steps like these can free up money for debt service, because the state or local government can scale back current contributions for future pension obligations.

Reducing benefits can be difficult, because most states have legal protections that apply to pension benefits for current employees and retirees, but these protections are not uniform among states. For example, Illinois’ state constitution says that pension benefits “shall not be diminished or impaired,” which has limited the state’s ability to address their large liability. Texas, on the other hand, has less strict protections for state-administered plans3, making it easier to address their liability. No state, according the Center for Retirement Research at Boston College, protects benefits for future employees—meaning that new employees may not be offered a pension plan but instead a defined-contribution retirement plan, similar to a 401(k), where the burden to fund the employee’s retirement is mostly the employee’s responsibility.

Legal protections for pensions vary by state

 

State

State constitution explicitly mentions benefit protections?

Prospective changes to current employee benefits (other than COLAs) and/or contributions allowable

Flexibility to alter retiree COLAs?

California

No

No

No

New York

Yes

No

No

Texas

Yes, for most local retirement systems

Yes

Yes

Illinois

Yes

No

No

Florida

No

Yes*

No

Massachusetts

No

Yes

Yes**

Pennsylvania

No

No

Yes**

New Jersey

No

Yes

Yes

Washington

No

Yes

Yes

Ohio

No

Yes

Yes

Georgia

No

No

Yes**

Maryland

No

Yes

No

Virginia

No

Yes*

Likely no

Michigan

Yes

Yes

No

 

Source: Moody’s Investors Service, as of 10/17/2017.

States selected account for the top 15 in the Bloomberg Barclays Municipal Bond Index. Generally stronger protections are in bold type.

*for those not yet eligible to retire

**allows for “ad-hoc COLA awards”

Most states are keeping the problem at bay

According to Moody’s, 29 states made at least enough pension contributions to “tread water.” In other words, most states contributed enough money in fiscal year 2015 to prevent the reported unfunded liability from increasing. The states that are a concern are those with already low funded ratios that didn’t contribute enough to “tread water.” A caveat is that those states may attempt to enact pension reforms in an effort to address the problem. For example, the Colorado state legislature recently enacted pension reforms that increased contributions and limited COLAs for retirees.

Over half the states made at least enough pension contributions to “tread water”

Fiscal year 2015 pension contributions as a % of the amount required to “tread water”

Washington, Oregon, Idaho, Montana, Wisconsin, Indiana, Georgia, New York, Florida and other states made 100% of the pension contributions needed to “tread water.” Other states, such as Alaska, Nevada and Texas, made below 70% of the needed contributions.

Source: Moody’s Investors Service, as of 9/13/2017.

An equity market downturn is a risk to already pressured municipalities

State and local government pension plans have in aggregate about half their investments in stocks and mutual funds4. If a market and economic downturn were to occur, it would likely cause pension plan assets to decline, pushing funding levels lower. State and local governments may have to increase contributions to raise funding levels if they can’t reduce benefits.

This may be difficult if the market downturn is accompanied by an economic downturn, because revenues will likely slow. This will put further pressure on already strained municipalities and reduce flexibility to make payments to bondholders. We don’t think a market downturn will lead to widespread defaults, but according to Moody’s, “significant equity market losses stand to broadly reduce state and local governments’ credit quality via their pension funds.” When a bond is downgraded it generally falls in price.

What to watch for

There’s no denying that large unfunded pensions pose a burden to some municipalities, but overall we have a positive view of credit conditions for most states and local governments. We think that the evidence suggests that unfunded pensions won’t pose a catastrophic risk to the entire muni market. However, they are an issue for some municipalities. To help limit the risk they may pose to your investments, consider the following:

  • Watch the credit rating. A municipal bond’s credit rating has historically been a very good indicator of its ability to meet near-term debt payments. We suggest sticking with bonds with a credit rating of A or better. Consider signing up for email ratings alerts on Schwab.com. These alerts should help you stay up to date on your municipal bonds. If you own individual bonds, and your bond is downgraded, it warrants additional attention as to why it was downgraded. Multi-notch downgrades are especially important to pay attention to, in our view.
  • Do your homework. If you’re a Schwab client researching a muni bond on Schwab.com, you can find recent disclosures, material events and financial statements in MuniDOCS®, which is under the Offering Documents and Material Events section. One thing to note: Muni disclosures have historically faced delays in being released and can be cumbersome to analyze.
  • Consider choosing a professional manager to do the homework for you. If you don’t want to monitor credit conditions for multiple individual issuers, you’re not alone. We believe professional management by bond fund managers or separately managed accounts can make sense. A professional manager can monitor issues that could cause problems—such as unmanaged pension liabilities or other credit risks.
  • Diversify. While we do not expect to see a significant increase in defaults or distress caused by pensions or post-employment costs, try to avoid too much exposure to any single issuer. We suggest owning 10 or more individual issuers, at minimum.

 

1 Source: S&P, as of 10/18/17

2 Source: Center for Retirement Research at Boston College

3 Accruals in many locally-administered plans are protected under the Texas constitution, according to the Center for Retirement Research at Boston College

4 Source: Federal Reserve, as of 7/7/2018

 

What You Can Do Next

  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
  • Explore Schwab’s views on additional fixed income topics in Bond Insights.
Tips to Help Young People Turn Financial Optimism Into Positive Action
Savings 101: How to Plan for College Bills
Savings 101: How to Plan for College Bills

Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

The Bloomberg Barclays U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

(0818-847F)

Thumbs up / down votes are submitted voluntarily by readers and are not meant to suggest the future performance or suitability of any account type, product or service for any particular reader and may not be representative of the experience of other readers. When displayed, thumbs up / down vote counts represent whether people found the content helpful or not helpful and are not intended as a testimonial. Any written feedback or comments collected on this page will not be published. Charles Schwab & Co., Inc. may in its sole discretion re-set the vote count to zero, remove votes appearing to be generated by robots or scripts, or remove the modules used to collect feedback and votes.