We believe that under-funded pension obligations pose a burden on some issuers in the municipal market, but the burden–and ability to address these challenges–varies widely.
We expect to see more stories about pension troubles, but overall most municipalities have been taking steps to address the 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 diversify among 10 or more issuers with different credit risks, among other steps–or consider professional management.
Pension problems have resulted in another ratings downgrade for a major U.S. city.
The city of Dallas recently saw the credit ratings of its general obligation bonds cut—from Aa3 to A1 by Moody’s and from AA to AA- by Standard & Poor’s—because of its struggle to fund its public pension plan and some potentially expensive legal challenges. The downgrades were significant for a few reasons: First, because of their magnitude, which lowered Dallas’ credit ratings by several notches. Second, because Dallas is a major U.S. city with generally healthy demographic trends, which is generally a sign of health for a muni issuer.
And Dallas isn’t alone in its struggle to fund its pension program. Last summer, Fitch downgraded the city of Chicago (to BBB–) because of its outside pension obligations, as did S&P (to BBB+). In 2013 Detroit filed for bankruptcy partly due to its own pension burden.
So, should municipal bond investors be worried about unfunded pensions? And what should they do about it?
How do pensions work?
Many municipalities—state and local—offer pensions as a retirement benefit that will provide a lifetime stream of income to public employees. The state or local government must contribute and invest funds to pay for future benefits (the employees may also have to contribute). Future needs are based on projected future investment returns, projected retirement dates for current employees and other factors.
Municipal pension plans vary by municipality in terms of funding levels, annual expenses and the ability and willingness to fully fund 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. Some plans are better funded than others, though. The average funded ratio is 73.2%, according to S&P.
The funded ratio varies by state
Source: S&P, as of 9/12/2016.
Most state and local governments have been addressing pension costs
Unfunded pension liabilities are a burden on the $3.6 trillion muni market. If a state or local government’s pension liability grows too large, it may risk defaulting on other obligations, including its bond payments. The burden isn’t uniform across all state and local governments, and the willingness and ability to address it varies by municipality. Many state and local governments have been taking steps to address their unfunded pension liabilities by reforming future benefits, increasing contributions or taking other steps. Still, problems can, and do, arise due to unfunded pension obligations and we don’t want to downplay the issue.
Municipalities are attempting to address the issue
More state and local governments than not appear to have taken steps to fund current pensions or reduce future pension costs. “Nearly three-quarters of state plans and over half of local plans have made some kind of pension reform since 2009,” according the Center for Retirement Research at Boston College.
This isn’t always easy because many states have legal protections that prevent the impairment of benefits for current employees. The most common kinds of reform have been reducing cost-of-living adjustments for retirees’ future benefits or requiring employees to contribute more to their plans. 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. No states protect benefits for new employees, according to the Center for Retirement Research at Boston College.
Generally speaking, reducing benefits in states with strong legal protections has been difficult. For example, the Illinois Supreme Court rejected a recent plan by the city of Chicago to deal with its outsized pension obligations, saying the plan violated the state constitution. But not all states have the same constitutional legal protections as Illinois. Some states protect past benefits already accrued, while others protect both past and future benefits. Others, like Texas, offer less strict protections to state plans, though local plans are protected under the state constitution. Generally speaking, benefits that are protected by the state’s constitution are more difficult to reform.
Legal protections by state
Source: Center for Retirement Research at Boston College, as of January 2017.
*Promissory estoppel is the protection of a promise even where no contract has been explicitly stated.
** In Texas, state-administered plans are treated as a gratuity. However, many local plans are protected under the Texas constitution.
We believe investors with bonds in states with large unfunded pension liabilities and strong legal protections against reducing benefits should review the rating on their bonds and decide if they still meet their risk tolerance. A caveat is that not all municipal bonds are impacted by pension obligations to the same degree. For help, consider reaching out to a Schwab Fixed Income Specialist.
What should I do if my bond gets downgraded?
If your bond is downgraded because of pension troubles, you should consider a few different factors before taking action. Was it downgraded due to a problem that the municipality can address? Some problems can be fixed. We’d be more concerned about a downgrade relating to deteriorating demographic problems that cannot easily be reversed. Also, what was the starting rating and how many notches was it downgraded? A multi-notch rating downgrade is worth noting. A downgrade to the BBB or below-investment-grade category is especially worth watching. Lastly, does that bond still meet your investment risk tolerance and objectives?
What to do next
We don’t expect widespread defaults due to unfunded pensions. However, some issuers could still face fiscal and legal struggles related to pension liabilities. How should the issue change your approach to investing?
- 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. (You can also subscribe by calling your local Schwab representative). These alerts should help you stay up to date on your municipal bonds.
- 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. An alternative would be to consider investing in a fund or other option that utilizes professional credit monitoring.
- Consider qualitative factors. If you own state and local government bonds, it’s worth exploring recent news or bond rating reports on whether government leaders are tackling pension problems or postponing action. Tracking qualitative factors is tricky, though, because it’s easy to miss something, and not every relevant development gets covered. A ratings downgrade or news item can be good a starting point, but this is a challenge in the muni market. If you own bonds from issuers that have been less proactive in addressing pension or other budget issues, you should generally receive higher yields in exchange for the higher risk.
- 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.
- Consider professional management. If you don’t want to monitor credit conditions for multiple individual issuers, you’re not alone. We believe that 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.
Talk to Us
- Call Schwab anytime at 877-338-0192.
- Talk to a Schwab Financial Consultant at your local branch.