US Public Sector Pensions: Understanding The Risk by Joseph Rosenblum and Larry Bellinger, AllianceBernstein

The high cost of retiree pensions is putting stress on city and state budgets. Most municipalities will absorb the expense, but some won’t. We’ll see increased market volatility and rating downgrades and, possibly, defaults.

Shortchanging Pension Contributions

Most of the roughly 90,000 state and local governments provide employee pension plans. Generous pensions make it easier to recruit and keep quality public workers whose salaries are below average compared with those in the private sector. But politicians often find it too easy to award these benefits, which will be paid long after they’ve left office.

To help plan for large future payments to current employees, actuaries tell municipalities the dollar amount they must pay into the plan each year. It’s called the actuarially determined contribution (ADC). By contributing the ADC each year, municipalities build reserves to pay their future liability. They invest those reserves with the hope of increasing assets. But the ADC isn’t an annual obligation—it’s just a recommended best practice. And it has often been ignored.

Tough Markets and Low Growth: A Painful Cycle

Severely negative investment returns, particularly in 2008–2009, made it necessary to increase the ADCs, making it harder for governments to fully fund their pensions. Slow economic growth after 2009 didn’t help, either. It crimped tax revenue growth, increasing budget pressures.

As a result, many governments chose to temporarily underfund their pension contributions. Their budgets couldn’t stretch enough to pay both the full ADC and the cost of essential services like police, road repairs, garbage trucks and elementary schools. Underfunding drove ADCs even higher to make up for the loss, and the painful cycle pulled many pensions deeper into the red.

The Problem Is Severe for Only a Few Municipalities

By our reckoning, these pension troubles are severe for only a few issuers. The most visible include Illinois, Chicago, Chicago Public Schools, New Jersey and Pennsylvania. These governments mismanaged their pension liabilities over a very long period of time, consistently and significantly funding below their ADC. Once the recession and economic downturn hit, they faced even greater pressures. Current ADC levels appear unsustainable, and the political costs of fully addressing the issue with substantial tax increases or service cuts are very or too high.

Although all governments will have to make hard choices, the majority will manage the pension challenge effectively. Today, most municipalities make room in their budgets to pay the full ADC—or close to it—consistently. In 2014, governments boosted their payments from 82% to 88% of the ADC on average (Display). The overall funded ratio for the entire sector—the percentage of the plan that’s fully funded—actually rose to 74% in 2014 from 72% in 2013. That was mainly due to good investment returns in 2012 and 2013.

Pensions

Cities and states are also taking steps to curb costs. Between 2009 and 2014, a majority of governments enacted pension reforms: these included bumping up the retirement age for new hires and freezing cost-of-living increases.

New Accounting Rules Improve Transparency

Past accounting rules allowed officials to factor in actuarial assumptions that lowballed pension costs. But new 2014–2015 government reporting standards require municipalities to provide deeper disclosure. Now they need to offer more information on annual costs, liability, asset valuations and other pension aspects. Municipal rating agencies have gotten stricter, too, in assessing pension liabilities.

We expect to see higher market volatility and more credit downgrades, particularly given pension plans’ aggressive investment return expectations of 7%–8% per year. Investors have already begun to demand higher rates from muni bond issuers who have the potential for severe pension challenges.

Greater Need for Research

Assessing pension liabilities and a government’s ability to meet these liabilities over time has always been an important part of municipal bond research. We believe the vast majority of governments are healthy enough to avoid financial stress. Some, however, are not.

Furthermore, increased pension liabilities, coupled with greater reporting transparency, will likely increase volatility in the municipal bond market as investors demand compensation for assuming pension-related risks. Consequently, the need for municipal research and analysis will grow.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.