Public Pension Funding Cloud
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The la r ge s t c l oud ov er hangi ng publ i c f i n a n ce
cr edit qual i t y i s not Puer t o Ri c o or t he
pot ent ial f or m or e m uni c i pal bankr upt ci e s
The Municipal Market’s Pension Cloud
A missed debt service
payment is a default. A payment of
less than the annual
actuarially required
contribution by the
employer is often an
accepted practice.
•• The annual expense of funding pensions will increasingly squeeze out other spending priorities
such as citizen services, education and much needed infrastructure investment.
•• Unfunded pension liabilities are a form of debt and should be considered as a balance sheet element along with bond debt and other liabilities when analyzing the fiscal heath of a municipal
bond issuer.
•• Unlike annual principal and interest payments (debt service) on bond debt, which are specific
defined obligations, annual employer (state or local government) contributions to pension plans
are soft obligations, subject to fiscal and political vagaries, allowing this important, proverbial can
to be regularly kicked down the road.
•• A missed debt service payment is a default. A payment of less than the annual actuarially required
contribution by the employer is often an accepted practice.
•• Under new GASB accounting standards, the optics of pension funding will shed a harsher light on
poorly funded pension plans, increasing media focus on the problem.
•• Most systems are in need of some reform, but political and legal headwinds have stymied many
efforts.
Alan Schankel
Managing Director
215 665 6088
[email protected]
See page 6 for important
information and
disclaimers.
JANNEY MONTGOMERY SCOTT
www.janney.com
© 2015 Janney Montgomery Scott LLC
Member: NYSE, FINRA, SIPC
Pensions 2015 • Page 1
Pension funding continues to be the largest cloud overhanging public finance. From a political view,
pension funding is a 30 year problem being addressed by leaders with time horizons often dictated by
2-year or 4-year election cycles. Failure to adequately fund public pension plans in the past is adding
to current budgetary pressures. Inadequate funding today will increase future obligations. As funding
of these obligations consumes a growing share of annual governmental expenditures, other important
priorities will be crowded out, with much needed infrastructure maintenance and investment particularly vulnerable.
Defined Benefit Plans
vs
Defined Contribution Plans
Unlike most of the private sector, retirement plans for state and local government workers are typically
defined benefit plans (DBP), where the employer (state or municipality) promises to make regular payments to retired workers (and usually surviving beneficiaries) for life. This contrasts with the private
sector where retirement plans, when they exist, are usually based around defined contribution plans
(DCP) such as a 401(k) plan, whereby contributions from the employee, employer or a combination
of both, are made to fund an employee’s retirement account. There are multiple, distinct and important differences between the two plan types. For the purpose of this report the key difference is the
employer’s future liability. In both cases plans are funded by contributions from the employer and/or
employee, but a DBP, as used by most municipal issuers, includes a liability on the part of the employer
in the form of a promise to pay future pension benefits. In contrast, a DCP, such as a 401(k) plan,
includes no future employer liability. Retirement distributions from a DCP are limited to amounts previously contributed to the plan, along with any earnings and gains (minus any losses).
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Shifting to a Defined
Contribution approach
may be in the best
interest of public sector employees as well
as employers.
As noted, the private sector has largely evolved to using defined contribution plans for its employee
retirement funding, thus limiting the amount of an employer’s future liability. Although a few public
pension plans have adopted a defined contribution component, the vast majority of public sector employees are depending on defined benefit plans for retirement income. In states such as New Jersey
and cities such as Chicago the tension between the interests of taxpayers and public employees/retirees will grow as the expense of annual contributions consumes an ever larger share of annual budgets.
Migration of public pension plans to defined contribution structures will benefit employers, and may in
some instances also be in the best interest of employees. As part of the Central Falls, RI bankruptcy,
pension benefits for retirees were reduced by 45%. Although, post-bankruptcy, pension payments for
Detroit and Stockton retirees will be impaired moderately (Detroit) or not at all (Stockton), bankruptcy
judges in both cases ruled that pension obligations could be impaired in bankruptcy, leaving the door
open for future pension benefit restructuring, since these cities’ long term financial challenges have not
been eliminated. Shifting to DCP approaches may be in the best interest of public sector employees
as well as employers.
Budget Busting
Employer and employee contributions made to a state or local government pension plan are held in a
trust account usually invested in various securities. Ideally the amount held in a pension trust account,
along with future earnings, will be sufficient to fund promised pension payments. In reality funding is
often inadequate, a condition that in some instances has been increasing fiscal stress and weighing on
credit quality and ratings.
Actuarially Required
Contribution (ARC) is
the amount of money,
as determined by actuaries, which should
be contributed each
year to bring the pension funding ratio to
100% over some period of time (typically
30 years).
Pension math is the province of actuaries who use a combination of hard numbers and educated guesses to determine future pension liabilities. Two key metrics are the Funded Ratio and the Actuarially
Required Contribution (aka Actuarially Determined Contribution). The funded ratio is basically assets
divided by liabilities. A plan with $15 billion of assets and $20 billion in future liabilities (present value)
is 75% funded. Actuarially Required Contribution (ARC) is the amount of money, as determined by
actuaries (based on assumptions provided by the government employer), which should be contributed
each year to bring the pension funding ratio to 100% over some period of time (typically 30 years).
Too often, especially during economically difficult times, states and municipalities choose to contribute
less than the actuarially required contribution, which causes funding to deteriorate. ARC is an actuarial
concept, but actual minimum contribution levels may be set by statute or policy.
Chicago, which has the most poorly funded pension plans among large US cities, illustrates the fiscal
danger of kicking the pension can down the road. For many years Chicago has contributed less than
the ARC to its four plans. The ARC amount rose each year for multiple reasons, but largely because of
past underfunding, which raises the contribution hurdle if the funded ratio is to improve. Over the 10
years from 2004 to 2013, the annual ARC amount tripled but the actual annual contribution grew by
only 28%. These undercontributions caused the funded ratio to fall from 65% to 34%. To understand
the strain this placed on finances, consider that the ARC grew from 12% of city revenue in 2004 to
30% of revenue in fiscal year 2013. In dollar terms, in 2013, Chicago should have contributed $1.7
billion of its $5.6 billion in revenue or 30%. Instead it paid only $443 million into its pension plans,
causing funding to fall further behind.
Chicago’s Persistent Failure to Make ARC Has Caused Funding Ratios to Deteriorate
$2,500 mln
$2,000 mln
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© 2015 Janney Montgomery Scott LLC
80%
$1,500 mln
60%
$1,000 mln
40%
$500 mln
20%
0%
$0 mln
2004
2005
2006
2007
2008
2009
2010
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Pensions 2015 • Page 2
100%
Actuarially Required Contribution
Actual Contribution
Funded Ratio (Right Axis)
Source: Janney Fixed Income Strategy and Research, Chicago Financial Statements
2011
2012
2013
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Persistent Underfunding Pushed ARC From 12% to 30% of Chicago’s Annual Revenue
$8,000 mln
Actuarially Required Contribution
ARC % of Rev (Right Axis)
$6,000 mln
Reported funded
ratios for poorly
funded plans will be
significantly lower
than they would have
been under previous
standards, casting a
harsher light on funding levels.
40%
Government Revenue
30%
$4,000 mln
20%
$2,000 mln
10%
$0 mln
0%
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Source: Janney Fixed Income Strategy and Research, Chicago Financial Statements
GASB
New standards (GASB statements 67 and 68) established by the Government Accounting Standards
Board (GASB), will change and improve the calculation and reporting of state and local pension liabilities as presented in financial statements. Rather than being included in the notes section of annual
financial reports, pension funding liabilities will become part of the balance sheet, and annual pension
expense will be included in the income statement. Certain assumptions used by actuaries to calculate
liabilities will be standardized, supporting easier comparability across public pension plans. Key assumptions, such as the projected investment returns on pension assets, will now be determined using
more conservative and realistic rules. One key effect of these changes is that reported funded ratios for
poorly funded plans will be significantly lower than they would have been under previous standards,
casting a harsher light on funding levels.
In dollar terms, the
estimate of underfunding across New
Jersey’s seven pension
plans rose from $34
billion to $83 billion.
In December, New Jersey released pension liability data using the new GASB standards. Comparing
this updated data to similar information, released earlier using previous GASB standards, highlights the
major impact that the new rules will have on disclosure and transparency. In calculating the previous
standard’s “actuarial accrued liability”, New Jersey had actuaries use a 7.9% expected investment
return assumption for discounting future liabilities, but the blended rate of the new standard requires
that a more market based rate be applied on the unfunded portion of “total pension liability”, which
was 4.29% for New Jersey. Across all 7 of New Jersey’s plans, application of the new standards was
largely responsible for lowering the actuarial estimate of the state’s pension funding level from a very
low 57% to an extremely low 33% one year later. In dollar terms, the estimate of underfunding rose
from $34 billion to $83 billion.
New GASB Reporting Standards Increased New Jersey’s Reported Liability to $83 mln
Old GASB as of 6-30-13
Actuarial
Value of
Assets
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Pensions 2015 • Page 3
Actuarial
Accrued
Liability
Unfunded
Actuarial
Liability
New GASB as of 6-30-14
Funded
Ratios
Plans
Fiduciary Total
Net
Pension
Position Liability
Net
Net
Pension Position % Depletion
Liability
of TPL
Date
9,512
19,384
9,872 49%
PERS
8,650
30,976
22,327
28%
2024
31,214
52,637
21,423 59%
TPAF
27,327
80,140
52,813
34%
2027
2,074
4,027
1,953 52%
PFRS
1,888
6,622
4,734
29%
2027
2,264
3,386
1,123 67%
Other
2,180
5,081
2,901
43%
20212032
45,064
79,434
34,370 57%
Total
40,045 122,819
82,774
33%
Amounts in millions of US dollars. PERS = Public Employee Retirement System. TPAF = Teacher’s Pension and Annuity Fund.
PFRS = Police and Fireman’s Retirement System. Terminology changes under new GASB standards include Actuarial Value
of Assets = Fiduciary Net Position, Actuarial Accrued Liability = Total Pension Liability, Unfunded Actuarial Liability = Net
Pension Liability and Funded Ratio = Net Position as a % of Total Pension Liability.
Source: Janney Fixed Income Strategy and Research, New Jersey Financial Statements
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The newest New Jersey data include estimated dates by which pension assets will be depleted. When/
if this occurs, pension payments will become pay-as-you-go as part of the state’s budget. A Moody’s
report about New Jersey’s pension challenges notes that benefit payments from the two largest plans, the
Public Employees Retirement System (PERS) and the Teachers Pension and Annuity Fund (TPAF), totaled
$4.9 billion (16% of operating revenues) in FY 2013. This compares to an ARC of $3.4 billion and actual
contributions of only $878 million. According to Moody’s, New Jersey has not contributed the full ARC
in at least 17 years.
Debt and Unfunded Pension Liabilities Are Both Forms of Debt
We believe that pension liabilities and
bond debt should be
considered in combination for credit
analysis purposes.
30%
Adjusted Pension Liability as a % of State Personal Income
Debt as % of State Personal Income
25%
20%
New York and Texas
Liabilities Are About
Equal, But the Mix
is Very Different
15%
10%
0%
IL
CT
KY
HI
MS
MA
NJ
LA
CO
AK
WV
RI
MD
KS
PA
NM
DE
VT
AL
CA
ME
WA
OK
OR
TX
NY
WI
IN
SC
MN
VA
MT
GA
UT
NV
MO
MI
AZ
NC
NH
AR
FL
OH
ID
WY
ND
SD
IA
TN
NE
5%
Source: Janney Fixed Income Strategy and Research, Fitch
Pension Liabilities
Many state and local
governments have
been and are legislating reform measures
to manage pension
funding challenges.
are
Debt
As noted, new GASB standards will bring pension liabilities onto the balance sheet, joining bond debt
in the liability section, which is appropriate. An argument can be made that pension liabilities are
“softer” than bond debt, since reforms or unexpected outcomes can modify the liability number. We
believe that pension liabilities and bond debt should be considered in combination for credit analysis
purposes. One issuer might have large pension liabilities but low debt, while another may have a
large debt load but relatively well funded pension plans. Data on state pension and tax supported
debt from Fitch illustrates the utility of combining debt and pension liabilities. Near the middle of the
graph are New York and Texas. Based on Fitch’s data both have similar liability totals as a percent
of personal income, but New York’s liabilities are dominated by debt while Texas has relatively high
pension liabilities.
Pension Reform
Many state and local governments have been and are legislating reform measures to manage pension
funding challenges. Actual and potential reforms include:
•• Requiring employees to make larger contributions
•• Requiring the appropriate government to make larger contributions
•• Changing from DBP to a combination of DBP and DCP
•• Increasing retirement age and/or length of service for current and/or new employees
•• Modification of future benefits
•• Elimination or modification of cost of living (COLA) increases
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Pensions 2015 • Page 4
In 2011, Rhode Island enacted legislation that transformed its retirement system into a combined DBP/
DCP plan. Other changes included suspension of cost of living increases and changes to retirement
eligibility ages. Moody’s reported that the reforms reduced the state’s future pension liability from
$4.4 billion to $2.7 billion. The story has not ended however. Retiree organizations and employee
unions opposed the changes in state court leading to a lower court ruling that pension benefits could
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not be impaired. Both sides are preparing for a Superior Court trial to begin in April if no compromise
agreement is negotiated beforehand. Illinois reforms were ruled unconstitutional in November 2014,
with an appeal headed to the state’s Supreme Court.
Looking Ahead
Many public pension plans are well
funded. Only a minority of state and local
governments have
significant funding
issues. Also, pension
funding is far from the
only consideration for
assessing creditworthiness.
The pension challenge continues. Recently strong securities markets have increased pension plan
asset valuations, which is helpful for funding calculations, but the current extremely low yield environment may make it challenging for many plan results to match projections in the near future, since
portions of most plans’ assets are invested in bonds. Updated GASB requirements will cast a harsher
light on more poorly funded plans, and media focus will amplify the negative optics. State funding
receives more rating agency focus and media attention, but some cities and other local governments
also face pension funding challenges. Moody’s dropped Chicago’s Aa3 rating by four notches to
Baa1 in the past 18 months, primarily due to large pension underfunding. We encourage continued
reform efforts where needed, but are also mindful that government employees deserve fair treatment.
A gradual but deliberate shift to 401(k) type plans could offer benefits to both government employers and employees, but so far the concept has gained minimal traction. As annual public pension
expenses grow, they crowd other government spending priorities, which may lead to reduced future
government employment levels.
We must emphasize that many public pension plans are well funded and only a minority of state
and local governments have significant funding issues. Also, pension funding is far from the only
consideration for assessing creditworthiness. The scorecard system Moody’s uses as the first step to
determining the rating of local government issuers has a 10% weighting for pension liabilities (plus
10% for debt). S&P’s rating methodology incorporates a framework which gives a 10% weighting
to debt and contingent liabilities combined (which includes pensions). In both cases there are other
factors and considerations that could modify the final impact of pension funding on rating.
Other Post-Employment Benefits (OPEB) is a pension-like issue that will garner more attention in
the future. OPEB generally refers to retiree healthcare premium obligations. Pew Charitable Trusts
estimates state obligations of about $577 million and the 61 largest cities at $217 billion. Typically OPEB obligations are funded on a pay-as-you-go basis, with little prefunding, but this may be
changing. We see OPEB liabilities as a much softer obligation than pension liabilities. In Detroit’s
bankruptcy, for example, pension obligations will be largely met under the city’s Plan of Adjustment,
but healthcare obligations will be covered by pennies on the dollar. Under Stockton’s plan, pensions
were unimpaired while retiree healthcare obligations were eliminated. GASB has released draft rules
for consideration, which if/when implemented will improve transparency and disclosure of OPEB liabilities.
Perhaps the biggest casualty of pension and perhaps OPEB induced spending constraints will be
infrastructure investment. We see frequent reports of unsafe bridges, decrepit airports, deteriorating
school buildings and inadequate public transit systems. State and local government tax revenues
have largely recovered to pre-recession levels, but the rate of growth is likely to be slower than in the
pre-recession years, constraining future expenditure growth. Political leadership will increasingly be
faced with competing priorities. Investors should remain cognizant of these challenges and require
more yield to offset the risks of issuers with outsize liabilities (including pensions) and little demonstrated willingness to make annual ARC payment or take necessary steps to reform pension systems.
We see little likelihood that the pension cloud will dissipate in the near future.
JANNEY MONTGOMERY SCOTT
www.janney.com
© 2015 Janney Montgomery Scott LLC
Member: NYSE, FINRA, SIPC
Pensions 2015 • Page 5
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Analyst Certification
I, Alan Schankel, the Primarily Responsible Analyst for this report, hereby certify that all of the views expressed in this report
accurately reflect my personal views about any and all of the subject sectors, industries, securities, and issuers. No part of
my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this
research report.
Disclaimer
Janney or its affiliates may from time to time have a proprietary position in the various debt obligations of the issuers mentioned in this publication.
Unless otherwise noted, market data is from Bloomberg, Barclays, and Janney Fixed Income Strategy & Research (Janney FIS).
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Pensions 2015 • Page 6