Mon, 16 Sep 2013
With vast differences in funding levels across states, muni investors need to carefully consider the impact of pension obligations when assessing muni-credit worthiness, says Morningstar's Rachel Barkley.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We recently released our state pension report, and I am here today with Rachel Barkley, a municipal credit analyst, to see which states came out on top, which came out on bottom and why investors should care.
Rachel, thanks for joining me.
Rachel Barkley: Thank you for having me.
Glaser: Let's start and talk a little bit about why investors should be interested in pensions or the state of pensions across the country. What is the potential impact on municipal credit?
Barkley: The impact could be very broad. And we look at state pensions particularly for a number of reasons. One is obviously that they impact the states themselves directly. Pensions falls under one of our four main pillars, when we are looking at states, under the debt and liabilities pillar.
Additionally states very commonly provide pension plans that cover local entities, as well. If you are looking at the fiscal health of one pension plan, that might say a lot about the fiscal health of pensions for entities in the state as a whole. These days we've even seen pensions become more in the spotlight. The cost of pensions and the liabilities have been escalating in past years which [have also seen], as you can imagine, contributions from these entities to the pension plans in a time when governments are really still recovering from recession and extra revenues are scarce. This can become a pressure.
In some rare circumstances we've seen pension liabilities be a driver for municipalities filing for bankruptcy. Obviously, this can't happen on a state level since states aren't allowed to file for bankruptcy, however, it's still something we need to look at the municipal level.
Glaser: Therefore, if you are trying to say that the creditworthiness of a bond you really need to have pensions in mind?
Glaser: What are some of the big findings that you found this year, and what have some of the changes been from when you looked at state pensions just a year ago?
Barkley: Overall, we are still seeing the general funded level in aggregate fall. Although it's been a slight fall, pensions as a whole for the states are a little over 72% funded this year and that's just slightly over a 2% decline from the prior year. However, we'd like to point out that there are very wide disparities in the pension-funded levels among these groups and that they shouldn't be looked at in just a collective basis.
Glaser: What states look like they are in the best position right now?
Barkley: Wisconsin continually stands out as sort of the best of the best. They are practically fully funded at 99.9%. And then another key characteristic, we look at which is the unfunded liability per capita is quite low at $18. Then on the other end of the spectrum, when we're looking at just states, Illinois does remain the worst. It's about 40% funded and then the unfunded liability per capita is over $7,400.
One thing we also added in this year, which does change the picture, is we added in Puerto Rico. And when you look at Puerto Rico, it really is an outlier. Their three pension plans as a whole are only 11% funded with an unfunded liability per capita of close to $9,000. They have recently passed pension reforms, but they previously had stated that there was a good possibility that they could run out of money as a whole in their pension plans in the next few years.
And even with the pension reform that they've passed, we still think it's going to be a very significant hurdle an obstacle for them to overcome in the foreseeable future.
Glaser: Given the problems in places like Illinois and Puerto Rico, should investors just be avoiding all bonds that are from those states right now?
Barkley: Again, I think that it's important to understand that this varies drastically state from state. But in the places that are very poorly funded, we definitely consider it to be a red flag. And it's something that bondholders would need to take in account for when they're deciding whether to invest in a bond. And pensions are something that we call a soft liability, meaning that unlike debt, which is a hard liability where you know the exact principal and interest that you're paying, it's more of an approximation because you're not completely sure what the stock market is going to do in terms of your investment returns. You're not completely sure what payments you're going to need to make from year to year. However, it is something that needs to be considered.
There are some things that governments can do. Puerto Rico again was successful in getting some pension reforms through this year though we believe that more will be needed for this to become manageable. On the other hand, Illinois has yet to pass additional pension reform this year even though they have brought it into discussion on multiple occasions.
It's not something that we would necessarily say you should steer clear of those bonds as a whole, but we definitely think that you need to incorporate that into your analysis of the risk level.
Glaser: You mentioned earlier that some municipalities are filing for bankruptcy, citing some of these pension liabilities. Do you think that's the beginning of a trend, that we're just kind of at the start of this, and do you need to expect a lot more municipalities to try to shed some liabilities in bankruptcy?
Barkley: I'd like to point out that municipal bankruptcy does still remain very, very rare. We're not seeing a rash of bankruptcies compared to what we had seen in prior years. However, there are two municipal bankruptcies now and how they're playing out with their pensions that could potentially have an impact going forward.
One is Detroit. While Detroit is not in a state plan, we still think that it could have an impact on state administrative plans that include local governments. Now, in the Detroit bankruptcy, the emergency manager has proposed exchanging a portion of the city's debt and liabilities, and under that he's included there the estimated pension liability for a lesser amount of limited recourse notes.
So, you have two things happening here. You have the estimated pension liabilities being swapped out for a lesser amount of liability, and you also have pension beneficiaries and bondholders really being pitted against each other. That's obviously something that could potentially affect the market.
Now, on the potential reduction of pension benefits, this is also where it gets really interesting. The pension beneficiaries are saying that this is unconstitutional, that the city can't do that. Under the Michigan constitution, pensions are clearly defined as a contractual obligation which cannot be impaired or diminished, and you would think on the face of it that swapping out the estimated pension liability for a lesser liability would be an impairment or diminishment of that benefit. The interesting thing will be how this state constitutional protection holds up in a federal bankruptcy proceeding, if it gets to that last level.
Then on the other side we have San Bernardino in California. They are part of the statewide CalPERS plan. Since they've declared bankruptcy, they have missed the portion of their payments to CalPERS and have indicated that they might not be able to make that up. Again you have a case where that would be an impairment to CalPERS. Now, CalPERS has filed an objection, and how that gets played out will also potentially have an impact on how state pension benefits are impacted for the state plans that include local governments going forward and potentially bankruptcies, as well.
Glaser: Given some of these challenges, are these pensions a major issue, or is it really that investors have to look at them on a case-by-case basis where there might be some hot spots, but generally things are looking OK?
Barkley: Overall, we'd like to point out that we believe that pensions will be an integral part and credit quality going forward and in some cases could become a significant pressure. However, again, with the very significant variance and how these pension plans are funded, they shouldn't be considered collectively. Again, they should be considered on a case-by-case basis.
Going forward, we think that the key driver for pension fiscal health will be management, which obviously does differ on a state-by-state basis. Are these pension plans funding the actuarial required amount? Are they able to implement pension reform, if they do have a sizable liability that might be able to pressure them down the road? I think how they handle these situations and also something they can't control--their market returns and how those compare with their assumptions--will be some of the big indicators on pension fiscal health going forward.
Glaser: Rachel, thanks for sharing your report with us today.
Barkley: Thank you, again.
Glaser: For Morningstar, I'm Jeremy Glaser.