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By Jeremy Glaser and Rachel Barkley | 11-16-2012 02:00 PM

Big Divergence in State Pension Health

Over 40% of states fall below Morningstar's threshold of a 70% funded ratio (assets divided by liabilities) for pensions, says Morningstar municipal credit analyst Rachel Barkley.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

I'm here today with Rachel Barkley. She is a municipal credit analyst at Morningstar. She recently completed a report on the state of pensions across the country. She is going to fill us in on some of the details, and what it could mean for muni investors.

Rachel, thanks for joining me today.

Rachel Barkley: Thank you.

Glaser: So we've been hearing a lot about pension plans recently. Here in Chicago, we hear about Illinois pension woes pretty frequently. Why has this been such a hot topic?

Barkley: A lot of pension plans were hit pretty severely by the recession in terms of their assets. They lost a lot of their revenues as a lot of investment portfolios did, and they are still recovering from that.

With pensions that's led to an increase in contributions from the participating governments, which has added additional budget strain to governments that are still recovering from the recession. In a few rare cases this has even led to governments declaring bankruptcy, and that's all catapulted in increased news coverage of the subject.

Glaser: So has this news coverage been fair so far, or do you think it's missing some of the bigger points?

Barkley: A lot of it is very inflammatory, and we feel that a lot of the news coverage out there doesn't add a lot of value to what's being said.

However, Morningstar is trying to provide some logical analysis to help investors actually evaluate the issue. And what we found is that the pension issue varies very, very drastically. And when we look at pensions, we look at two major drivers: one is the funded ratio, assets divided by liabilities, which is a good indicator for the fund's ability to pay its liabilities. The other ratio that we like to look at, that we don't think is looked at enough in other avenues, is the unfunded liability per capita, or the UAAL per capita, and this is basically what each resident would be required to pay to fully fund the obligation. It's a liability burden for each resident.

Now looking across the spectrum of states, there is a very wide variety in how states fair. On the top, we see a place like Wisconsin that has almost 100% funded ratio and an unfunded liability per capita of roughly $23, so it's very manageable for them. Then on the lower end of the spectrum, we see lot of places are faring pretty poorly. Over 40% of total states fall below Morningstar's threshold of a 70% funded ratio--we consider anything below that to be poor.

Now two examples: Illinois across the board pretty much has the worst funded pension plan. It's funded in the low 40% [range], and it has an unfunded liability per capita of over $6,500. Another important point here, though, is that by and large, funded ratios and liability per capita have a correlation, so the wide majority places with a high funded ratio have a low liability per capita and vice versa. However, they don't completely correlate in some instances. Alaska still has what we would consider to be a poor funded ratio of roughly 60%, but that's much better than Illinois' 43%, but when you look at liability per capita Alaska actually comes out the worst with a liability per capita of over $10,000, which is much more severe than Illinois’s $6,500. We would point out that Alaska funds its pension plans and all of its plans through a different revenue source than other states. So it's not exactly apples-to-apples, but it is something important for investors to keep an eye on.

Glaser: So it sounds like there are some pretty big divergence between the states. So what does that mean for municipal credit quality? Do states that have these huge unfunded liabilities, does that necessarily mean that the municipal credit is worse?

Barkley: There are two ways to look at it. So these are state pension plans, and one of the interesting things to look at is you have to look at the state and you also have to look at the contributing governments, if there are any.

State pension plans usually take one of two forms, and oftentimes a state will have multiple plans that cover both forms. One form you see is an umbrella plan. So that plan would cover state employees, but it might also very well cover employees for counties, school districts, cities, that sort of thing, within the state. Now if that had a low funded ratio, that would cause fiscal strain perhaps on the local governments contributing into it because they would see increased contributions.

The other type of plan is a single employer plan. So for the state, that would mean it would only cover employees of the state. Now this still can have implications, not just for the state, but also for the lower governments, because if the state is having to ratchet up its pension contributions, that could mean less money available for things like school district aid and aid to local municipalities.

In general, when looking at credit quality for a state, this is definitely something that we consider: If pension contributions are escalating wildly, if it's a large portion of state spending, those are red flags for us, and a low funded ratio means that this is something that the state is going to have to look to in the future.

So it's an important part of credit quality; however, it's not the only part. There are many more facets of the state that we look at and that determine overall credit quality. This is just one of the inputs.

Glaser: So if you're looking at these state pension plans, what are some of the red flags that indicate that there may be more strain on some municipalities or that it could be a problem for investors in the future?

Barkley: The upside here is that a lot of the fiscal strain that you see with some of these pension plans can really be pinpointed years out. This is isn't something that happens overnight, unless there is a sweeping pension reform.

So some things that you would like to look for are a declining funded ratio, an increasing liability per capita, drastically increasing pension contributions, or any pension changes that would give additional benefits to employees that would be very significant, and could very much alter the pension plan. Those are just a few of the red flags that we think are important.

Glaser: So if you see this coming, it's not necessarily that you need to bail out of muni credit in that state, but certainly it probably warrants a closer look.

Barkley: Exactly, it would warrant a closer look.

Glaser: Well, Rachel, I really appreciate you sharing the report with us today.

Barkley: Oh, thank you so much.

Glaser: For Morningstar, I'm Jeremy Glaser.

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