Jason Stipp: I'm Jason Stipp for Morningstar.
Morningstar just released its first city pension report, an inside look at the cost and liabilities associated with the pension plans in the largest U.S. cities.
Here to talk about the takeaways from that report is Rachel Barkley. She is a municipal credit analyst with Morningstar.
Thanks for joining me, Rachel.
Rachel Barkley: Thank you for having me.
Stipp: Can you explain first of all which cities you looked at? Which cities were in the criteria you used?
Barkley: We looked at the top 25 cities in the country based on population, and we chose these cities for a number of reasons.
First of all, they are the most likely of cities to have their own city pension plans, as opposed being in a state plan. The pension plans for these cities tend to be the larger of the city pension plans, and these cities themselves tend to be very important players not only in the bond market, but also in the overall national economy.
Stipp: You have released in the past two state pension plan reports, but this is a city pension plan report. And as you said, they can be separate, so it's important to consider both in some cases.
Barkley: Yes, that's a good point. In actuality, they should be combined whenever possible, so that you get a good sense of what a taxpayer, for instance, in the city of Chicago or in the city of New York would be required to pay or to fund for the combined city and state pension liability, as well as any other overlapping entities that would also have a pension liability.
Stipp: When we looked across all of these cities and when we aggregate the results, it's not an especially pretty picture.
Barkley: I would agree with that. So of the top 25 cities, we found that 22 of them have pension plans where they are either the sole employer or the majority participant. That means that respective city would be responsible for funding either all of the unfunded pension liability or at least the vast majority of it. That doesn't include some additional pension liability that very well may be there, and in some cases definitely is there, in state plans, but due to accounting regulations, we can't currently identify the exact magnitude of that.
However, just for these sole employers and majority participant plans, the numbers are quite staggering. For these cities we looked at, they have over $125 billion of unfunded pension liabilities. To put that in some perspective, these same cities have over $135 billion of outstanding direct debt. So you can see that pension liabilities have really grown to be comparable as a long-term liability for cities to their more traditional long-term liability of debt or bonds.
Stipp: When you are looking at the health of a city pension plan, there are few different metrics you use. Obviously, how much they are funded is one of those metrics, but can you describe the different ways and the different dimensions you use when you are figuring out [the health of] a city's pension plan?
Barkley: We look at two basic metrics, and we look at them in two ways. We look at each of these metrics, first of all, for each individual plan, because when you are looking at a city, or a state for that matter, they oftentimes have multiple pension plans, and the fiscal health of each of those plans can vary quite drastically. So it's important that you look at each individual plan. Then additionally, we like to roll those up in aggregate to get a sense of how the city is faring overall.
For both of those on the individual plan level, as well as the aggregate city, we look at two main metrics. The first is the most traditional, it's the funded ratio, and that is simply your assets divided by your liabilities: How much of your projected liability do you currently have in the bank?
The other [metric] that we are big proponents of at Morningstar is the unfunded liability per capita, and that's simply your unfunded liability divided by your resident base, and that is an indicator of what each individual resident would need to fund over a period of years to get to a fully funded pension plan.
We note that this is usually over a 30-year time period, but we also feel that this metric is especially valid when looking at multiple levels of government, so that you can compare the unfunded liability per capita for a city, then if you layer on a state and any other political entity such as a county or a school district, you will get a true sense of what the resident pension burden would be.
Stipp: There obviously are some big differences in the cities that you looked at. I know Chicago, as you mentioned before, is one that's really not looking very good. What kind of range did you see? Who is looking good from a city perspective, and who has really got some problems to deal with?
Barkley: Well, Washington, D.C. tends to be the top of the top. They are over 100% funded, which means they have actually a negative unfunded liability.
Then on the other hand, as you mentioned, Chicago, unfortunately is toward the bottom, is the lowest of the 25 cities we've looked at, with a 35% funded ratio.
New York City, which is by far the largest, had only a 60% funded ratio. To give some perspective, we recommend, and we think strongly of, a funded ratio that is above 80%, and we consider a ratio beneath 70% to be fiscally unsound. So, those are two of the top three cities in population, and they both fall to various degrees beneath the fiscally unsound level.
Then, when you're looking at our other metric, the unfunded liability per capita, those two cities also appear at the top. New York City has over $8,000 in unfunded liability per capita just at the city level, whereas Chicago has over $7,000. Now again layering in the state information, since Illinois has the lowest funded level of all the states, you then get an unfunded liability per capita for Chicago residents--combining the city and the state--of over $14,000. And again, that doesn't take into consideration Cook County or Chicago schools. So you can get more of a clear idea of the magnitude of the situation.
Stipp: Some of those numbers per capita are staggering. Can you tell me what does this really mean for a Chicago resident or an Illinois resident, and what options do we have at this point to try to resolve this problem?
Barkley: On an annual basis, we look at pensions as a percentage of city spending for two reasons: one is obviously the stress that this can play on a budget for a city. And again, here we see a wide range. Places like Washington that have a very high funded ratio can be paying as low as 3% of their total spending, which we think is definitely manageable. For the 25 cities we looked at, the median was around 12%. So, it's still, I would say, a significant issue in the budget, and something that would need to be addressed, but it's something that would be manageable. On the other hand, there are several cities that are above 20% and are closer to 30%.
The other way we like to look at city contributions is how they fare compared to the actuarial determined contribution, which is basically what the actuary says you would need to pay on an annual basis to eventually get to a fully funded level. Another worrisome note or red flag is that only half of the cities we looked at are actually paying the full arc. So, on one hand, on an annual budget basis, it might right now not be that much of a percentage of spending, but by not paying the full arc, they're really pushing the liability further down the road, which would indicate that they're probably going to have to increase spending, if nothing else, going forward.
On the flip side of that, we have seen a lot of cities enact pension reform. Pensions are what we refer to as a soft liability as opposed to debt service for bonds, which we consider to be a hard liability. It's pretty set in stone with bonds that you're going to pay debt service with this much principal and this much interest on these dates for the life of the bonds. Whereas pensions are more of an art than a science. There are a lot of actuarial assumptions from the assumed interest rate to how long they expect people to live, which can really fluctuate. The other very interesting thing about pensions is that the actuaries and the experts in the field often disagree drastically about what these assumptions should be. So, it's sometimes even difficult to get a best-practice measure that things can be compared to.
A lot of these [cities] have options. They could enact some type of pension reform, which is mainly done for new employees. One of the interesting things about pensions is that, to various degrees across states, pension benefits are protected by the state constitution, which gives entities limited wiggle room in what they can do, but again, this varies drastically state to state. So, unfortunately, it's not a cookie-cutter approach of every place can do X [to resolve their pension funding problems].
So, it's definitely something that many cities are going to have to address, either through increasing contributions, which could then mean cutting back either in other areas of city services or alternately in some cases some significant increases in tax rates.
On the other hand, some of them might be able to successfully negotiate some pension reforms, which would make that much more containable. In the end, I think there are still a lot of balls up in the air, and it's something that's going to be a focal point when we look at credit quality of cities going forward.
Stipp: Rachel, it sounds like there's no shortage of red flags and several yellow flags as well going forward. Thanks for this research and these very interesting insights.
Barkley: Thank you. I appreciate it.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.