Public pension sponsors have not previously felt much pressure from muni bond investors to shore up their plans’ funding — but a shift has begun.
Pensions raise interest rates on muni bonds by just three to seven basis points, according to an analysis of 37,500 bond issues from 2005 to 2009 by The Center for Retirement Research (CRR) at Boston College. And pensions did not appear to impact bond ratings, according to CRR’s paper published in February, “ The Impact of Pensions on State Borrowing Costs.” But the influence of public pension funding on ratings and investors has begun growing, says CRR Director Alicia Munnell, a co-author of the study. “The interesting thing will be to redo this study and look at 2010 to 2012,” she says.
What explains the previous lack of muni-bond investor pressure on troubled public plans? “The ratings agencies did not really consider pension funding,” Munnell says. They likely saw no risk of underfunded pensions leading states to default on their bonds, she says.
Pension funding is actually a relatively new diagnostic for analysts to consider, says Cynthia Brown, director of municipal bond research at investment manager Gannett Welsh & Kotler, LLC (GW&K). “Up until 15 years ago, state and local governments did not even report their pension liabilities, so people do not have a good long-term yardstick,” she says. “And not until 2006 did they have to disclose as much information as they do now about the annual required contribution (ARC)” due to the enactment of GASB (Governmental Accounting Standards Board) Statement No. 45.
Also, in recent years many governments have made their pension formulas more generous, Brown says. And the previous decade’s long market rally produced rosy investment results for many plans. “They had a long period of time when they had very good returns, and people kind of ignored it,” she says. “It has always been viewed as a long-term obligation, and never as anything immediate —until the funding levels dropped precipitously.”
With the market slump, reality hit. “These benefits are guaranteed, so that will force the states and local governments to come up with the money,” Munnell says. “The ratings agencies are now making noises about taking pensions more seriously.” She points to the January announcement by Moody’s Investors Service that it has started including pension liabilities in its evaluations of states’ total current liabilities, as well as Standard & Poor’s citing pension obligations when it downgraded the State of New Jersey’s debt in February. And muni-bond investors have become a little more discerning about states’ differing pension-fund health, as reflected in the spread they will purchase bonds at, Brown says.
Public pension sponsors may feel the impact of the growing scrutiny in several ways, Brown says. It increases the odds that GASB will change its rules to make public pension funds’ assumptions more comparable in areas like the assumed rate of return, amortization, and smoothing returns. Now, she says, “a 75 percent funding level in state A versus a 75 percent funding level in State B could have vastly different underlying assumptions.”
And contributions likely will increase at many underfunded pension plans. “I think there will be much more accountability on the part of lawmakers and decision-makers,” Brown says. “That will be a good thing.” Adds Munnell, “You would hope that if it is going to affect the cost of the debt through the rating, then that would be an incentive to fund more.”
Plus, all the attention makes retirement-benefits changes easier. “It is very hard for administrators to talk about reform unless they have public sentiment in their court,” Brown says. “Now, everybody understands the same information. And if they are taking steps to fund higher or reel in some of the costs, that goes a long way. This does not have to be corrected in one year: It is a long-term obligation.”
