With pressure mounting for state governments to reduce billion-dollar budget deficits, policymakers are floating the idea of a new federal bankruptcy option to give states a court-sanctioned way to shed their debts.
If calls for a new federal bankruptcy regime allow states to restructure their finances, they’ll be able to pay less than they have promised to state employee pensions and bondholders.
The losers in any state bankruptcy filing would be the investors in state bonds. As a holder of state general obligation bonds, widely considered the strongest credit of any local government, you do not want to realize one day that because states are declaring bankruptcy, the bonds you’re holding are being treated as unsecured credits, subject to reduction under Chapter 9.
Anything that makes it seem easier for states to default on their obligations will translate into higher interest rates when states borrow and paper losses for existing bondholders.
In his recent paper, “ State and Local Pension Funding Deficits: A Primer,” Douglas Elliott, a fellow in economic studies and public policy at The Brookings Institution, discusses various options that could solve states’ pension deficit problems. He addresses the political controversy surrounding the issue with Institutional Investor writer Janice Fioravante:
Institutional Investor: Among the various suggestions to deal with state pensions’ severe underfunding crisis is bankruptcy. How will this impact investment strategies for pension fund managers?
Elliott: If they thought that states were going to default, the yields that managers would demand would shoot up to 10, 15 or even 20 percent and we haven’t seen that happen. But it’s clear that municipal bonds in some states are priced to indicate some risk.
There has been no governor or mayor who has gotten behind bankruptcy yet, but they’ve publicly endorsed pension reforms. No bankruptcy judge will be in a position to make inherently political decisions.
Pension plans are constitutionally under the control of the states. State constitutions would have to be altered. It is quite unclear how a federal bankruptcy regime would interact with the sovereign immunity that states enjoy under our constitution and whether states would have the ability to abrogate union contracts under such a bankruptcy law.
The shortfall across the nation adds up to over $3 trillion — more than two years’ worth of state and local tax revenues. The real costs would spook the markets. Calls for a federal law to allow states to declare bankruptcy may be more of a threat to get unions to negotiate in earnest.
A remedy already under consideration is tinkering with inflation indexing — some states are challenging this while labor unions and pension holders contest that. How do you think this will play out?
One idea is to eliminate or lower inflation-adjusted benefits. As soon as this was floated, unions went straight to the courts to sue because attempts to reduce the inflation index for past service renege on promises made. Trying to reduce a promised benefit? I see it going all the way up to State Supreme Court.
It’s much easier to do it for future service. It’s pretty clear that new employees will have to contribute more to their plans. And some states will morph new employees’ pensions into defined contribution plans.
If full-out bankruptcy is probably not going to happen, how will states and pension plans deal with gargantuan shortfalls?
A federal bailout is a huge possibility. The federal government can’t force states to pay anything to a creditor. The state has to be willing. A precedent for bankruptcy is the municipalities who’ve done it, like New York City in 1975 restructuring with the Municipal Assistance Corporation, New York City had a sugar daddy in the State of New York. This is why I can imagine some federal guarantees happening.
Public employees have made a tradeoff to accept lower wages — 10 percent less pay for 10 percent more benefits — salary deferred for payment to pension plans. One has to consider the total compensation package. It’s not crystal clear that union employees are getting away with murder compared with private employees. Conservatives think states are overpaying public employees and if that is so, that’s the argument for renegotiating existing plans.
Let’s talk about investment alternatives. How is risk being factored into pension accounting?
Another remedy—to get higher returns, pension plans take higher risks and the Government Accounting Standards Board allows this. There is more money funneled into alternative investments, which, in some cases, makes sense,
It’s a way to raise expected returns and lower contributions.
You’re strongly in favor of reforming accounting and actuarial rules to show more reliable liabilities, yes?
A large number of economists agree that the discount rates currently used make no sense. States should use either the Treasury rate or high-quality municipal bond rate. It would more accurately reflect the level of risk. If states were right that they can get an eight percent return, but they have a 50 percent chance of making that eight percent. It’s not a responsible way of determining the discount rate.
It’s not a perfect storm. If one expects the stock market to do badly, there’s a correlation that the economy tanks as well, which means a systemic risk. Accounting rules need to change to make them more like FASB (Financial Accounting Standards Board) rules, broadly speaking.
But the rules encourage states to take more risk — it’s a way to game the system. State and local governments are legally committed to support these pension payments, and therefore pension liabilities should have a discount rate no higher than the interest rate the market requires on municipal bonds to compensate for the risk of default on general obligations of these entities.
