What happens when a pension python and a budget blob walk into a bar? Naturally, an epic public pension debate ensues. This isn’t just a bad municipal bond joke. Public finance and elected officials are becoming very creative at describing the budget pressures caused by pension funding. Former Illinois Governor Pat Quinn described his state’s pension issue as being like a giant python squeezing the breath out of the state capital. The City of Philadelphia Finance Director described his city’s pension issue as a blob crowding out public services funding. So what happens when a giant python and an all-consuming blob meet at the bar and debate public pensions? Well, there are number potential outcomes.
One, the jurisdiction could sell or lease an asset such as an airport, gas utility or toll road. The City of Chicago offered to privatize and lease Midway Airport, and Philly tried to sell its gas utility. Both of these initiatives failed to move forward.
Two, the jurisdiction could reduce pension benefits. This is extremely hard to do because many states have constitutional protections of pension benefits. A few political entities have reformed benefits, such as Rhode Island and the City of Atlanta, but in each case the modifications are being challenged in court.
Three, raise revenues to cover the additional costs. This solution is also generally difficult, even if the political will exists to increase taxes, because the ability to raise more revenue could be limited at the local government level to due to caps on property tax rates and annual property assessment valuation increases.
Four, cut public services like police and education programs. Bloomberg News reports Philly’s pension costs are now greater than the city’s police funding. We have also seen reduced service funding via larger K-12 class sizes in Washington and Oregon and reduced state aid to public universities. The University of California System just approved a 28% hike in tuition by 2019 prompted by withering state funding.
Five, pension costs could be reduced by growing the existing asset base. In simple terms, pension costs are calculated by taking the difference between the total pension liability and the value of the underlying pool of investment assets. The difference is amortized over a long period using various assumptions. If investment returns exceed the assumed rate of return, then annual pension costs fall. Moody’s Rating Agency just reported that based on fiscal year 2013 data more than half of all U.S. states decreased their pension liability levels due to positive market conditions. We agree that pension liabilities have fallen because of improved market conditions. However, moving forward, the only way to grow pension assets above the assumed rate of return is to take on greater investment risks. Given that the current investment outlook is for a low-interest rate environment and subdued equity returns, it will be difficult to grow out of severe pension underfunding without taking on materially more risk.
Six, issue more debt. Some jurisdictions have great pension funding ratios. They have accomplished this feat by issuing subordinate pension obligation bonds or managing their pensions well. For very well run municipalities with manageable pension liabilities, issuing more debt may be a feasible option. For example, San Luis Obispo County, CA is a strong municipal credit with pension debt outstanding. For others, like the City of Detroit’s pension obligation bondholders, the outcome is potentially very bad due to significant existing indebtedness.
Seven, enter federal bankruptcy protection and restructure the outstanding liabilities. This is the option of last resort, and for bondholders its outcomes can be devastating. In the Detroit bankruptcy case, pension obligation bondholders received just 14 cents on the dollar and a package of vacant lots and asset leases. Moreover, recent municipal bankruptcy judgments have favored pensioners over bondholders. These results have the municipal market revising long-held assumptions about the relative credit risk of muni bonds.
So when a pension python and devouring budget blob meet at a bar, the result is generally bad, and the risks it presents to municipal bonds holders is material. These risks can be mitigated by a leadership team willing to pursue any one of the numerous policy and financial options laid out above. If a municipal issuer has a strong balance sheet, flexible revenue capacity and/or a growing economic base in their district or region, then municipal bonds may continue to be a compelling investment choice.
Sources: SNWAM Research, Bloomberg News, Moody’s Rating Agency