Challenges Ahead for Public Pensions?

A number of disturbing reports about municipal pension systems have hit the news media recently. In addition to the immediate statistics and investor concerns, we need to consider when in the financial cycle this complex issue occurs. The tenor of most reports is (1) that unfunded actuarial liabilities for state and local government pensions are enormous and growing, (2) that governmental units have been slow to respond, (3) that public pensions tend to be more generous than their private-sector counterparts and that public employees can often game them to the point that payments in retirement can exceed the salaries earned during their working years; and (4) that widespread governmental insolvencies are in the offing unless things change and change quickly. At SNW Asset Management, we routinely look at pension disclosure as part of our credit-review process, and have some thoughts that we would like to share.

“…all of these issues are matters that we at SNW Asset Management considered when selecting municipal credits for our clients’ portfolios.”

First, pension obligations are ongoing and permanent. State and local governments are funding promised pensions for current retirees, for employees who will retire in the future, and even for future employees. Second, pensions represent vested assets that are well protected by law. Outside of bankruptcy, it is extremely difficult for states and local governments to reduce their obligations to pensioners. Third, when evaluating pension liabilities it is also important to view reported obligations within the context of the investment return assumptions that were used. There is some risk that municipalities may use overly optimistic assumptions to value their projected investment results, thereby reducing their pension costs and making it easier to show balanced budgets. In general, investors should look for return assumptions which parallel long-term returns of the asset classes in which plan assets are invested.

Finally, promised payments are to be made over a very long time horizon, which makes it important not to overreact to shorter-term phenomena, even those as traumatic as the two stock market crashes since the year 2000. Estimated obligations are quite large, but estimates can be distorted if you do not take into account when during the financial cycle they were made. Municipal pensions are the subject of recurring actuarial reviews, and these reviews are often completed with a lag time of one or two years or more. Our view is that current numbers being shown are colored by the stock market rout of 2008 – something that is hopefully not the normal state of affairs. We think that projected pension shortfalls will be substantially smaller once the stock market rebound of 2009-10 is factored in. It is true that prudent governmental units must react responsibly to fluctuations in funding ratios, but they must do so with a longer-term perspective. They do need to take timely action to keep current with their actuarial obligations, and they must avoid the temptation to fudge estimates by overestimating investment returns, or underestimating wage and salary inflation. We believe that most governments are reasonable and responsible about their pension obligations. Governments that respond reasonably to their actuarial estimates are likely to be able to manage well in the coming years. Because of the long time-frames that normally govern pensions, even those governments that do not address their problems promptly and prudently are likely not to hit the pension wall for 10-20 years or more. The point here is not to justify inaction or irresponsible action. It is simply to observe that, right now, unfunded pension liabilities – as material as they appear to be – are not as significant to municipal credit analysis as are shortfalls in tax revenues, cuts in shared revenues, and rapidly increasing mandated expenditures. These issues are immediate for municipalities; the pension liabilities are a considerably longer-term concern. However, all of these issues are matters that we at SNW Asset Management considered when selecting municipal credits for our clients’ portfolios.

A large number of state and local governments are taking action to improve their pension positions by moving towards defined contribution plans for new employees, making supplemental payments to their pension funds, eliminating employer pick-ups of employee contributions, and bonding a limited portion of their pension obligations. These actions, singly and in the aggregate, may be in place for some time before their impact becomes evident and material, but this will eventually happen.

Let us consider some additional details to add context and nuance to the more generalized comments that have been offered thus far. The accompanying table sets out comparative pension data for seven states of particular interest to our readers – California, Idaho, Oregon, Washington, Florida, Illinois, and Texas. The first four are the states where most of our clientele resides. Florida and Texas are similar to Washington: large populations, high wealth levels, sizable bond issuance, and no state income tax. We, therefore, routinely buy Florida and Texas bonds to diversify the portfolios of our Washington clients. Illinois is included because it is often mentioned as a state with a serious pension problem.

The table includes data about the latest pension evaluation date, as well as the assumed rate of return on pension plan investments. To forestall an overload of data, we have omitted wage and salary inflation, and length of workforce service assumptions. Key data in the table are the assets and currently estimated actuarial liabilities of the plans, together with the resulting funding deficits or (in the case of Florida) surpluses. The table adds explanatory detail by calculating the funding ratio (which simply divides assets by liabilities), the per capita unfunded pension liability (unfunded liabilities divided by population), and the unfunded liabilities as a percentage of aggregate personal income in each state. All the data in the table are based on the largest pension plans in each state – normally, the public employees’ retirement plan plus the teachers’ retirement plan. The exception is Florida, the data for which also include the plan for retirement health care benefits, which, though small at present, still shows a large unfunded liability. What is impressive about Florida is that the basic retirement plan, taken strictly by itself, was overfunded by $6.6 billion as of mid-2008.

The results reported in the table highlight a number of interesting points. Some states, such as Texas and Washington, are clearly in systemically better shape than others. States with large populations and high income and wealth levels stand to do better than smaller, less diversified and wealthy jurisdictions. In some states, such as California, unfunded pension liabilities are considerably less than the state’s outstanding bonded debt. Other states are less well positioned, for example Oregon and Illinois. Even here, though, the reader must be very careful with these numbers. Earlier portions of this comment noted the critical importance of when in the economic cycle pension numbers are analyzed. In fact, from year to year the numbers can be surprisingly volatile, which reinforces the idea of examining comparative pension data over a number of years rather than simply taking a “snapshot.” Consider Oregon, which as of mid-2008 showed a funding ratio of 71% and rather high levels of liability versus population and personal income. Yet, only one year earlier – in mid-2007 – Oregon’s funding ratio was 98%, and the other numbers were much, much smaller. Investors who are concerned about pension liabilities should therefore take care to look at the numbers over a long period – no less than 5 years – and avoid jumping to too-pessimistic conclusions right now, when we are still near the bottom of the financial cycle.

The bottom line for investors is that pension liabilities should be analyzed with a long-term perspective and with attention to the details of each municipality’s program and invest accordingly.

SNW Asset Management Investment Committee