Congress, Muni Bond Risk and Pensions

by: Susan Mangiero, CFA

According to a press release dated February 9, U.S. Congressman Devin Nunes and U.S. Senator Richard Burr are about to force their peers to focus on public pension fund finances. While the House gets the Public Employees Pension Transparency Act this week, a version for the United States Senate is expected in a few days. The goals of this proposed legislation are several:

  • Provide one set of financial statements (and underlying assumptions) for state and municipal plans to the U.S. Secretary of the Treasury that are based on prevailing accounting methods, even if flawed.
  • Report a second set of financial statements that reflect the level of liabilities for each reporting entity as determined according to a uniform set of rules. "These guidelines will include more realistic discount rates, as well as controls to assure assets are counted using a reasonable estimate of fair market value."
  • Penalize non-compliant government units by withholding federal subsidies of state and local debt and nixing federal tax-exempt status for their bonds.

According to "U.S. House Republicans Rule Out Federal Bailouts For States" by Andrew Ackerman (Wall Street Journal, February 9, 2011), today's Congressional discussion about the state of public employee benefit plans made it clear that states and/or municipalities seeking refuge from their funding problems will not get a federal bailout.

Unless struggling government plan sponsors rescind benefits and/or increase local tax revenue and/or take on a lot more investment risk, they are going to feel immense pain in the coming years. The bad news is not spread out equally. A table that describes the "Public Pension Crisis" and is based on "Public Pension Promises: How Big Are They and What Are They Worth" by Professors Robert Novy-Marx and Joshua D. Rauh projects that Oklahoma, Louisiana, Illinois, New Jersey, Connecticut, Arkansas, West Virginia, Kentucky, Hawaii and Indiana will exhaust their funding first.

The vicious cycle begins. If municipal bond investors view these issuers as higher risk, their respective costs of money will go up. More expensive debt service will exacerbate the overall problems, regardless of which accounting rules are used for reporting. Taxpayers will get more upset and possibly vote with their feet, moving to what they perceive as fiscally sound cities, towns and states. Yet another falling domino, a shrinking tax base will mean fewer available dollars to pay bills, widening the money gap.

According to "Bond Rating Drop Ignites Pension Fight" by Lisa Fleisher and Jeannette Neumann (Wall Street Journal, February 9, 2011), the Garden State is now on the receiving end of a ratings downgrade and "is one of the seven lowest-rated states in the country." They report that New Jersey missed a $3.1 billion pension payment and could well have been a factor in the drop from AA to AA-.

I hate to say "I told you so" again, but I wrote about the political impact of pension funding in the mid-2000s since it was obvious even then that there were large problems afoot. If you missed it, read "Tea Party Redux: State Pensions in Turmoil" (July 27, 2006) and note that the term "tea party" has nothing to do with the party or movement of late.

Watch carefully as to how these plans change their asset allocations. Already there is a significant move towards investing in funds and instruments with an expectation of higher returns. That's not a problem as long as a robust risk management process in put in place or improved upon if it exists already. My forthcoming book on this topic will elaborate on the potential dangers of taking on too much risk.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.