By Patricia Healy, CFA
Today's municipal bond market is anything but "sleepy," as Spencer Jakab characterized it in his Wall Street Journal article, "Prophet of Muni Market Doom Wasn't Wrong, Just Early" (10/26/2018). The Prophet of Doom he referred to was Meredith Whitney, who shortly before the financial crisis successfully predicted the damage to Citibank by bad mortgages. In 2010, on 60 Minutes, she contended that municipal market participants were not addressing or recognizing pension risk that would contribute to "50 to 100 sizable defaults" on municipal bonds over the next year. This comment caused a rout in the municipal bond market, but we now know that a large number of defaults did not materialize.
The market is heterogeneous. There are over 80,000 municipalities in the United States, and each of those entities can issue various types of debt, from general obligation bonds backed by the taxing power of the municipality to revenue bonds that are secured by user fees such as water and sewer rates. Municipal bonds fund everything from fire trucks to schools to major road projects. Bond maturities can exceed 30 years. Thus, there are many investments to choose from. Municipal bonds offer tax-exempt income and can be used for impact investing, because municipal bonds finance projects that have environmental, social and governance (ESG) implications.
Many participants in the marketplace are aware of pension-funding shortfalls as well as the growing burden of providing healthcare to retirees and paying for long-term debt. They understand that if the problems aren't dealt with, the financial implications down the road could be severe. Jakab's article does not mention the states and municipalities that are taking action to improve pension funding status and what those actions are. That perspective could have helped WSJ readers and others, whether they are taxpayers, pensioners, or bond investors, to understand their towns and states better and take some action instead of being afraid.
Pension obligations are long-term and large. Just as an ocean liner takes a long time to turn, so too, municipalities must anticipate in advance how to proceed. The pension issue does need to be addressed; however, it may not be an immediate threat in many jurisdictions. Actions that can improve pension funding include lowering the assumed rate of return on investments and fully funding or overfunding the actuarially required annual contribution (ARC) to the pension (funding at this level keeps the funded level growing to meet future obligations). The municipality can alter certain pension benefits, for example by reducing cost-of-living adjustments or changing the level of benefits for future employees - all difficult decisions. Because liabilities can mushroom, it is important for municipalities with underfunded plans to make changes sooner rather than later. An increasing pension burden, just like your personal credit card debt, can balloon if you do not make more than the minimum monthly payment. These payments can compete for spending on other items.
States that have been able to implement pension reforms include Ohio, Colorado, Minnesota and Kentucky. Although the Kentucky changes are being challenged, there is now more recognition in the state that something needs to be done.
Many observers look at the unfunded status of a plan. For example, Pew Charitable Trust annually calculates those figures. The average funded level of a state pension fund based on 2016 data is 66%, with the lowest-funded at 31% for New Jersey and Connecticut and the highest-funded plan was Wisconsin at 99% funded. Moody's calculates an Adjusted Net Pension Liability (ANPL) by making changes in assumed rates of return, among other variables, to all state pension funds. This makes state-funded levels more comparable and realistic. Moody's uses discount rates between 3.0% and 4.0%, while most pensions still assume 6.5-7.5%. A lower discount rate increases the unfunded status of a plan so is more conservative. Moody's compares the ANPL with state revenue to rank the states based on the metric. The highest ratios are for Illinois (600%), Connecticut, Kentucky and New Jersey (290%), while North Carolina, North Dakota, Wyoming and Utah have ANPL well lower as a percent of revenue at 45% or under.
Other post-employment benefits (OPEB), mostly healthcare, were historically funded on a pay-as-you-go basis. OPEB liabilities are now required to be recognized in accordance with accounting standards recently implemented for periods beginning after June or December of 2017, specifically Governmental Accounting Standards Board (GASB) Statements 74 and 75. This is a positive development, allowing a municipality and its citizens a more transparent view of fiscal health. It is even more important as retirees live longer and the cost of healthcare rises. Many healthcare benefits are not contractually fixed, as pension benefits are; however, reducing benefits may be politically unpopular, in effect making healthcare benefits almost as difficult to change as pensions are.
Technological improvements have helped improve efficiency at municipalities, but the improvements have also led to there being fewer current employees to support a growing retiree population, which further exacerbates the pension issue. Further developments in technology may give municipal managers pause as they determine which direction to invest in for the future.
There are other risks to the long-term economic viability of municipalities - exploding pensions are just one of them. There is the widely publicized issue of deferred infrastructure spending, which reduces livability and could be a negative for economic development and a safety risk to a community. Deferred spending also makes projects more expensive. In addition, there is the prospect of having to prepare for sea-level rise, coastal erosion and more extreme weather and fire events.
The increasing wealth gap and affordability issues affect social service spending, and tax rate and service fee rate increase management. Municipalities have many competing spending needs.
I'm not trying to paint a dire picture, but I am trying to impress upon readers and casual observers of the municipal market that market participants are, in fact, aware of long-term challenges. Ratings and credit analysis are based on many factors, including the strength of the service area economy, financial operations, long-term plans and management performance. Ratings are not based on one item unless that one factor is overwhelming.
The fear of widespread municipal defaults in 2010 and the ensuing rout in municipal bond prices created a buying opportunity for investors that knew the market. For many investors, the timing of when to exit a bond is the issue. Do investors exit as soon as they see the light of the pension crisis train barreling down the track, or just before the train wreck? Conservative investors generally do not invest in the state obligations of Illinois, New Jersey or Connecticut because of those states' burgeoning pension and OPEB obligations (additionally, these states suffer from slow or negative growth in population and dysfunctional governance). Cumberland, as a conservative investor, has avoided the bonds that would have suffered from the multiple downgrades of those states.