The world of state pension obligations
(MoneyWatch) All the news surrounding the fiscal problems of Detroit has brought more attention to the municipal bond market and raised questions about the safety of the general obligation bonds of the states and municipalities.
In a June 2013 report, Moody's analyzed the pension data for the 50 individual states. Their report ranks states based on ratios measuring the size of their adjusted net pension liabilities (ANPL) relative to state revenues, GDP and personal income. States set their own estimates of future returns, (which are often set at unrealistic levels to keep funding requirements down), so Moody's created their own ANPL which is based on more realistic forecasts. The following are a few of the highlights:
- State pension burdens vary widely. The median value of the ratio of ANPL to governmental revenue is about 45 percent. Adjusted net pension liabilities for individual states ranged from as low as about 7 percent to over 240 percent of government revenue in fiscal 2011.
- The largest accumulated liabilities most often reflect management decisions not to fund contributions at levels reflecting actuarial guidelines. Of the 10 states with the largest pension burdens, six have been downgraded in recent years for the magnitude and management of their pension obligations, in part a reflection of persistent underfunding.
- The level of state contributions to cover pension costs of teachers and other local government employees is a significant factor in the size of state liabilities. The largest pension burdens are also associated with states that directly cover the cost of local school teacher pensions.
What may come as a surprise to many municipal bond investors is that California is not the state with the biggest problems. If you thought Greece had problems with its debt to GDP ratio of well over 100 percent, Illinois is in another league entirely with its ratio of 241 percent -- even worse than Puerto Rico's 234 percent. Looking at other financial indicators presents a similar picture. When ranking: by ANPL to personal income, Illinois is the second worst state (23.6 percent); by ANPL to GNP it's also second worst (19.8 percent); and by ANPL per capita it's third worst ($10,340). Note: Alaska was the worst in all three of those categories though its ANPL to revenue ratio is about 55 percent, putting it just 10 percent above the median.
- Momentum is everywhere, including government bonds
- Don't commit this investment "crime"
- What Fed's monetary tapering means for bonds
Connecticut* isn't far behind Illinois with an ANPL ratio of 190 percent. Seven more states had ratios above 100 percent -- Kentucky (141), New Jersey (137 percent), Hawaii (132 percent), Louisiana (130 percent), Colorado (118 percent), Pennsylvania (105 percent) and Massachusetts (100 percent). Three more states, Maryland, Texas and Rhode Island, were above 90 percent.
On the other end of the spectrum was Nebraska, with a ratio of less than 7 percent. Eight states had ratios below 20 percent (Wisconsin, Idaho, Iowa, New York, North Carolina, Florida, Tennessee, and Ohio).
For many states the data presents a dismal picture, one with the potential for "vicious cycle" type outcomes with higher tax rates leading to out-migration, especially of the wealthier people and businesses that pay most of the taxes, and lower property values.
Most states don't face any immediate or even short-term crisis, but actions must be taken to avoid long-term problems. What seems likely is that we could see employees being required to make greater contributions to their pensions. It's also possible that some pensioners will not receive the benefits they expected and are counting on. It might come in a direct cut in benefits or perhaps via a change in the COLA adjustments. Unfortunately for bondholders, it looks like they will have to live with some uncertainty as the outcomes may rest with the courts. Which is why the Detroit bankruptcy situation is attracting so much attention -- the outcome may impact the bonds of many other municipalities and states.
With those thoughts in mind, at the very least investors should be paying close attention to credit ratings. My own personal recommendation has always been to avoid buying municipal bonds that don't have standalone ratings (without insurance) of at least AA, and to limit purchases to only general obligation and essential service revenue bonds (regardless of the rating). To have a AA rating requires a three-year average ANPL to revenue of less than 120 percent. Six states fail that test. Personally I would recommend a tighter standard of 100 percent. For relatively short-term bonds (under three years), for those willing to take a bit more risk that rating hurdle could be lowered to A.
There are a few reasons to consider the state ratings even when buying the bonds of a municipality. First, states often provide fiscal support to their municipalities. If a state has to cut spending to meet pension obligations, that could impact the credit worthiness of the municipality. More important, as mentioned earlier, a high level of state's pension obligations can have economic consequences that impact local municipalities. Given the role that I believe fixed income should play in a portfolio -- to dampen the overall risk of the portfolio to an acceptable level, not to take risk -- I would also recommend you consider avoiding all bonds, even from highly-rated municipalities, from states with ANPLs of over 100 percent. There are plenty of other alternatives an investor can choose from.
*Author's note: In the original post California was incorrectly named in the Connecticut figure.