The Sisyphean task of funding U.S. state and local-government retirement plans, a hidden risk for municipal-bond investors, will get even more daunting under proposed new accounting rules.
Pensions in Illinois, New Jersey, Indiana and Kentucky may have less than 30 percent of the assets needed to cover promised benefits under the measure, according to data from the Boston College Center for Retirement Research. The changes, which take effect starting in June 2013, will alter how liabilities are calculated and how assets are reported on financial statements.
“People are going to be really surprised,” Matt Fabian, managing director with Concord, Massachusetts-based Municipal Market Advisors, said by telephone. “It’s one of the few things out there that could precipitate a major change in investor demand.”
The rules may raise government costs in the $3.7 trillion municipal market as investors demand more yield to compensate for higher pension risk and possibly lower ratings. Illinois became Moody’s Investors Service’s lowest-rated state in January because it hadn’t dealt with its underfunded pensions.
Twenty-year munis yield 3.81 percent, close to the lowest since 1967, according to a Bond Buyer index. The gauge touched 3.6 percent in January, the lowest since 3.4 percent in 1967.
Pushing Up Costs
The need for higher contributions can add to the returns investors require, according to the Boston College center.
“The market is starting to look much closer at what governments are doing to address the pension problems,” said Jean-Pierre Aubry, assistant director of state and local research at the center, in an interview. “Contributions to pensions matter to bondholders.”
A center report in February 2011 showed pension costs as a proportion of budgets rose to 3.8 percent in 2008 from 3 percent in 2005. The effect may increase as unfunded liabilities grow.
The changes may force government officials to cut benefits or spend more to cover what they’ve promised, Fabian said. That may lower funding for other programs or prompt tax increases.
“The numbers are going to look worse,” Joe Pangallozzi, a managing director and analyst with BlackRock Inc.’s fixed-income group in Plainsboro, New Jersey, said by telephone. “Now that you have these numbers, what are you going to do to put the system on a solid footing?”
Assets held by U.S. public pensions are starting to show a turnaround in returns that is raising the funding level for some. Retirement plans ended the first quarter with a median gain of 7.5 percent on investments, the best performance since 2010, as stocks and real estate boosted the results, Wilshire Associates has said. State and local governments have spent the past three years dealing with stagnant revenue and rising costs after recovering from the longest recession since the 1930s.
The Governmental Accounting Standards Board, which decides how states and municipalities must keep their books, is set to issue the new rules next month. Any decisions made so far are “tentative and subject to change,” John Pappas, a spokesman for the Norwalk, Connecticut-based organization, said by e-mail. Pensions would begin using the rules for fiscal years starting after June 15, 2013, and employers such as school districts would follow a year later.
As currently set up, the changes would force pensions and municipalities to report the portion of current and future retiree obligations that exceed projected assets as a liability on balance sheets for the first time.
The new method also may widen the gap between assets and promised benefits by applying a lower discount to the uncovered portion. The rules would tie the measure to a 30-year, AA rated municipal bond, rather than a typically higher expected investment return.
The average AA+ municipal bond yields about 4.2 percent for 30-year maturities, according to a Bloomberg Fair Value index. The Teachers’ Retirement System of Illinois has an assumed rate of annual return on assets of 8.5 percent, which is lower than its average of 9.3 percent each year during the past three decades, Dave Urbanek, a fund spokesman, said by telephone.
Under the new rules, the so-called funded ratio would fall to 53 percent from 77 percent for 126 plans, taken as a group, according to a November 2011 study from the Boston College center. The measure gauges assets as a proportion of obligations and was applied to both state and local pensions.
May Surprise Officials
“The liability will appear to be larger than it has in the past,” Cathie Eitelberg, national public-sector market director for New York-based Segal Co., a pension consultant, said in a telephone interview. “There could be some very surprised elected officials.”
Municipal-bond investors will have two numbers to look at rather than one, Eitelberg said. Currently, they get a liability item in footnotes of financial statements. Under the new rules, governments will have the figures listed on a balance sheet and an explanation of what is being done to address it, she said.
Illinois, which already has the U.S. state pensions with the widest gaps between assets and promised benefits, will see two of its funds fall to the lowest among the 126 plans studied by the Boston College center. The state Teachers system’s funded ratio will drop to about 18 percent, the lowest level in the study, from 48 percent, and the State Employees’ Retirement System of Illinois will sink to 22 percent from 46 percent, ranking second.
The Illinois Teachers’ plan has lost ground because the Legislature failed to fund state pensions at required levels. The $34.6 billion system got $10 billion less from lawmakers than it needed from 1970 to 2011, said Urbanek, the spokesman.
“Changing accounting rules so the underfunded liability gets higher is like saying you’re stirring your coffee in the wrong direction,” Urbanek said. “We already know we’re the worst in the nation.”
Governor Pat Quinn, a Democrat, has proposed changes that may cut the unfunded liability of state plans by boosting worker contributions, lowering cost-of-living increases and raising the retirement age to 67.
New Jersey’s Public Employees’ Retirement System will see its funded ratio drop to about 30 percent from 62 percent, while the New Jersey Teachers’ Pension & Annuity Fund will fall from almost 58 percent to about 25 percent, according to the Boston College study released in November.
Without changes Governor Chris Christie pushed through last year, the state’s unfunded liability for retirees would be $20 billion higher, according to Andrew Pratt, a state Treasury Department spokesman. The Republican’s overhaul raised employee payments and the minimum retirement age for most workers.
“Governor Christie has put the pensions on course for solvency without draining resources needed for schools, transportation and aid to the poor and disabled,” Pratt said by e-mail. “Taxpayers will be asked to pay less for government pensions, and public employees have a far greater certainty of a secure retirement.”
Pensions in Washington, Minnesota, Pennsylvania and Texas may see funding levels worsen the most under the new accounting rules, according to data from the Boston College center. Two plans for teachers run by the state of Washington would fall to about 40 percent from almost 93 percent.
The new public disclosure requirement may “exacerbate” the unfunded liability of some plans, Washington Treasurer James McIntire said by telephone. He said he doesn’t expect the rules to change how the gaps are dealt with in his state, which has taken steps to improve asset levels.
“It doesn’t change the amount of money you put into your pension plans and it doesn’t change what you owe,” he said. “It just changes how you value it for reporting purposes.”
Following are pending deals:
CALIFORNIA HEALTH FACILITIES FINANCING AUTHORITY plans to issue $415 million of tax-exempt revenue bonds as soon as tomorrow. Proceeds will help renovate Stanford Hospital & Clinics facilities and refinance debt sold in 2003, according to sale documents. Morgan Stanley will lead the marketing for the issue. Moody’s rates the bonds Aa3, its fourth-highest grade. (Added May 9)
OKLAHOMA DEVELOPMENT FINANCE AUTHORITY is set to issue $190 million of tax-exempt revenue bonds as soon as today on behalf of St. John Health System. Proceeds will help finance the acquisition of a hospital facility and refinance debt sold in 1999, according to offering documents. Goldman Sachs & Co. and Citigroup Inc. are the underwriters. Standard & Poor’s rates the bonds A, sixth-highest. (Added May 9)