Pension Funds Burn Cities as $1 Trillion Shortfall Set to Grow

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The cost to American cities for their cash-strapped pension funds is starting to look a lot worse, and it’s not because the stock-market rally may be losing steam.

Houston was warned by Moody’s Investors Service this month that it may be downgraded because of mounting retirement bills, the latest municipality put on notice as the company ignores bookkeeping gimmicks that let cities mask the size of their debt for years. The approach foreshadows accounting rules for even top-rated issuers that are poised to cause pension shortfalls to swell as new financial reports are released.

“If you’re AAA or AA rated and you’ve got significant and visible unfunded pension obligations, you’ve only got one direction to go in terms of rating, and that’s potentially down,” said Jeff Lipton, head of municipal research in New York at Oppenheimer & Co. “It’s the presentation on the balance sheet that is now going to drive urgency.”

Cities that shortchanged pensions for years are under growing pressure to boost their contributions, even after windfalls from a stock market that’s tripled since early 2009. Janney Montgomery Scott has said growing retirement costs are “the largest cloud overhanging” the $3.6 trillion municipal-bond market, where investors are demanding higher yields from borrowers under the greatest strain.

Chicago Pays

That was on display this week for Chicago, whose credit rating was cut to junk by Moody’s in May because of a $20 billion pension shortfall. The city was forced to pay yields of almost 8 percent on taxable bonds maturing in 2042, about twice what some homeowners can get on a 30-year mortgage.

Estimates of the pension-fund deficits facing states and cities vary, depending on the assumptions used to calculate the cost of bills due over the next several decades. According to Federal Reserve figures, they have $1.4 trillion less than needed to cover promised benefits.

Officials have been able to lower the size of the liability by counting on investment earnings of more than 7 percent a year, even after they expect to run out of cash. New rules from the Governmental Accounting Standards Board require a lower rate to be used after retirement plans go broke. Many reported shortfalls will grow as a result.

More Coming

Moody’s, which in 2013 began using a lower rate than governments do to calculate future liabilities, has estimated that the 25 largest U.S. public pensions alone have $2 trillion less than they need. Cincinnati and Minneapolis are among cities Moody’s has since downgraded.

The credit-rating company said in a report Friday that the shortfall in Dallas’s police and firefighters’ pension system will more than triple to $4.7 billion because of the accounting-rule shift.

“You’ll probably start to see a lot more negative outlooks,” said David Ashley, who helps oversee $10 billion of munis at Thornburg Investment Management in Santa Fe, New Mexico. “That’s on the horizon.”

The new reporting requirements are taking full effect just as stock and bond markets sputter as the Federal Reserve prepares to raise interest rates for the first time in nine years.

The California Public Employees’ Retirement System, the largest U.S. pension, this week said it earned just 2.4 percent last fiscal year, one-third of the annual return it projects. The California State Teachers’ Retirement System, the second-biggest fund, gained 4.5 percent, compared with its 7.5 percent goal.

Gains Slow

The Standard & Poor’s 500 Index has climbed 3.2 percent this year, following double-digit gains for each of the last three years.

Pension systems have been a particular strain for local governments, which have less ability than states to raise taxes.

Like other cities, Houston’s revenue is limited by property-tax caps. Its three pension plans have combined unfunded liability of about $3.4 billion, according documents for a debt sale last month.

On July 2, Moody’s lowered Houston’s outlook to negative, citing the “challenges the city faces from growing pension costs and liabilities.” The Aa2 rating is the third-highest investment grade.

Prophecy Fulfilled

Any downward rating moves could hinder efforts of states and localities that are working their way out of the problem by increasing borrowing costs, further straining budgets, said Vikram Rai, head of muni strategy in New York at Citigroup Inc.

For more, read this QuickTake: Pension Pinch

Downgrades “could become a self-fulfilling prophecy and exacerbate the fiscal distress,” Rai said. It could also drag down prices in the municipal market, he said in a July 8 report.

On the other hand, the new accounting rules and pressure from credit-rating companies may spur action by officials.

“Any time you have clarity around pension funding versus the provision of essential services versus tax levels, it helps generate good policy,” said Shawn O’Leary, senior research analyst at Nuveen Asset Management, which oversees about $100 billion in munis. “The market is really paying attention to these issues. The rating agencies are just catching up.”

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