For all the flack Moody’s took for its rating of mortgage-backed securities in 2007-2008, it deserves credit for the work it has done to provide a clearer picture of public pension funding. Unfortunately, in general that picture isn’t pretty. Earlier this month, Moody’s released a report, titled “Market Volatility Points to Growing U.S. Public Pension Debt in 2016,” that attempts to quantify funding statistics as of fiscal 2016 (for state governments, this would typically be July 2015-June 2016). Because most government reporting is published with a significant lag, other than work like Moody’s, there’s no easy way to know what updated pension funding metrics are. Before I go into the details, I’ll start with background on the pension funding landscape for state and local governments.
How We Got Here
Like any other form of pension fund, state and local governments have a portfolio of investment assets in place to cover future pension payments owed to current and former employees. What has become abundantly clear, though, is that many state and local plans are substantially underfunded, which simply means the size of the plan’s investable assets is much smaller than the size of the payments they owe. In many cases, this problem has been compounded by two issues: 1) state and local plans have not been accurately valuing the size of their liabilities, and 2) many state and local governments have not been making large enough contributions into the plan to cover the funding gap. To be fair, many state and local governments argue that they have been accurately valuing their liabilities, but the economics are crystal clear insofar as the discount rates used to value the liabilities have been (and continue to be) too high.
Moody’s restates the size of the liability using a lower discount rate, which allows them to create a statistic called the adjusted net pension liability (ANPL). The ANPL is a dollar value that represents the size of the liability minus the size of the plan’s investable assets. A positive number means the plan is underfunded while a negative number would indicate the plan is overfunded. The ANPL can then be scaled by various metrics to get a sense for the size of the ANPL relative to a government’s annual revenue, tax base or other variables of interest.
The Moody’s Study
The three basic findings in the Moody’s study are that fiscal 2015 and 2016 investment portfolio performance results are likely to undo any gains from fiscal 2013 and 2014, many governments continue to make pension contributions that are too small to close the funding gap and the level of pension funding continues to vary widely across governments. This last point is important because many articles fail to note that a number of plans are well-funded.
The Moody’s study covered 56 plans representing more than half of total U.S. public plan pension assets. Using its “mid-range” estimate for fiscal 2016, because fiscal 2016 is still ongoing, Moody’s estimates that the total ANPL across all 56 plans will be about $2.1 trillion, which is 15 percent of the size of U.S. Treasury debt held by the public. In other words, it’s a really big number. It’s also more than half the size of the municipal bond market.
In addition, Moody’s found that less than half of the governments in the sample it studied are making contributions at sufficient levels to reduce the size of their net liabilities. This means that even in the presence of reasonable returns on a go-forward basis, many of these governments will still see the size of their net liability increase.
In terms of dispersion in funding levels, Illinois and Kentucky have teacher pension plans with underfunding approaching 700 percent of covered payroll while the teacher’s plan in the state of New York is overfunded. This shows that while there are numerous plans in significant financial trouble, there are also plans with solid funding ratios and even a few that are overfunded.
Potential Impact on the Municipal Market
The Moody’s study shows that in aggregate pension funding continues to be a problem facing the municipal bond market. While the market is aware of many of the problem areas (e.g., the state of Illinois and city of Chicago), logic still dictates that investors looking for lower-risk municipal bond portfolios should try to use bond funds or build individual bond portfolios that are both very well diversified across issuers and that have low exposure to known problem issuers like those noted above.
Investors should also be aware that we will likely continue to see numerous headlines about this issue, as well as some states and localities grappling with financial difficulty, for at least the next decade and likely longer. This of course doesn’t mean municipal bonds should be entirely avoided (far from it, in fact). But investors should be prepared to weather these headlines without panicking while paying greater attention to the construction of their municipal bond portfolios.