Almost every local and state government in the United States is currently struggling with their unfunded pension liabilities – which essentially means that local and state government workers have been promised far more in pension benefits than the monies set aside to meet those obligations.
Furthermore, most states have strong constitutional protections for these pension benefits, which protect against any proposed reductions in originally promised pension benefits or increases in the employee contributions. According to a report published by the American Legislative Exchange Council – which uses more appropriate assumptions on investment returns than the plans use themselves – state and local governments’ unfunded liabilities now exceed $6 trillion.
In this article, we will take a closer look at the impact of unfunded liabilities on local governments and how local and state governments are preparing to meet these unfunded liabilities.
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What Are Unfunded Liabilities?
Unlike the private sector, most state and local government employees participate in a defined benefit pension plan with a central authority similar to a pension fund for the state and localities within that state. These public pension plans typically provide pensions based on members’ years of service and average salary over a specified number of years of employment. Many members also receive cost-of-living adjustments that help maintain the purchasing power of their benefits in retirement.
In understanding the unfunded liabilities, let’s take an example of an employee who started his career at the age of 25 with a local government. That local government, with the help of an actuarial accountant, will work out the monthly pension liability of that employee based on his current age and make a few assumptions about their number of projected years of service and earnings. These projections help the local government come up with a final pension number that they will need to meet for this employee upon their retirement. Furthermore, the local governments, with the help of an actuarial, discount this future liability at a “discount rate” to come up with a current pension liability number that they would need to fund to ensure that they will have this person’s retirement benefits fully funded by the time they retire. This present value of the future benefit is primarily funded by the local or state government and a small portion is contributed by the employee.
Now, the local or state government typically runs into the issue of unfunded liability when the pension fund isn’t able to generate enough returns to meet the discount rate. For example: if the future value of an unfunded liability was discounted at the rate of 7% to come up with the present value of pension contribution – it assumes that the current and future contribution must earn at least 7% to get to the desired “predetermined” future value. If the pension fund is unable to return the 7% annual return on its portfolio, it will mean that either the employee or the employer will need to come up with the difference to make sure that the future number is met.
For example, CalPERS, the largest U.S. public pension fund, has been struggling to meet the expected discount rate of return for the past few years and has already told participating agencies they will be obligated to increase required employer contributions to the retirement fund. The burden to meet the shortfall for the future pension benefits falls primarily on the employing local or state government, which needs to increase the current pension liabilities significantly for these employers.
This is bad news for taxpayers in states and localities where government workers have been promised far more in pension benefits than politicians set aside to pay them. Like mentioned earlier, most states have strong protections for promised pension benefits, meaning there is little prospect of reducing a pension benefit or asking employees to contribute more to it.
How Are Localities Preparing to Meet These Shortfalls?
According to the Urban Institute, in fiscal year 2018, state and local governments contributed around 6 percent of direct general expenditures to employee retirement systems. Still, these contributions do not account for unfunded future liabilities and, thus, underestimate the full burden of pensions on state and local governments. Estimates of unfunded liabilities range from $4 trillion to $6 trillion. The total contribution numbers are projected to increase as more state and local governments prepare to pay down their unfunded liabilities.
- Almost all states have enacted major changes to their public pension systems to reduce costs in recent years. Among the most frequent reforms are reduced benefit levels, longer vesting periods, increased age and service requirements, limited cost-of-living adjustments, and increased employer and employee contributions.
- Some governments have also moved new employees onto defined contribution (DC) plans, or hybrid plans combining aspects of both DB and DC plans, in part because DC plans shift risk from employers to employees.
- Many local governments are looking to set aside funds into their own investment pools that will be used to meet the future pension liabilities.
It’s also often seen that public employees are contesting many of these changes in court, arguing that state and local government actions violate their pension’s contractual nature.
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Key Considerations for Investors
Some of the key points that are critical for investors to review when assessing the overall risk of unfunded liabilities on municipal debt are discussed below.
- Investors and credit rating agencies often see pension liabilities and bonded liabilities as the same when assessing a local government’s default risk.
- It’s also important to note that for local and state governments, pension liabilities are often protected by constitutional provision and hold a higher position in the event of a municipal bankruptcy – which means that in the event of a municipal bankruptcy the pension liabilities are likely to be satisfied before municipal debt obligations.
- Investors must stay cognizant of the efforts of their respective local governments and their preparedness efforts in mitigating the potential risks posed by unfunded liabilities on both the local government’s operations and its ability to access the capital markets.
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The Bottom Line
Given the increasing number of unfunded liabilities for almost every local and state government, investors must look closely at the short- and long-term fiscal impacts. The municipal debt investors must also carefully analyze the structure of their holdings and understand how this structure will be treated in the event of increasing unfunded liabilities and the possibility of municipal insolvency.
The recent bankruptcies of well-known American municipalities should admonish investors who may think that municipal debt is immune to financial downturns.
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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.