The Distant Meteor of Underfunded Pensions

If a private sector company had $15 billion in assets and $40 billion in liabilities, it would be probably be declared insolvent in the courts, and prevented from conveying payments at 100 cents on the dollar to creditors just because they sit at the top of the queue. When a public sector pension fund has $15 billion in assets and $40 billion in liabilities, it is simply described as underfunded, and payouts continue at 100 cents on the dollar as the state tries to fix it. That is the dynamic of a small number of severely underfunded state pension plans. It will take many years to play out, but without radical transformation of taxes and spending in a few states, the impact on pensions and bondholders could be substantial.

Every 3 years, we perform a deep-dive analysis of the fully-loaded liabilities of US states: their bonds, and their obligations related to underfunded pensions and retiree healthcare benefits (“OPEB”). Pensions and OPEB are a big part of the debt picture: while US states have ~$500 billion of bonds supported by state tax collections and general revenues, they have another $1.0-$1.5 trillion of unfunded pension and OPEB liabilities, depending on rates used to discount them. This year was a good time to do it, since new GASB rules have substantially improved disclosure on pensions, and modestly improved disclosure on OPEB as well.

After analyzing 330 single-employer and multi-employer pension and OPEB plans, we created a single measure for each state. The chart shows the ratio of what states currently spend on bonds, pensions and OPEB as a percentage of their revenues (blue bars), and what they would spend assuming a 6% return on plan assets, amortizing any unfunded pension and OPEB liabilities over 30 years (total bars). 

One obvious conclusion is that the ratios vary a lot. Consistent with a country founded on States’ Rights, there are large differences in pension and retiree healthcare systems across states. Many articles in the press over-generalize the issue and neglect to mention that many states do not need a disproportionate share of revenues to service their debts; these states are at or below the green line. When a state is at the red line, however, they’ve got some serious challenges since the math becomes very difficult. The next table shows the 6 states with the highest ratios of fully-loaded debt service to revenues, and what they would have to do to meet future obligations. The reason this is important: these 6 issuers represent 27% of the entire general obligation bond market.

One example: the state of New Jersey

• NJ could increase tax revenues by 26% and leave such a surtax in place for 30 years, using the proceeds solely for pension remediation, or…
• NJ could cut state spending on everything that is non-pension related by 24% for 30 years, diverting the proceeds to pension remediation, or…
• NJ could raise annual public sector worker contributions to pensions by 470%
• New Jersey’s effective state tax rate on middle income earners (including the benefit of the Federal deduction) is already 9%
• New Jersey’s bonds represent 8% of the entire general obligation bond market
• In the absence of changes to taxes, spending and worker contributions, the other states shown could meet their obligations if they earned huge, unprecedented returns on plan assets for 30 years in a row. But for NJ, we could not find a return that would do it

Tax increases will be politically difficult, since some of these states already impose the country’s heaviest tax burdens on middle-income earners. There are some cost-of-living adjustments that states can make (many already have), and many states continue to adjust the scope of retiree healthcare coverage. But aside from these two rather marginal changes, there isn’t much that states can do to alter obligations that have already been accrued.

Since the US is in the grip of yield frenzy driven by years of Fed-induced financial repression, and given the lack of judicial clarity regarding the rights of pensioners vs. bondholders, I'm not surprised that credit spread differentials in the municipal bond market are still rather small, even in the case of Illinois and New Jersey.  But like a distant meteor, there may be a slow but inexorable day of reckoning in the future for some of these states.

Notes

This post is derived from a longer piece on the subject published in May 2016. For multi-employer pension and OPEB plans, we only include the state’s share of pension and OPEB liabilities since local entities are responsible for the rest. One unorthodox approach that has been discussed in some journals: migrating public sector employees to the Affordable Care Act, which could relieve states of some of their OPEB obligations. However, we do not know of any states that have broadly pursued this option.

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