Bonds

Why muni analysts need to focus on pensions during COVID-19 recovery

When the spread of the COVID-19 pandemic caused swift and severe losses in the stock market in March 2020, municipal bond investors immediately focused on the potential risks posed by public pension funds — in particular, the specific challenges posed by declining asset values.

Those concerns faded relatively quickly, after substantial Federal stimulus aid helped fuel a market bounceback that largely erased the losses by the end of most funds’ fiscal years on June 30th. Additional stimulus from Washington appears to be imminent, and can further cushion the blow to Fiscal 2021 budgets. However, pension issues should remain central for municipal bond investors because state and local governments’ fiscal policy decisions made today could have long-term implications.

Assessing pension risk for a given issuer means determining how its pension costs will impact the budget, and potentially affect the ability to pay debt service. To date, investors and policymakers have primarily focused on how the risk profile could be elevated by pandemic-related factors that are beyond an individual issuer’s control: Asset values and demographic trends.

The next phase of pension risk analysis will be different and more challenging: Assessing the long-term impacts of individual jurisdictions’ choices in the context of their unique workforce demographics, benefits and salary structure, and pension funding status.

The origin of this recession is very different from the Great Recession of 2008-09, but some issuers are likely to experience a similarly dramatic reduction in local revenues. The National League of Cities surveyed 485 cities for its “City Fiscal Conditions 2020” report, which revealed that cities anticipate an average 13% revenue loss when comparing fiscal 2021 to fiscal 2020.

This anticipated revenue decline is similar to that experienced in the years following the Great Recession. Actual revenue declines will vary from jurisdiction to jurisdiction, based on such factors as severity of the pandemic’s impact on revenue, industry mix, and sources of government revenue, but it is reasonable to assume that we may see many state and local governments respond to pandemic-related revenue losses with some of the same tactics they employed during and following the Great Recession.

That creates an opportunity to look back on the budget policy choices made then and their impact on pensions to get a sense of how the current economic crisis may impact pension risk in the next decade. These actions are divided into those that can increase risk, decrease risk, or can either increase or decrease risk depending on individual circumstances.

Policy Changes That Typically Increase Risk

Pension funding “holidays.” Decisions by pension plan sponsors to reduce, defer or skip pension contributions were widespread during the last recession. The National Association of State Retirement Administrators’ (NASRA) Public Fund Survey, which encompasses about 85% of the U.S. public pension universe, shows that between 2008 and 2011, both the percentage of actuarially determined contributions (ADC) received and the number of plans receiving at least 90% of the ADC declined. The data supports the conclusion that when governments were faced with tough financial choices, service delivery won the battle of the budget dollars against pension contributions.

In pension risk analysis, sound plan funding is extremely important. At BAM, we define sound funding as a policy under which the annual contribution will pay for the current year’s benefit accrual plus an amount to pay down unfunded liabilities over a reasonable period of time (BAM uses a maximum of 30 years for this purpose). Critical to municipal credit is the fact that if contributions are too low today, future contributions must make up the shortfall, exacerbating pension-related budgetary burdens in the future. In extreme cases, this could even crowd out the ability for a bond issuer to pay debt service.

Taking on more investment risk. The 21st century has been marked by the dual trends of public sector pension funds taking on more investment risk at the same time that pension plan populations are becoming more mature in that greater portions of pension plan populations are becoming made up of retirees. These trends picked up steam in 2008-09. As revenue losses caused employers to make workforce adjustments, many workers retired. At the same time, employers were tempted to make riskier pension fund investments in the hope of earning greater returns that would stem the tide of increasing contribution requirements. Public Fund Survey data further shows that beginning in fiscal 2009, the percentage of pension plans’ asset allocations to equities held fairly steady, while the allocation percentages to alternatives rose and to fixed-income investments declined.

In terms of pension-related credit risk, taking on more exposure to equities and alternatives (and similar investments that pair higher expected returns with elevated volatility) at the same time that a population is becoming more mature increases risk because it raises the chance that a short-term drop in asset values could coincide with the fund’s need to sell holdings in order to pay benefits — forcing the fund to lock in a loss and raising future funding requirements. At BAM, we consider pension fund asset allocation-related investment risk in the context of plan demographics, such that the level of investment risk should decline as a plan population matures. Data shows that this risk increased in the years following the Great Recession.

Policy Changes That Typically Decrease Risk

Benefit and Funding Reforms. In a 2018 paper, “Spotlight on Significant Reforms to State Retirement Systems,” NASRA noted that since 2009, almost every state had “passed meaningful reform to one, or more, of its pension plans.” In light of revenue losses related to the COVID-19 pandemic, it seems reasonable to assume that public sector pension plan sponsors will again turn to pension reforms as a way to level off or lower the trajectory of projected required contributions. While the implementation of benefit reforms almost always decreases pension risk in municipal credit analysis, some types of reforms are more effective in that regard than others. BAM attributes greater positive credit impact to reforms that take effect immediately (like increased employee and/or sponsor contributions or benefit changes that impact current employees), because they are more effective in reducing risk than reforms (such as a new, less generous benefit tier affecting only future new hires) that may take many years to have a material impact.

Policy Changes That Can Increase or Decrease Risk

Many actions taken in response to the Great Recession had impacts on pension risk that can only be evaluated in the intermediate- to long-term, because analysts need to wait and see how they interact with developments that are outside the policy makers’ control, like long-term investment returns.

Workforce adjustments. In this context, “workforce adjustments” is really a euphemism for “cutting payroll expenses.” When revenues are deficient, governments are sometimes tempted to reduce payroll (through steps that can include layoffs, pay freezes, and early retirement incentives) in an effort to cover some or all of the deficiency. The impact on pension risk is dependent on such factors as the specific action taken, the economic and demographic impacts of the action, and follow-up actions taken after the fiscal crisis eases, such as backfilling positions and retroactive pay increases. Future actuarial measurements would indicate the ultimate impact of these actions on pension liabilities and contribution requirements and related pension risk.

Pension obligation bonds. The typical form of pension obligation bond (POB) issuance consists of issuing a bond at a low interest rate, then depositing the proceeds in the pension fund and investing them in assets that would (hopefully) earn more of a return than the interest paid on the bond. Because there are more assets available in the pension trust, pension contributions decrease, but debt service payments increase. Thus, for the POB to be a financial “winner” for the issuer, pension fund asset returns on the bond proceeds need to exceed bond interest paid. In today’s low-interest environment, this would appear to be easy to do — but it is not guaranteed. Also, the debt service payments on the POB can be structured in many ways, and possibly even extend the payment period otherwise used to pay down unfunded pension liabilities — which may be tempting when confronting pandemic-related revenue losses. The impact of POBs on pension risk, therefore, can only be determined once more details are known about the specific issuer’s issuance plans, and pension fund asset returns over time.

The true impact of the COVID-19 pandemic on state and local government pension risk will be defined by actions taken by bond issuers to confront revenue losses. Some of these actions can reliably be predicted to increase or decrease pension risk, but others will require future actuarial measurements to determine their impact. It is important when analyzing a bond issuer’s credit risk, to carefully consider its specific actions, if any, and what they imply for the issuer’s ability to pay their debts.

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