Moody's Sees No Rating Changes Despite Investment Drop

Major declines expected in the value of state and local government pension investments may have a negative impact on pension funding levels, but are unlikely to result in immediate ratings changes for municipal issuers, Moody's Investors Service said in a report released yesterday.

Sharp decreases in the value of retirement systems' investments, as reflected by large drops in stock indices, come not only as stocks are on track for one of the worst years in recent memory but also as "alternative" investments such as hedge funds, which pensions have used to offset exposures to stocks, have also suffered major losses, the report said.

"Any losses will trigger increased funding requirements for state and local governments during the next several years, when budgets are already likely to be strained by deteriorating economic conditions," said the report, which was written by Moody's assistant vice president Ted Hampton. "Even so, because of the long-term nature of pension liabilities and investment horizons, Moody's does not foresee an immediate impact on state and local government ratings."

The report comes as many states with large unfunded pension liabilities have disclosed that the value of their funds have fallen dramatically over the course of the calendar year.

In a statement last month, New York Comptroller Thomas P. DiNapoli said that the value of the state's Common Retirement Fund has fallen about 20% since April 1, when it was valued at about $153.9 billion. Florida saw the value of its primary employee pension fund decrease about 20% from $126.9 billion June 30 to about $100.5 billion at the end of October. Massachusetts' state employee pension fund dropped 25% from January through the end of October, falling from about $53 billion to about $41 billion.

Though officials in those states noted that some of the declines are attributable to pay-outs for pensioners, most of the losses stem from declines in the stock market. New York and Florida officials also said that their funds are historically fully funded. In fact, as of June 30 Florida's fund had a funding ratio of 107%, which means it had more assets than liabilities at the end of its fiscal 2008.

Investment declines are not limited to just state governments. Localities are also experiencing sharp losses, too. For instance, Philadelphia Mayor Michael Nutter said last week in a letter to Treasury Secretary Henry Paulson that the city's pension investments declined $650 million January through September. Nutter cited the losses as part of a plea for access to more than $50 billion in Treasury assistance for cities under the $700 billion Troubled Asset Relief Program.

Meanwhile, Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management LLC, said that several school districts now have annual pension contributions that equal or exceed their debt service levels, especially in Michigan and Ohio and some southern states, where the public pension systems replicated generous terms offered by private companies, particularly in the auto industry.

When faced with expected increases in their pension burdens, along with new requirements that they account for retiree health care benefits, states and localities are presented with a "daunting task," Ciccarone said.

"This also sheds light on the issue of whether the current investment-return assumptions used by governments are accurate and reasonable," he said, noting that many states expect average annual investment returns of over 8% and localities expect returns in excess of 7%.

In its report, Moody's noted that the vast majority of issuers have pension plans with plenty of assets to meet their obligations to retirees this year and in the immediate future. But, Hampton said, as the value of their investments decline and the value of their unfunded pension liabilities rise, the question becomes: what will issuers choose, or be forced, to do to improve their funded status?

One option mentioned in the report involves the sale of taxable pension obligation bonds to address "emerging or widening pension funding gaps."

Issuers have sold taxable POBs for years under the assumption that the return on investments made with the bond proceeds will be greater than the yield on the bonds themselves, allowing the issuer to better manage their year-to-year contributions that would otherwise be made on a pay-go basis.

"These transactions will add to debt burdens, but they will also improve funded ratios, at least in the short term," the report said.

But the ongoing economic crisis has made it impossible for issuers to sell POBs, as traditional buyers for the paper have disappeared and the cost of issuance has skyrocketed, sources said yesterday. Earlier this month, Philadelphia added itself to a growing list of states and localities to delay the issuance of a large POB transaction, citing market turmoil.

Because the actuarial valuation of public pension plan assets is based on an average of several years, rather than the most recent market value of the assets, the impact of the investment losses will be spread over a period of five to seven years through a "smoothing" process, Moody's said.

And the losses will not immediately cause the contribution rates to increase for some pension plans because the rates already have been set for the next year or two.

"Actuarial valuations reflecting the current stock market downturn therefore generally will not begin to affect budgets prior to fiscal 2011," Moody's said, noting that New York and the local entities participating in the state's Common Retirement Fund actually will see lower pension contributions rates for the fiscal year beginning April 1, 2009, even though the fund has lost over 20% so far in the current fiscal year.

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