CHICAGO — Municipal investors shouldn’t automatically shun an issuer’s debt due to a severe unfunded pension obligation without a more in-depth review that includes an issuer’s ability to address the liability, Nuveen Investments suggests
Nuveen is the latest to weigh in on the topic of unfunded pension liabilities — a subject that has garnered growing attention from a public confronting headlines warning of the staggering size of unfunded obligations and lawmakers looking to pension funding amid ongoing budget stress.
“State and local pensions and the challenges they pose for the municipal asset class are highly individualized and should be viewed by investors on an issuer-by-issuer basis,” Nuveen senior research analyst Shawn O’Leary wrote in the report, “State and Local Pensions: A Primer for Municipal Investors.”
He said that investors seeking exposure to the municipal asset class, but wishing to avoid issuers with intractable pension problems, should look past the headlines and conduct fundamental credit research on individual issuers.
That’s because headlines that dramatize the size of pension obligations and highlight poor funded ratios provide just a snapshot of the problem. O’Leary said investors digging into an issuer’s pension funding status should review its plan assumptions, annual pension contributions, and funded ratios as they relate to the actuarially based annual required contribution, or ARC, and the amount it represents in an issuer’s overall budget.
Potential buyers also should look at whether the issuer is making the full ARC payment and consider the size of the unfunded liability on a per-capita basis, as a percentage of an issuer’s tax base, and as a percentage of personal income.
When Nuveen analyzes the credit impact of an issuer’s pension obligations, they look at how the funded ratio — the difference between plan assets and liabilities — is reached. Actuaries reach ratio estimates by considering investment return rates, retirement age, inflation, discount rates that assign a present value to futures payments, and annual salary increases. Even slight changes in those assumptions can dramatically change a funded ratio.
The report cites the city of Evanston, just north of Chicago, as one example. It made several modest changes — such as lowering its estimated investment earnings — in assumptions used to determine the funded status of its two public safety pension plans between 2006 and 2007. The changes produced a more than 40% gain in each plan’s unfunded liability.
Investment results are usually smoothed out over a period of time that varies depending on the issuer. While most issuers smooth out results over three to five years, the California Public Employee Retirement System smooths returns over a 15-year horizon.
“The longer the smoothing period, the greater the likelihood the reported asset value will materially depart from current asset value,” the report warns.
Some analysts and public policy groups have warned that funds are counting on overly aggressive investment return rates. Nuveen’s contention is that a more detailed review of how a plan’s assets are invested is needed, or at least a review of a plan’s historical performance, before deciding on whether an issuer’s assumed rates are reasonable.
Nuveen also pays close attention to the actuarially determined ARC and whether an issuer historically has met that payment. “Nuveen takes a dim view of issuers that routinely fail” to meet the ARC. Nuveen also looks at whether issuers are scaling back on ARC payments to inflate the health of their general fund.
The report cites Cook County, Ill., as another example. It reported in fiscal 2008 an unreserved fund balance of $103.6 million but contributed just 52.9% of its ARC payment. If Cook had made the full payment, it would have closed the year with a negative balance.
The report also highlights for comparative purposes the huge pension obligation problems facing Chicago and San Diego, both of which use similar actuarial assumptions. Chicago manages four funds with unfunded liabilities totaling $11.9 billion compared to San Diego which has a $2.1 billion unfunded liability.
Chicago’s liability is $4,374 per capita, more than 2.6 times larger than San Diego. Both cities contributed just over 16% of their general fund revenues to their pension plans during fiscal 2009. For San Diego, this constituted nearly full funding of its obligation. Chicago’s contribution amounted to between 36% to 46% of the amount due to each of its pension plans. A full funding payment would consume 40% of Chicago’s general fund.
“The economic impact of meeting this challenge differs widely,” the report notes.
In San Diego, the issue has received much public, media, and legislative attention. But Chicago’s problem is much worse and has received little attention. A special task force appointed by Mayor Richard Daley did release a report earlier this year warning of the daunting challenges ahead in funding the city’s plans.
Nuveen sees the heightened attention resulting largely from the poor economy as positive.
“When you look at fiscal stress in general, these periods of heightened awareness give elected officials the political leverage they need to effect change,” O’Leary said. “Over the long term, it may come in fits and starts, but we expect they will move towards restructuring these plans in a sustainable way.”
That power from the public — resistant to paying higher taxes or seeing services cut amid ongoing budget challenges — is needed as elected officials face politically difficult decisions, such as whether to anger unions by demanding contribution increases or benefit cuts. Nuveen holds a positive view that governments will improve the status of their pension funds over time and that ultimately debt service to bondholders won’t be imperiled.
