Municipal bond analysts should expect increased uncertainty as they work to assess the impact of pensions and other postemployment benefits on credit quality in 2024.
Pension risk — the possibility that pension and other postemployment benefit costs can rise to such a degree as to impair a bond issuer's ability to pay its debts — has receded from the headlines, with many public sector employers benefitting from post-pandemic investment gains while maintaining or even increasing their annual contributions.
But with economic uncertainty ahead and the Federal Reserve potentially shifting to interest-rate cuts, analysts should take a closer look at individual issuers' financial disclosures. Some economic trends and individual issuer policy decisions will support continued improvement,
The tight labor market. Many public sector employers are having difficulty attracting and/or retaining employees, which could lead to higher wages or benefit improvements. Pension benefit calculations are typically based on wages, so when wages rise faster than projected by the pension plan's actuary, pension liabilities rise, as do the budgetary requirements to pay for them. Unanticipated benefit increases, such as placing employees in a more generous benefit tier, have the same effect. Therefore, employer actions in response to the tight labor market are likely to increase pension risk.
The return of budget deficits. As surplus funds resulting from, among other things, federal stimulus deposits dry up, we may see budget deficits emerge. Employers who want to close budget gaps by reducing their overall compensation budget may consider an early retirement incentive, in which the employer temporarily grants a benefit sweetener in exchange for an election to retire. Even if positions are refilled, the new employees are likely to be lower-paid than the retiring employees. Depending on the nature of the incentive granted, pension liabilities may rise. Whether the incentive is a financial winner or loser is dependent on the incentive offered, the demographics of those who accept the offer and the number of positions refilled. Thus, the impact on pension risk is unknown until after the program is complete.
Budget stress could also interfere with one of the fiscal success stories of the last decade: Actual pension contributions as a percentage of actuarially determined contributions have been trending up. Data from the National Association of State Retirement Administrators show that after reaching a low of under 80% in the years immediately following the Great Recession of 2008-09, the average contribution reached a little over 100% in 2022. However, as budget stresses take hold, some employers have historically cut back on pension contributions. The pension liabilities don't go away, though: at some point they must be funded, so cutting pension contributions now just pushes those funding obligations to the future—and increases pension risk.
Elevated inflation. Inflation appears to be moderating, but it is still well above the Fed's target of 2%. The impact of elevated inflation can affect pension risk in various ways. It can cause actual wage increases to be greater than the actuary's assumed rate, and it can result in pension plans granting higher cost-of-living adjustments to retirees' pensions than assumed by the actuary. These would drive liabilities higher and increase pension risk.
Re-assessing investment risk. Public sector pension funds' asset allocations have grown steadily riskier over the last 20 years or so, but that trend may slow this year. Bond yields are currently high compared to the recent past, with 10-year Treasuries yielding 4.30% as of Monday, and the Fed has signaled rate cuts in 2024, leading some investors to believe that now is the time to begin shifting assets into fixed-income investments. If funds are able to achieve their target returns while also shifting assets away from riskier asset classes such as equities and alternative investments, then portfolios may be less risky overall and lead to a decrease in pension risk going forward.
Can the financial markets hold onto gains? The performance of pension fund investments relative to the actuary's assumed rate of return is a powerful driver of pension risk. Should actual returns surpass the assumed return, unfunded liabilities should decrease as would future budgetary requirements to pay for them. For the fiscal year ending June 30, 2023, an Equable Institute survey reported an average actual return of 7.05%, which is slightly higher than the average assumed rate of return of 6.9%. So, based on fiscal 2023 reporting, investment returns should, on average, be a neutral factor for pension risk (although individual pension funds' returns can vary widely from the average).
How fiscal year 2024 returns will play out is anyone's guess, but the year started out strong: from June 30, 2023 through February 22, 2024, the S&P 500 index has returned 11.9% and the Bloomberg Aggregate Bond Index has returned 1.1%. If these returns hold, fiscal 2024 will be another year of positive investment performance and decreasing pension risk.
These factors, and others, can affect an individual bond issuer in different ways. It will be important for those involved in credit analysis to keep their eyes on the trends discussed here and factor them into their granular analysis of individual issuers.
Les Richmond, ASA, EA, MAAA, FCA is a Vice President and Actuary at Build America Mutual. He assesses pension risk for all bond issuers BAM considers for insurance.
