Avoiding Pension Hell for Munis

¹²Up And Down Wall Street: Avoiding Pension Hell for Munis
Huge retirement-plan shortfalls pose risks for states and localities; what investors can do.

By Randall W. Forsyth | 15 June 2010

As greece's debt completes its journey across the River Styx to full junk status, it's easy for Americans to cluck condescendingly at the feckless borrowing and spending practices that put the Hellenic Republic in the fiscal hell in which it finds itself. Moody's Investors Service Monday lowered its rating of Greek debt four notches, to Ba3, essentially matching the cuts by Standard & Poor's and Fitch Ratings. Even though Moody's move followed that of its rivals by a month and a half, it served to remind markets that the European debt crisis is as still with us.

Well, Athens has nothing on Albany, the capital of state of New York in terms of budget legerdemain. Already more than two months late in submitting a budget for the fiscal year that began April 1, New York hasn't had to resort to tactics such as California, which last year paid its bills with IOUs when its coffers ran dry. Instead, New York State merely is funding the state employees' pension system with its IOUs.

"In a classic sleight-of-hand," the New York Times reported over the weekend, New York "will borrow the money to make payments to the pension fund— from the same pension fund."

Notwithstanding such maneuvers, New York actually is one of the better states in terms of its pension liabilities, according to a municipal-finance expert. "The State of New York has many economic and political issues, but it continues to maintain strong funding levels for its pension liabilities," writes Howard J. Cure, director of municipal research for Evercore Wealth Management of New York, in a report to clients. Indeed, New York was among only four states that could boast of having fully funded retirement systems as of 2008, with Florida, Washington and Wisconsin being the others.

After the budget and economic crises of the 1970s and 1980s, New York was forced to implement more affordable pension plans with tiered benefits for newer employees. Under the tentative agreement for this year's funding, New York state and its municipalities would borrow in order to reduce their pension contributions for the next three years, in exchange for higher payments over the following decade, Cure explains. After 2013, they would have to repay the borrowings with interest. (New York City has its own pension plans and doesn't figure into the proposed arrangement.)

On average, state pension plans are 84% funded, according to a February report from the Pew Center on the States cited by Evercore. Ohio and California are 87% funded, while New Jersey is 73% funded and Illinois is just 54% funded, although Cure says the latter two states are "beginning to address some of the most costly, burdensome and generous benefits". Barron's readers are well aware of the massive threat posed to state and local finances posed by public pension plans from Jon Laing's cover story a few months ago ("The $2 Trillion Hole," March 15.) And, as Laing further noted, taxpayers are up in arms for footing the bill for these lush benefits.

"Some 90% of public-sector employees enjoy defined-benefit plans with guaranteed pension payments," according to Evercore's Cure, "compared with on 20% of private-sector employees. The growing resentment of taxpayers who largely lack these benefits but must support them through their taxes is thus understandable." With everyone from Warren Buffett on down warning that American states and municipalities are heading into the financial abyss like Greece and Europe's other debt-burdened countries, what can investors do? After all, households own over $1 trillion in state and local securities. And with income-tax rates certain to head higher, intermediate-to-long-term munis remain the fixed-income asset of choice in taxable accounts.

Cure suggests several tacks for muni investors to deal with the risks posed by public pension funds:

Bonds backed by specific revenue streams, such as sales or personal income taxes, with the debt service on the securities getting first dibs. He cites the New York City Transitional Finance Authority, backed by the city's sales— and income-tax revenues in a strong legal structure that segregate them from general credit risks of the state and city of New York.

Essential-service revenue bonds, such as for water, sewer or electric utilities. Even people who "strategically" default on their mortgages keep paying their utility bills so the lights or water don't get turned off. Moreover, Cure points out most municipal utilities typically only distribute power that they purchase. That means fewer employees and hence fewer pensions.

Bonds issued by private colleges and universities. While they are getting increasing competition from cheaper public colleges, private institutions typically have defined-benefit plans. Universities with substantial endowments and that are broadly attractive to students provide strong bondholder protection.

Finally, go for states with stronger pension funding, which as noted includes New York. Illinois and New Jersey finally have begun to address their pension problems, Cure says, while Colorado and Minnesota are challenging existing retirees' benefits. So, he says, "there is hope for progress in other states as well."

The European debt crisis serves as an example of what happens when public-employee expenses reaching the breaking point. And, no doubt, the pension problems aren't going away anytime soon, barring a swift ascent to Dow 36,000 or some other such miracle. Barring that, bond issuers' pension burden should be a key consideration in muni investors' decisions.

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Normxxx    
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