Moody's Proposes Making Pension Liabilities a Bigger Factor in Bond Ratings

Moody's proposes making pension liabilities a bigger factor in bond ratings, which may lead cities to make better financial decisions.
September 19, 2013

States and localities with big pension liabilities could see changes to their overall bond rating if new rules proposed this summer by Moody’s Investor Service are adopted.

Moody’s is proposing giving more weight to pension liabilities and other long-term debts in its overall scorecards for rating general obligation (GO) bonds. The agency would increase the weight to 20 percent from 10 percent and decrease the weight for economic strength to 30 percent from 40 percent. Weights for governance and management (20 percent) and financial strength (30 percent) -- the other two factors in the way Moody’s scores its GO ratings -- would stay the same. The step by Moody’s is just the latest in what has become a marathon of changes by various organizations in recent years that aim to place a bigger emphasis on pensions’ effect on fiscal health.

Interested parties and stakeholders have until Oct. 14 to submit comments to Moody’s.

In its methodology paper, Moody’s noted that debt burden trends are an indicator of a population’s capacity to absorb additional obligations. In the event that a local government’s capital needs are great, this may foretell future financial distress. Thus, a bigger weight should be given to such burdens when considering an overall GO rating. Moody’s said in a release that it chose to reduce the weight on economic health because it recognizes that some local governments are either unwilling or unable to capitalize on the strength of their local economies (i.e., a city may not be able to raise taxes because of anti-tax sentiment).

But municipalities with a large unfunded liability may not necessarily see their rating automatically fall under the new rules, Moody’s said. “We recognize that funding levels naturally will rise and fall as retiree activity diverges from actuarial assumptions, as benefits change, or as investment returns fluctuate. In the case of an unfunded pension liability, Moody’s will examine the reason that it has arisen and the entity’s ability and willingness to address it over a reasonable period of time, which is broadly defined to encompass the working life of the beneficiaries so that liabilities are not passed onto a succeeding generation."

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Only if such an analysis showed a pattern of underfunding annual pension contribution requirements, would a large unfunded liability “be viewed as a negative credit factor because it is a claim on resources that reduces financial flexibility,” Moody’s said.

Moody’s maintains GO ratings or issuer ratings for approximately 8,200 local governments: 2,960 cities, 864 counties and 3,362 school districts.

The methodology change, if kept intact, should bring more attention to dangerous unfunded liabilities earlier on in a municipality’s downward spiral and potentially help retirees, said Frank Shafroth, director of George Mason University’s Center for State and Local Government Leadership. He pointed to cities that have declared bankruptcy like Central Falls, R.I., where retirees had to give up half their pension income, and Detroit, where Emergency Manager Kevyn Orr has said pension cuts will be part of the restricting plan, and said that retirees have far less leverage in bankruptcy than out of it. If cities have more consequences for bad pension finance local officials may be more inclined to right the ship while it’s still feasible.

“We all have a human responsibility to protect these people,” Shafroth said.

The methodology proposal comes after a change Moody’s made earlier this year to the way it calculates pension liabilities. In April, Moody’s announced it would adjust pension debt using a long term bond index rate, a discount rate that would likely result in rates of return smaller than the 7 to 8 percent assumption over 30 years that most governments use in calculating their pension liabilities. The Governmental Accounting Standards Board (GASB) has also taken steps that have the effect of highlighting unfunded liabilities previously hidden in government financial reports. Beginning this year, net pension obligations must now be included as a liability on governments’ balance sheets. Governments should also use what GASB considers a more reasonable discount rate – one that more accurately reflects the current rate of return (generally between 3 and 6 percent for most funds) rather than the higher, historic rate of return.

Breakdown of Moody’s Rating Approach for Municipal GO Bonds

(Four key rating factors and 16 sub-factors)

1. ECONOMIC STRENGTH

a. Size and growth trend

b. Type of economy

c. Socioeconomic and demographic profile

d. Workforce profile

2. FINANCIAL STRENGTH

a. Balance sheet/liquidity

b. Operating flexibility

c. Budgetary performance

3. MANAGEMENT AND GOVERNANCE

a. Financial planning and budgeting

b. Debt management and capital planning

c. Management of economy/tax base

d. Governing structure

e. Disclosure

4. DEBT PROFILE

a. Debt burden

b. Debt structure and composition

c. Debt management and financial impact/flexibility

d. Other long-term commitments and liabilities

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