The Week in Public Finance: Why Some Pensions Are Falling Behind, Stress Testing States and More

A roundup of money (and other) news governments can use.
by | August 12, 2016

Want to read this regularly? Subscribe to "The Week in Public Finance" newsletter for free.

Pollyannaish About Pension Returns

Houston is fighting a losing battle with its pension system: The unfunded liability between Houston’s three plans totals at least $3.9 billion, up from $212 million in 1992. Meanwhile, pension costs as a percentage of the city’s revenue have doubled since 2000 and were one of the reasons behind a recent credit rating downgrade.

A new report from Rice University’s Kinder Institute identifies two main culprits for the funding crisis: Even though the city is now paying its full pension bill, it’s still not enough to chip away at the unfunded liability, and the three plans have assumed investment returns of between 8 and 8.5 percent -- that's higher than the national average and even higher than their own recent experience.

The report's authors looked at examples of pension changes in other major cities and highlighted potential solutions, including raising the cap on the city’s revenues so it can generate more money for pensions; increasing employee contributions; and reducing cost-of-living payments to retirees. “All of these options would generate different amounts of funding in different time frames,” the report said. "[But] none would likely solve the problem alone.”

The Takeaway: Houston’s predicament shows the dangers of consistently not making the investment return target. Of course, Houston's not alone. Alabama's unfunded liability has steadily increased over the past 15 years even though the state has consistently paid its full pension bill. A report conducted by the Pew Charitable Trusts found that the system’s 8 percent investment return assumption is partly to blame.

A danger in assuming a too-high rate of return is that it masks the true unfunded liability. That’s because the better the investments are expected to do over time, the less money a government needs to put in the system now. To illustrate: the city’s municipal employees plan (Houston’s largest) reports a $2.2 billion unfunded liability. If the plan uses its actual average rate of return since 2001 -- 6.2 percent -- it shoots up to a whopping $3.1 billion.

Most pension systems have lowered their return assumptions since 2000 from more than 8 percent to about 7.5 percent. Still, roughly one-quarter of plans assume an 8 percent average return or better.

Coming Back to Earth

After several months of gangbusters activity in the municipal market, the pace of new bonds issued by governments has slowed. In July, a total of $26 billion in bonds were brought to market. That's down from July's 10-year average of about $30 billion.

During the first six months of this year, a total of $221 billion in bonds were issued by state and local governments. Most of that activity came during the second quarter, specifically in May and June when the volume of new bonds in each month was the highest since 2008.

The Takeaway: One slower month is not a reason for concern as the conditions favoring the municipal market right now still hold. Those conditions include negative interest rates abroad and market uncertainty in Europe following the Brexit vote. In fact, reports RBC Markets’ Chris Mauro, activity in August looks on track to once again finish above the monthly average. Mauro said he is sticking to his recently increased prediction that new bond volume this year will finish somewhere between $400 billion and $425 billion.

And Landing With a Thud

A recent test performed by Standard & Poor’s Global Ratings found that Connecticut, Illinois, New Jersey and Pennsylvania are the states most likely to feel significant fiscal stress in the event of an economic downturn. The company performed what’s called a stress test on these and the other six top-borrowing states' 2016-2017 budgets. They looked to see  what would happen if global economies, such as those in the U.K. or China, slowed down more than anticipated.

Florida, New York and Washington state were the best-positioned for a downturn; while California, Massachusetts and Wisconsin landed in the middle, according to the results.

The findings aren’t too surprising, given that the four worst-performing states have continually struggled to balance their budgets since the Great Recession. Illinois, for example, has no reserves to cover the revenue shortfall generated in S&P's scenario. Florida had more than enough.

The Takeaway: Fiscal stress tests used to just apply to banks but are now increasingly being applied to government finances as well. In fact, the Governmental Accounting Standards Board is exploring financial stress indicators for governments and is asking governments to fill out a survey to help inform its research.

The depth of the recession and the markedly slow recovery have driven the interest. “While some governments were overwhelmed by forces beyond their control, many were simply underprepared for an economic downturn, regardless of the size,” wrote Moody’s Analytics economist Dan White in a column on stress tests. “This lack of preparation left some policymakers budgeting without a net at the absolute worst time.”

Want to read this regularly? Subscribe to "The Week in Public Finance" newsletter for free.