This is part of an ongoing series called Finance 101 that goes back to the basics to help public officials.
True or false? As unfunded liabilities have swelled following the Great Recession, most government employers have switched employees to a defined contribution (401k-style) pension plan.
A fair number of state and local governments have introduced 401(k)-style plans (see the National Association of State Retirement Administrators’ breakdown here). However, generally speaking, plan design changes only apply to employees hired after the date of the reform because of the legal protections of pension benefits. This means that only a small fraction of a government’s employees would be under the new plan.
Any Town, USA's parking authority is having trouble meeting its revenue-backed debt payments. Any Town decides that it would be too tight a financial squeeze to cover the authority's debt payment and declines to do so, noting that the bonds are not backed by the city government (General Obligation debt). What is likely to happen?
A) The parking authority will miss its payment but it won't count as a default unless more than three payments in a row are missed.
B) The parking authority will go into default but it won't hurt Any Town because the city is within its legal right to decline making the payment.
C) The parking authority will go into default and Any Town's credit could also be damaged because it refused to cover the payment.
D) The parking authority will go into default, forcing the city into bankruptcy.
As Municipal Market Advisors Analyst Matt Fabian puts it in Governing's Financial Illiteracy feature, a government allowing a default on a bond tied to a lease is tantamount to a default on a general obligation bond. That means that credit agencies view such defaults unfavorably, even though a government may not be legally bound to cover the bond payment. Vadnais Heights in 2012 saw its credit downgraded to junk status for failing to back revenue bond payments on a $25 million sports complex. Wenatchee, Wash., met the same fate for refusing to support a regional sports arena that defaulted on nearly $42 million in debt also in 2012.
Which of the following will help NOT reduce a pension plan's current unfunded liability?
A) Switching all new hires to a 401(k)-style plan
B) Suspending Cost-of-living adjustments for retirees
C) Increasing the retirement age for current employees
While switching new hires to a 401(k)-style plan will help a government manage future pension costs, unfunded liabilities refer to the value of future benefits payable (to current employees and retirees) minus the net assets of the fund at a given balance date. Therefore, changes made in the future won't affect what government's already owe.
Changing the COLA, however, does impact what a government will pay retirees on top of their vested pension. In the same vein, raising the retirement age will change when a current employee's pension vests and when a government can expect to start paying that pension. So, these two changes would impact the value of future benefits payable to retirees and current employees (the total liability).
When talking about pension funds, what does the "discount rate" refer to?
A) The rate of return actuaries use to determine future liabilities.
B) The rate actuaries charge their investment fund clients.
C) The rate of return in any given year.
Also called the assumed rate of return, actuaries apply this rate in a formula to estimate the present-day value of a plan's future liability. In a simple example, if John owes Jane $100 five years from now and he is going to invest money at a 10 percent rate of return, he would have to put away $62 today. (He'd actually have $104 at the end of five years.) Pension fund actuaries commonly use discount rates between 7 and 8 percent.
Which of the following can NOT be found in a CAFR (Comprehensive Annual Financial Report)?
A) Current assets
B) Current liabilities
C) Campaign finance spending
D) Total debt service
E) Infrastructure investment
CAFRs cover just about every financial aspect of government, which is one of the reasons they take so long to produce. Most are released at least six months after a government's fiscal year ends. The spending by an official's political campaign finance, however, is not only an entirely separate entity, most ethics law specifically bar conducting campaign-related work in government buildings.
What is a good rule of thumb for a government's debt service ratio (the annual cost of principal and interest on debt divided by the total expenditures)?
A) 1 : 1
B) 15% or less
C) Between 10% and 30%
D) 3 : 1
Which of the following is a true statement about OPEB? (Other Post-Employment Benefits)
A) Their unfunded liabilities are lower than pension liabilities because they are better funded.
B) OPEB benefits have constitutional protections in most states similar to pensions' protections.
C) Most states do not have an investment fund from which they pay these benefits.
D) Most states and localities are phasing out OPEB entirely.
While it is true that OPEB unfunded liabilities tend to be lower than pension unfunded liabilities, a small handful actually have established a trust to pay out those benefits. (Also, before 2004, governments weren't even required to report their OPEB liabilities at all, which made them easier to ignore.) What helps keep the alarm bells from sounding is that retiree health care (and other) benefits are generally not afforded the same protections as pensions are, which makes them easier to reduce if need be. Still, that's not always the case - in the fall of 2013, a judge sided with two employee unions in a case brought against the city of Los Angeles' OPEB cuts. That ruling found that health subsidies are a vested right in the eyes of California law and the city could not unilaterally change policy without providing relatively equal replacement benefits.
True or False? Most states protect pensions through the constitutional provision that protects contracts.
How many states allow to some degree their municipalities to file for Chapter 9 bankruptcy?
Broken down by category, 12 states specifically authorize Chapter 9 filings; 12 authorize a Chapter 9 filing upon meeting conditions met and further action/approval from state officials or other entity (such as a receiver), and in three states, municipalities have limited authorization. The remainder of states either do not outline an authorization at all for Chapter 9, the laws are unclear or, in the case of Georgia, the filing is specifically prohibited. For full details, see Governing's bankruptcy laws map.