(and the Implications for Muni Bonds)
August 31, 2010
Fabian cited a 2010 study by Robert Nory-Marx of the University of Chicago and Joshua Rauh of Northwestern University, Public Pension Promises: How Big are They and What are They Worth?, which said that states now pay $150 billion annually to current retirees. Those costs will double over the next 20 years, but currently they are relatively small compared to state budget deficits, which are estimated to be $215 billion for 2009 and 2010. Those operating deficits were closed, albeit through measures that may not be sustainable (stimulus payments, employer payment holidays, and other accounting gimmicks).
States face much larger problems in their operating budgets than they do though unfunded pension liabilities. As long as states continue to find ways to meet their short-term operating needs, Fabian expects pension problems to remain in the background.
Fabian expects that states will reform their labor agreements to make pension obligations to not-yet-hired employees more manageable.
While investors should not be concerned with the possibility of municipal defaults, ratings downgrades are another story, according to Fabian. Some states will suffer downgrades because of their financing strategies. Illinois, for example, has chosen to continually borrow in the public debt market to fund both immediate and long-term pension costs, and it has scheduled dramatic increases in state contributions based on projected economic growth. That has placed strains on its operating budget. “While the risk of Illinois actually defaulting on a bonded obligation is remote,” MMD said in its report, “its continual replacement of flexible with inflexible obligations is surely moving in the wrong direction.”
Pension liabilities will affect other stakeholders, according to Fabian. Tax rates will go up, there will be less infrastructure investment, and citizens should expect cutbacks in education, welfare, prisons and other social services. “The country as a whole will see slower economic growth, as tax revenues are used to meet pension obligations,” he said. Municipal bondholders, though, will get paid before other fiscal measures are taken.
Unfunded liabilities will continue to make bold and ominous headlines. Many states, like Washington, which have thus far avoided scrutiny, will face problems because of their excessive private equity allocations. For municipal bond investors, though, pension obligations will not lead to defaults in GO bonds.
Fabian recommends disregarding the comments from “market observers” who point at pension issues as a reason to worry over municipal defaults. “Any source making this connection has a limited grasp over what, exactly, they are talking about,” he said.
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