Transcription:
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Mike Scarchilli (00:04):
Hi everyone, and welcome to The Bond Buyer Podcast, your essential resource for insights into everything municipal finance. I’m Mike Scarchilli, Editor-in-Chief for The Bond Buyer, and this week we’re delving into the crucial and ever evolving topic of public pensions. Joining us to explore this issue is Howard Cure, director of Municipal Bond Research at Evercore Wealth Management. Howard brings his deep expertise to our discussion providing a comprehensive outlook on the current state of public pensions, including the impact of strong market performance and rising interest rates on unfunded pension liabilities. In this episode, Howard sits down with Bond Buyer senior reporter Keeley Webster, to discuss how recent improvements in the funded status of public pensions might not be the whole story. They also dive into the challenges still facing many states, the risks pension funds are taking to meet their targets and the implications of pension obligation bonds. With that, let’s get started and dive into this important conversation.
Keeley Webster (01:04):
Hello and welcome to another Bond Buyer podcast. Today I have with me Howard Cure, Director of Municipal Bond Research at Evercore Wealth Management for the discussion on the state of public pensions. In July, Moody’s Ratings reported that strong market performance and high interest rates resulted in a $3 trillion drop in unfunded pension liabilities as of June 30th compared to the peak in 2020, a 60% reduction. And then the Equitable Institute reported that the average funded ratios for pensions are expected to be 80.6% for 2024, which is better than they’ve been for some time, though equitable also warned that pension funds appear to be taking on greater investment risk to hit that target. So Howard, what is your outlook on pensions given this set of circumstances?
Howard Cure (01:56):
Well, hello Keeley and thank you for having me. And hello to your listeners. Clearly the pension situation for municipalities and states has improved from where it was 10, 15 years ago. There is no doubt in my mind that these entities have started focusing on these issues. The bond market has started focusing on these issues over that period the rating agencies have. So there’s been a lot of progress where analysts were afraid that this was a systemic problem. It’s now I think, more idiosyncratic with fewer issuers having as great a burden as they did in the past. So that’s overall what I think there’s still plenty of room for improvement. You have to admit that part of this recent improvement in the statistics that you cited were due to a very much improving muscular equity markets in the United States, and then also rising interest rates, which has potential problems for some parts of the economy, but helps if you’re investing in fixed income.
(03:29):
So that’s been an important point. The other things are, over that period of time that we started with, I think a lot of entities have become more aggressive about cracking down on individual employees abuses of the system where they were looking to inflate their numbers. Toward the end, I think there’s been negotiations with new employees about not quite as generous benefits. There’s clearly been an increase in the amount of money dedicated to the funds for pensions as well as more conservative assumptions about the discount rate and rates of the rate of return. So I think overall the situation has improved a lot.
Keeley Webster (04:32):
Okay. So some would argue that pensions should always be 100% funded. What’s your view on that?
Howard Cure (04:40):
Ideally, they should be 100% funded, and I think views like that sort of incorporate what corporations have to do with their pensions because corporations should be a hundred percent funded since they have the potential much more so than cities and states of essentially going out of business. So not only are they higher funded, but they also have more conservative assumptions on things like their discount rate, which is based on yields of high-quality bonds rather than expected returns that cities and states use. So I think the difference is you have a longer horizon for most public pension plans, so it gives you an ability to invest with a little more risk also because these entities have hopefully for them a captive population and you could raise revenues to help support pensions by raising tax. So I think it’s a different perspective. I think the being funded is going up and the goals are for all these entities to ultimately have a hundred percent funding or pretty close to that, but it will take a number of years still because it took a number of years to get into this mess to begin with. So it can’t be done overnight without putting a tremendous burden on the taxpayer. So it has to be done gradually.
Keeley Webster (06:28):
So historically, really it’s more been maybe since 2008, and I don’t remember exactly when. I don’t know if it’s saying it correctly to say that pensions weren’t really on the balance sheet before and they started taking them into account, and I think municipalities were more concerned about making bond payments and taking care of that. But when the rating agency started taking notice and it ended up being a GS B factor, that kind of changed things. So can you speak to a little bit about that, and do you think that pensions are more solid as a result of all of that, and do you think that was a needed improvement?
Howard Cure (07:21):
It was a neglected area that needed improvement. You cite 2008, so that’s the financial crisis. So also at a time when interest rates started and continued to go down up until pretty recently. So it used to be that a pension fund could gain a significant amount of their earnings just through fixed income because interest rates were high. Then they had a resort to using equities and more risky assets in which to invest. So you had that. Then I think what under the radar for a lot of analysts is the fact that for cities rather than increasing salaries where there might be a tight budget and you would have a yearly expense, they shifted from increasing salaries to increasing benefits. It could be health benefits, which is a whole other story, but really pension benefits, more generous pension benefits, and you brought up a comparison of pensions to bonds and debt service because if an entity were to miss a payment on debt service, you would immediately have the bond holders and a trustee coming after them. But it’s easier to neglect making your full yearly pension payment when it doesn’t have an immediate effect on the pension system or the payouts to the pensioners. So it’s something that really needed attention, and I think the analyst community is glad that there were enough events going on that really brought into question the viability of the pensions and the attention for this what would be considered a long-term liability, not much different from debt.
Keeley Webster (09:36):
So how did, well, you actually already went into how pension funds got into the situation they were in, that it became a primary concern of rating agencies. So do you think we’re seeing headway among the states that were struggling with the issue?
Howard Cure (09:52):
You’re starting to see headway with the states that were struggling. I mean, it took years for New Jersey just to start making their full pension payment on a yearly basis, or the term is making sure treading water where it doesn’t get worse by making the payment, then you have now started to exceed that. Illinois also and Connecticut all have become adherence to making these payments and then some, because there have been a lot of budget surpluses going on as well. So it’s become easier. But muni analysts have a long memory and you don’t know if some of these states could revert back to their bad practices where if they have a tight budget, would they resort to making cuts in their yearly pension payment, which is significant part of the budget now versus either raising taxes, revenues or making cuts in other areas. So how committed, the question is, how committed are they to making these pension payments these costs every year? Are they as committed as to making debt service payments because that’s the way it’s viewed.
Keeley Webster (11:21):
What are you seeing in terms of states like New Jersey and Connecticut that have wrestled with the issue of having a high level of unfunded liabilities? Are they on the right track or do they have a lot more ground to cover to be truly sustainable?
Howard Cure (11:33):
Yes, and yes, if they’re on the right track, they had such a large pension liability that it’s going to take years to get themselves out of that problem. So they’ve shown discipline, but keep in mind that over the last few years there have been pretty significant surpluses generated from a strong economy and federal aid that came in during Covid. So again, the question is how disciplined are they? Will they continue to be disciplined in a down economy and without the federal aid coming in to help? So it’s still a matter of wait and see. They’re on the right track, and I think it’s been recognized from the bond community in tightening spreads and the rating agencies, which used to consistently cite the problems of the pension funding situation as reasons for the continuing downgrades of these entities.
Keeley Webster (12:53):
I know that Hawaii has, but they basically have baked, they baked it into legislation that they have to prepay that with other states. Are you seeing them set it into public policy so that they will continue to make these payments even in downtimes, or do you feel like it’s too much up in the air and really based on how they’re doing financially?
Howard Cure (13:28):
Well, just because it’s set in legislation doesn’t mean it can’t be unset through legislation. So it’s a burden for a lot of these entities to pay these fixed costs every year. And it’s a problem in a sense that you’re paying your employees a benefit that most of the general public doesn’t get anymore. They don’t have these index pensions or pensions generally. So you really have to be committed to both make the payments on a consistent basis through good times and bad and be willing to explain to the voters that this is why we have to make these payments. The other thing I just want to point out is that it gets hard to recruit public employees because there is pressures on pay compared to the private sector. This is an important benefit that has to be used as a recruitment method as well. So it’s important on a number of different fronts, but it’s painful for an entity because it’s really starting to consume a large part of the personnel costs. And these are entities that are very personnel driven as opposed to capital driven. So it’s expensive.
Keeley Webster (15:09):
So New Jersey’s major pension fund is still only funded at 54% and doesn’t expect to hit 90% funded until 2047. Is the state’s pension fund considered sound at that level, or are they getting credit from the ratings agency because it’s a vast improvement from where they were?
Howard Cure (15:27):
They are getting credit, and you could see it in the rating changes, both getting rid of negative outlooks and or actual rating upgrades. But I could bet you that if they were to forsake that and start funding below their tread watermark for a few years, they will get downgraded. It’ll be noted, and their spreads will widen from the bond community because of that. So it’s still the onus is on the state of New Jersey to show their commitment to this and improvements.
Keeley Webster (16:05):
So do you think public pension funds have lowered their return assumptions enough given the average is still above 6.5% and common wisdom is the stock market returns 5% over time?
Howard Cure (16:18):
They probably could lower it a little more than what’s been done, but as I mentioned earlier, they have a slightly different perspective in that it’s a longer term horizon and they aren’t a corporation that’s going potentially out of business or it’s been very rare that that happens. So you would like to see it as low as practical. What I focus a little bit more on is the actual investments, which I’m sure you’ll want to get into, but this has been an opportunity to start shifting the investment portfolio because of rising interest rate to more fixed income, safe fixed income, and that really, based on what I’ve been reading in various studies, hasn’t been done. So one of the concerns besides the political pressure and the economics and the cost of funding these large liabilities is to make sure you don’t suffer inordinately endowed markets.
Keeley Webster (17:36):
So equitable mentioned in the report, and you and I had talked about it before, that they were concerned about the risk profile and a lot of the pension funds that they had taken on too much risk. It sounds like you’re saying also that you’re concerned that they’re not shifting fast enough over to fixed income to cover that with rising interest rates. Am I reading that right? Or
Howard Cure (18:00):
You are reading that right? You’d think they would make more of a shift to fixed income in this environment. If they can get four or 5% pretty consistently, that would go a long way. And imagine if they had lowered some of their discount rate or return on assets assumptions to 5%, that would be easy then to make your mark because it’s safe fixed income. So they’re going into things besides the stock market equity and different variations of large, small, medium cap international. They’re also getting involved with private equity and derivatives and distressed debt. And one of the risks in those areas is unlike bonds or equity in large markets where you can mark to market, you’re now marking to management. You don’t quite know if there’s a market, if you need to liquidate also. So it’s volatile and you really need to have sophisticated managers overseeing this. And if you needed to liquidate, it might not be that easy if you’re forced in a down market for some of these more esoteric type of investments.
Keeley Webster (19:25):
So one solution that some cities have turned to deal with pension liabilities or pension obligation bonds, do you think they are a valuable tool or something that cities shouldn’t consider?
Howard Cure (19:35):
So I follow the Government Finance Officers Association sort of guidelines on this, and they think it’s a bad idea as do I, because it’s essentially a bet. You’re making a bet that you’re going to be paying, these are going to be taxable bonds just by basis of the use of proceeds. You’re going to be taking those proceeds and financing and investing those monies. So you’re hoping that the earnings on those investments will exceed the cost of your capital for these bonds. And let’s say you were to do this today with the equity markets at near record highs, are you risking a dramatic drop off right at this time? So not only would you have a loss in your investments, but you still then have to pay the debt service on the pension obligation bonds, and there are other areas that used to be more pronounced.
(20:50):
Well, it was difficult to call the bonds because you had to make whole call provisions in the past. So if you were unhappy with the interest rates you were paying on the bonds, you really didn’t have an opportunity to refinance it, although they’re making some changes to those provisions, but it’d be more expensive. You’d have to pay a higher interest rate to remove those, make whole provisions. And you could also, I guess, invest the proceeds because you’re not bound by public finance law since it’s taxable over a gradual period of time, rather than essentially dumping all the proceeds into your investments at once. But overall, I’m not a big fan of it. And then you have to also try to understand the thinking behind these pension obligation bonds from the issuer. Are they desperate to relieve their large liability and are they committed to continue to make their annual payments not only for the debt service, but also to continue making their payments to fund the pension funds? So you have to really speak to the issuer and understand the philosophy and be convinced that they’re sophisticated enough to understand all of these risks.
Keeley Webster (22:23):
So it doesn’t sound like you would be an investor in them, but if you were an investor, I mean, are those some of the questions you would ask? Are you trying to close a budget hole here or, and does this fit in with your other investments? I mean, what are some of the,
Howard Cure (22:45):
I mean, you have to take a holistic approach on this and understanding, making sure you’re comfortable with their budget process. Are there audits coming in on time where their major sources of revenues have there been problems? What’s the underlying economy? What’s the demographics of the city as far as a growing tax base? And as well as understanding if it’s a shrinking city and you have fewer employees contributing to the fund pension fund and you have a large amount of retirees, well, that’s not a good trend either. I mean, eventually it’ll help, but at this moment it may not. So you really need to be convinced of a commitment and an understanding for all these issues.
Keeley Webster (23:43):
So is what I had heard from some of the financial advisors who worked on the wave of them that kind of appeared before 2000 and maybe, I mean not 2000 before 2020 into 2020, was that they were not, in most cases, taking them out to 30 years on the maturities. They were doing maturities of 10 to 20 years and that they were not putting hold provisions in them, and they were baking a callable date into it, which some of the historic ones hadn’t done. Do you think that takes away some of the concerns that GFOA had around them before or do you still think they’re a bad idea?
Howard Cure (24:37):
I think it takes away some of the concerns. I still think the preference would be for entities to have a plan to fund their pension liabilities, to get rid of them on a gradual basis and a commitment to that. You’re still taking, at the end of the day, a risk because you’re making a bet about what the markets are going to do when you start investing the proceeds versus the additional liability you now have for paying off the debt.
Keeley Webster (25:11):
So there was a huge wave of these from Illinois and California. Like I said before, the 20 20 21 timeframe, they started to fall off. Do you think we’re going to see problems with them like we did from the ones that were issued a decade or more ago?
Howard Cure (25:35):
Well, that depends on how those proceeds were invested, frankly, because if they invested heavily in equities, the stock market’s done so well, and if they’ve done it a few years ago, interest rates on their liability, the pension obligation buttons were so low that they might’ve done pretty well. So I don’t anticipate, assuming they’re still committed to continue to make their payments for their overall pension liability, I don’t necessarily foresee this doom rate to come over these cities.
Keeley Webster (26:15):
So this has been a really insightful conversation. I really appreciate taking the time to speak with us today, Howard.
Howard Cure (26:22):
It’s my pleasure. Anytime.
Mike Scarchilli (26:25):
We hope you enjoyed this episode. A big thank you to Howard Cure for joining us and to our own Keeley Webster for conducting the interview. Let’s review some key takeaways from this conversation.
One, public pensions have shown improvement with a significant reduction in unfunded liabilities thanks to strong market and higher interest rates. However, this progress may not be sustainable if the underlying economic conditions change.
Two. Despite these gains, many states still face significant challenges in managing their pension obligations. The commitment to consistent funding remains critical, especially in the face of potential economic downturns or reduced federal aid three pension obligation bonds while offering a potential solution for underfunded pensions carry significant risks. As Howard noted, they essentially represent a bet on market performance, which can backfire if not carefully managed investors and municipalities alike need to approach them with caution.
Thanks again for listening to this Bond Buyer podcast. This episode was produced by The Bond Buyer. If you enjoyed this episode, please hit like and subscribe on your favorite podcast player, and please rate us, review us and subscribe to our content at www.bondbuyer.com/subscribe. Until next time, I’m Mike Scarchilli signing off.