Notes on Municipal Pension Funds

Introduction to Municipal Pension Funds

A pension is an economic bargain ("deferred compensation") an employee makes to his employer. By making loans to the government in exchange for a series of repayments in the future, the employee expects to earn back his principal in addition to interest on the loan.

Open Questions

• Do Pensions Exceed The Discount Rate?

• How Do Defaults Impact Municipal Bond Markets?

How Are Pensions Funded?

1. Employer contributions

2. Employee contributions

3. Investment returns

Legal Protections for Pensioners

In 2006, the Pension Protection Act was passed by George W. Bush, which required employees to enroll in a 401K to insure against pension insolvency. Additionally, the act specified that pensions with less than 80% of funding be considered at risk of default.

NYS Pension Fund

Eligible members of the fund who are at least 55 years old are entitled to pension payouts. The payout is typically 1.67 percent of final average salary for each year of service, if retired with less than 20 years. With >20 years of service, the payout is 2 percent. >30 years, 2.0 percent, with 3.5 percent for each year of service beyond 30.

Pension Risks

Lower Credit Worthiness

• A pension portfolio is likely to include an allocation of long-term investment vehicles. This can offer investors the expectation of long-term returns, but it also introduces the risk of grift, or Ponzi-like behavior.

• Pension liabilities can constrict a government's financial flexibility, and in 2014, Moody's revised its credit rating methodology and doubled the weight of pension default risk from 10 to 20 percent while lowering the weight of generalized economic factors from 40 to 30 percent.

• A government's creditworthiness will impact its borrowing cost, which translates into a higher burden for taxpayers.

Increased Risk Taking

Higher pension liabilities can increase a government's appetite for risky investments. An assumed return of 7.5 percent assumes that every dollar contributed to the pension fund will be worth $2 in ten years' time, $4 in twenty years' time, and $8 in thirty years' time. However, returns of 7.5 percent can be achieved only with substantial investment risk. If a firm is to decide to pursue returns of this calibre and the investment fails to reach its benchmark, the liability is effectively transferred from present to future taxpayers.

However, the risk of underperformance is dwarfed by the risk of default. Retirees are legally entitled to their pension payouts, so the firm has zero recourse if their investments fail to reach their expected return. Moreover, in the event of bankruptcy, bondholders are required to be repaid before shareholders, which adds additional emphasis to the duty of firms to repay their lenders when payments are due.

Increased Tax Burden

Governments are appealing debtors because of their monopoly on property taxes. Governments unable to fulfill their pension liabilities can impose dedicates taxes on earned income, or limit access to municipal services to cut costs. This effects will come down hard on taxpayers who are forced to subsidize the obligations of their ancestral constituents.

Evaluating Fund Health

Is Funding Ratio the Golden Rule?

Common wisdom says that a 70 percent funding ration as the golden indicator of fund health. This figure is reached from the assumption that a fund need not pay its debts before the amount is due. Since a fund will continue to receive new contributions, the fund itself need not be the exclusive source of payments.

If the contributions to the fund (employer and employee contributions, as well as investment income) are adequate to offset the normal cost and inflation, then the unfunded liability of a plan will not change from one year to the next. [4]

While funding ratio is the prima facie indicator of pension health, it may be considered relative to the general economic strength of the municipality. For example, Illinois has one of the worst funding ratios in the country, with over $111 billion in pension liabilities in 2015.

What Returns Can Lenders Expect?

GASB 68 uses Treasury bonds as a risk-free benchmark for fund returns. This is the benchmark which the fund must satisfy on its balance sheet, but its actual return may exceed this conservative estimate.

The Municipal Bond Business

• Sales Tax is the second largest form of tax revenue, after personal income tax.

• FY 2017-18 tax receipts are estimated to be $13,641 billion, reflecting an increase of 4.1 percent.

Snapshot of Bond Offerings in New York State

NYS is offering bonds to fund DASNY, which manages the living spaces for state-subsidized housing, such as universities and public health facilities.

DASNY is governed by an eleven-member board who remain uncompensated for their services.

• The state issues bond offerings at a rate of 3.6x - 4.9x Debt Service Coverage.

• $5,000 denominations

• Interest paid on March 15 and September 15 each year.

• In 1965, NYS became the 39th state to impose general sales tax, which is currently 4%.

• Sales Tax applies to sales and use of (1) personal property, (2) restaurant meals, hotel occupancy, and "specified admissions and services."

• The Sales Tax is collected from the vendor at the point-of-sale. However, vendors with more than $300,000 of taxable sales in one of the preceding four quarters must remit the tax monthly by the twentieth day of the month following the month of collection.

• Vendors collecting less than $3,000 annually may file their tax each March.

Variables Behind a Bond Offering

• Tobacco tax collections are expected to decrease by $46 million in 2017 due to decreased consumption of tobacco products.

• Highway use tax is expected to decrease by $42 million as a result of the decision to lower decal fees per truck from $19 to $1.50 (Independent Owner Operators of America vs. NY Department of Taxation and Finance).

• 3.9 (projected) increase in sales tax due to population growth.

• Financial aid is financed from federal aid and commercial gaming revenue (casinos).

• NYS Payroll in 2018 is $12.9 billion annually. 60 percent of spending occurs in SUNY, mental hygiene, and department of corrections.

• NYS will pay $5.3 billion in debt service (interest) in 2018.

• NYS workforce is mostly service industry, less manufacturing.

• Financial services accounts for 1/5 of total wages in NYS - 7.6 percent total employment, 19.9 percent total wages.

• Most debt in NYS is from the dormitory authority, followed by the MTA.

Synthetic Fixed Rate Swaps

• Commercial borrowers use swap agreements to reduce the cost of borrowing. By committing to a longer term note (e.g. 10 years vs. 5 years), borrowers can achieve a fixed-rate interest payment instead of a floating-rate interest payment.

• NYS bonds are executed as synthetic fixed rate instruments, which is a hedging technique to manage the risk of an increasing interest rate. The swap is a separate contract from the loan

References

[1] https://bonds.ny.gov/currentOfferings/DA-Sales-Tax-Series-2017AB.pdf

[2] https://www.bloomberg.com/graphics/2017-state-pension-funding-ratios/

[3] https://reason.org/wp-content/uploads/2015/06/asset_sales_leases_pensions.pdf

[4] http://haasinstitute.berkeley.edu/sites/default/files/funding_public_pensions_-_publish.pdf


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