Inflation threatening large city pension funds

BY SourceMedia | MUNICIPAL | 09/27/22 02:30 PM EDT By Scott Sowers

The corrosive nature of inflation on the country's economy is sending up worrying signals regarding the financial health of public pension funds in several major U.S. cities.

A report authored by S&P Global Ratings analyst Stephen Doyle found "Broad-based inflation increases during 2022 led to weakening economic conditions and lower market returns. We believe positive market returns from 2021 have been or will be erased in 2022."

An in-depth analysis charting current pension costs vs. long-term costs as represented by unfunded pension liability shows Chicago and Dallas in the trouble zone with Washington D.C., San Francisco, and Indianapolis showing net pension assets, meaning they have more assets in the pension trust than liabilities.

S&P charts the performance of the funds against a minimum funding progress metric to assign ratings. Per the survey, "Many of the cities with the largest net pension liabilities compared with their governmental funds expenditures, such as Dallas, Jacksonville, and Fort Worth, also have relatively high current pension costs and are not meeting our MFP guideline."

Chicago's situation is nearly off the chart as it registers the highest current pension costs and the highest net pension liabilities of the surveyed cities. Recent numbers showing fixed costs as a percentage of expenditures are over 43%. Dallas is second highest with just over 30%. By comparison Seattle clocks in at 10.5%.

The Chicago pension crisis has been well-documented, with S&P currently pegging the city's general obligation rating at BBB-plus, the lowest of the group of surveyed cities.

The rating agency does bestow a "strong to very strong" budgetary flexibility to the Windy City but concerns remain.

"While greater budgetary flexibility is likely more important when assessing current or near-term pension costs, it is important to incorporate the long-term unfunded liability for a more holistic view of what could pressure each cities financial position or future financial performance," the report found.

S&P also takes measure of municipality pension discount rates which expresses future liabilities against current conditions. S&P likes to see discount rates at 6%, with anything above ascribed to a lack of funding discipline. A reform movement to lower the discount rates earned positive coverage for Philadelphia, Phoenix, Seattle, and Denver.

The survey called out efforts in three cities with unique stories to tell. Austin, Texas, gets credit for reforming its police pension fund by reducing the funding period from infinite to 30 years while increasing member and employer contributions.

Los Angeles is a cause for concern but appears to be making progress.

"The city has made changes to its assumed discount rates in recent years, most recently when the discount rate was lowered to 7% from 7.25% for the Los Angeles Fire and Police Pension Plan and Los Angeles City Employees' Retirement System plans," S&P noted. "The change in assumed discount rates will lead to progress toward funding Los Angeles' pension liabilities but will increase medium-term pension costs."

San Jose, California, the unofficial capital of Silicon Valley, was right behind Chicago in terms of required contributions vs. expenditures. On the positive side, the city is also sitting on the largest available reserve positions in the survey: 30% of fiscal 2021 expenditures.

San Jose is also the only city on the list that is considering the issuance of pension obligation bonds to improve funding levels. POBs are generally attractive options in times of lower interest rates but according to S&P, "Although none of the 20 largest cities surveyed has issued POBs in recent years, officials in some cities might see POBs as an opportunity to control or adjust fixed-cost payment schedules."

In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.

Lower-quality debt securities generally offer higher yields, but also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

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