Pennsylvania Pension-Fix Impasse Punishes Investors: Muni Credit

Jan 16, 2014 8:33 am ET

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Jan. 16 (Bloomberg) -- Pennsylvania, which shoulders one of the biggest pension burdens among U.S. states, is bucking the wave of local governments trimming the benefits. Its bondholders are paying the price.

Since 2011, seven of the 10 states with the nation’s largest retirement liabilities as measured by Moody’s Investors Service have cut the costs. Pennsylvania, ranked eighth, has made no progress in that span, after lawmakers last year failed to pass Republican Governor Tom Corbett’s proposal to curb the expense.

In the $3.7 trillion local-debt market, the state may see its relative borrowing costs double within two years and its credit grade weaken without a fix, said Adam Mackey, head of munis at PNC Capital Advisors LLC. In 2013, Pennsylvania bonds fared worse than those of Massachusetts, which has credit grades one step higher, data compiled by Bloomberg show. Obligations of Illinois, which last month broke an impasse to bolster its pensions, outperformed both states last quarter.

“We don’t want Band-Aids,” said Mackey, who helps oversee $6.5 billion in munis, including Pennsylvania debt, from Philadelphia. Pennsylvania “needs to legislatively get some stuff done” on pensions or see its AA credit grade drop three levels, he said.

Growing Hurdle

Financing retiree benefits is a deepening challenge for localities nationwide as they recover from the 18-month recession that ended in 2009. States’ median pension-funding ratio fell to 69 percent in 2012, from about 83 percent five years earlier, according to data compiled by Bloomberg.

The payments are taking money from needs such as schools, according to a Jan. 14 report from a privately funded panel of budget analysts led by former Federal Reserve Chairman Paul Volcker and ex-New York Lieutenant Governor Richard Ravitch.

Pennsylvania’s unfunded liability is set to grow by 38 percent to $65 billion in 2018, according to state estimates. It has the eighth-highest pension burden as a percentage of revenue, at 105 percent, compared with the U.S. state median of 45 percent, according to Moody’s. Massachusetts placed ninth.

In trading last year, the extra yield that investors demand to hold Pennsylvania obligations fell by 50 percent, to about 0.14 percentage point at year-end, Bloomberg data show. That trailed the 77 percent decline for the Massachusetts spread, to 0.08 percentage point. Mackey at PNC Capital said he compares Massachusetts and Pennsylvania debt for relative value.

2010 Changes

Pennsylvania’s most recent pension changes, in 2010, extended the practice of paying less into the systems than actuarially required, according to Standard & Poor’s.

Massachusetts in 2011 raised the retirement age for most workers to 60 from 55 and reduced benefits for new public-safety officers, according to data from the National Association of State Retirement Administrators.

Corbett, 64, who is running for re-election this year, plans to discuss the need for action in his Feb. 4 budget address, said Charles Zogby, budget secretary for the sixth- most-populous state.

Zogby said he expects the Republican-controlled legislature will propose bills this year that shift new workers to a defined-contribution plan, similar to a 401(k), from the current plan that guarantees specific benefits.

Ratings companies have cited pension funding as a concern, Zogby said.

Cost Consequences

“If we’re stymied in getting any reform, I think that will weigh negatively on the outlook that they take, and that’s going to likely mean increased borrowing costs,” he said from the capital, Harrisburg.

S&P grades the Keystone State AA, two steps below the top, saying in October it could lower it to AA- this year “in the absence of meaningful pension reform efforts or significant economic growth” that offsets growing pension costs. Moody’s ranks Pennsylvania the same level.

“If you have a challenge or an issue, and if you just sweep it under the rug and don’t try and address it, that’s not a credit positive,” said Marcia Van Wagner, a Moody’s analyst in New York.

Pennsylvania’s two plans cover about 800,000 people. As of 2012, the combined funded ratio was 63 percent, down from 97 percent in 2007, according to actuarial reports.

Illinois Reward

Since 2011, 32 states and Puerto Rico have approved changes to retiree benefits, according to data from the National Association of State Retirement Administrators.

Illinois shows how investors reward action, after lawmakers there passed measures last month that would save $160 billion over the next 30 years to boost the nation’s worst-funded state pension system.

The extra yield investors demand to own Illinois debt instead of AAA securities has shrunk to 1.56 percentage points, close to the lowest since August, Bloomberg data show.

“There will be a discount applied to any state that doesn’t handle its pension obligations appropriately,” said Mackey at PNC Capital.

Issuers nationwide have scheduled about $7.3 billion of sales in the next 30 days, down from the one-year average of $9.1 billion.

They’re issuing with benchmark yields at the lowest in more than two months.

The interest rate on AAA 10-year munis is 2.69 percent, the lowest since November. That compares with 2.89 percent on similar-maturity Treasuries.

The ratio of the yields, a measure of relative value, is about 93 percent, the lowest since May. The smaller the number, the more expensive munis are compared with federal securities.

--Editors: Mark Tannenbaum, Pete Young