This is a guest post by Les Richmond, Vice President and Actuary of Build America Mutual (BAM).
Credit ratings are the most visible (and sometimes only) independent assessment of the fiscal status of a city’s government – they have a direct impact on borrowing costs and the affordability of infrastructure investments, and they can also influence public opinion about the effectiveness of city leadership. Understanding how credit rating agencies think about liabilities from pensions and “other postemployment benefits” like retiree health benefits (OPEBs) can allow city leaders to be proactive in reducing benefits-related risks to taxpayers, improving credit ratings, and possibly lowering their city’s cost of borrowing.
The four major credit rating agencies are S&P Global Ratings, Moody’s Investors Service, Fitch Ratings and Kroll Bond Rating Agency, and each takes a unique and proprietary approach to factoring pension and OPEB obligations into their ratings. But three basic principles are embraced by all four agencies: predictability, stability and flexibility, and the concrete steps described below can address each one.
Some cities that manage their own pension systems can take action directly. Others who contribute to a statewide (cost-sharing) benefit fund will have less flexibility, but can still benefit from examining their state system’s performance and suggesting changes to its administrators where appropriate.
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Predictability
No one likes surprises, and this applies to ongoing pension and OPEB costs. Cities can build rating agency confidence in their pension and OPEB management by adopting policies that minimize cost volatility. Some examples of actions that enhance predictability are:
- Lower the risk profile of pension (and, if applicable, OPEB) fund assets. There’s plenty of incentive to invest pension assets in risky investments, but risk implies performance volatility in good markets and bad. The performance of pension/OPEB investments often has a direct bearing on annual contribution requirements.
- Make sure actuarial assumptions are up to date by reviewing them periodically — at least every five years (and more frequently is better). Letting actuarial assumptions get too out-of-date means that pension and OPEB actuarially determined contributions can change dramatically when they are finally updated.
- When thinking about plan design changes, think “defined contribution.” Employer contributions to these 401(k)-type plans are generally much easier to budget for than defined benefit plans.
- Consider reinsurance of retiree health claims, which make up the bulk of OPEB costs. This is particularly important for cities with relatively small workforces, where the cost of a single catastrophic health claim could be material to the budget. The issue of possible claim volatility should be addressed with the city’s health care coverage provider, who should be able to present plan design or financing options for review.
- Consider pre-funding OPEB liabilities. Establishing a systematic funding policy for OPEB helps to smooth out the costs of paying health costs directly.
Stability
Stable pension and OPEB plans are characterized by:
- The existence of one or more revenue sources that can reasonably and reliably be counted on to provide the funds needed for plan contributions each year, over a long period of time; and
- A funding policy that is expected to pay off unfunded liabilities over a reasonable period of time (say, 30 years or less).
A pension plan’s “funding policy” refers to how cash contributions for pension and OPEB benefits are calculated each year. For pensions, there is a wide variety of cost calculation methods, and a great many ways to structure contributions to pay off unfunded liabilities. In general, though, plan contributions can be structured to either be relatively level over time, or be structured to rise over time. A city that can demonstrate that it has the revenue sources to pay for either cost pattern would be viewed favorably. However, the preferred approach would be a level cost pattern, because a cost pattern that is expected to rise depends on a corresponding increase in the revenues that will be the source of the contributed funds. If that scenario doesn’t happen – due to a recession or other unforeseen event – the city’s pension cost increases could outpace its revenue increases, resulting in a budget shortfall.
Flexibility
Flexibility with respect to pensions and OPEB refers to the ability to make benefit and/or funding changes in order to decrease current or future unfunded plan liabilities, usually by increasing the pension fund’s assets or reducing its expected costs. Generally, cities that have been most successful in decreasing unfunded liabilities have adopted a balanced approach of asset increases and benefit changes. In this way, the financial burden is not entirely on the taxpayers or the employees.
Increasing plan assets is often an easier approach to addressing unfunded plan liabilities, because there is less risk of litigation by plan members. Being able to demonstrate an existing or new source of revenue that can be directed as additional contributions to a pension or OPEB plan would be viewed favorably. For example, a sales tax increase, where proceeds are dedicated to additional pension contributions, can be an effective way to build up pension assets.
Decreasing plan liabilities requires an action that would decrease pension or OPEB plan benefits prospectively. City leaders’ ability to achieve these changes may be limited by the legal, regulatory, and collective bargaining environment in each community. While many cities argue they have the ability to reduce plan liabilities, rating agency analysts and other market participants generally want to see the city actually take such an action, and have it survive litigation, before they recognize it as a viable approach.
Reforms that immediately reduce plan liabilities are viewed more favorably than benefit changes that only affect future employees, because the latter may take many years before having a material impact on unfunded liabilities. For example, a reduction to retiree pension cost-of-living adjustments would be viewed more favorably than implementing a new, less generous pension formula for future hires.
Summary
Pension and OPEB liabilities generally build up over time, and the fiscal challenges they pose cannot be solved overnight. But city leaders can take steps that will be viewed favorably by credit rating agencies and build support for the hard choices necessary to achieve greater budgetary stability in the long term. These include:
- Demonstrating predictability by taking steps to decrease the volatility of plan contributions;
- Demonstrating stability by making sure that there are revenue sources available to pay off unfunded plan liabilities over a reasonable period of time; and
- Demonstrating flexibility by enacting plan funding and/or benefit changes that decrease unfunded liabilities.
About the author: Les Richmond serves as Vice President and Actuary at Build America Mutual. He evaluates the pension plans and liabilities of the municipal entities BAM guarantees.