Pending Pension Meltdown

Anyone watching the little watched, esoteric, illiquid, and somewhat obscure taxable municipal bond market is well aware of the recent selloff in taxable municipal bonds supporting public pensions.  For clarity, taxable municipal bonds are issued for private purposes.  Taxable municipal bonds are defined as:

Taxable debt obligation of a state or local government entity, an outgrowth of the Tax Reform Act of 1986 (which restricted the issuance of traditional Tax-Exempt Securities). Taxable Municipal Bonds are issued as Private Purpose Bonds to finance such prohibited projects as a sports stadium; as Municipal Revenue Bonds where caps apply; or as Public Purpose Bonds where the 10% private use limitation has been exceeded.

Municipalities all over the country facing shortfalls in revenue due to lower tax bases and lower property values are running into high and rising deficits.  New York and California have made a lot of headlines recently, and Valejo, California was the first municipality to declare bankruptcy in the current cycle last year.

A growing but under-discussed crisis brewing are the massive pension obligations of both public and private employers.  Pension obligations are built on actuarial models that try to estimate the size and timing of future cash flows needed to pay benefits to retirees.  The models are built around estimated required annualized returns, typically of 8% or more, needed in order for the pension portfolio to grow enough to meet future liabilities.

The problems today are amplified.   First, a good number of organizations have been underfunding their obligations for years.  Public companies do so to goose earnings numbers particularly at the end of a cycle when EPS start to decline; public employers do so to preserve cash.  Second, earnings for both types of employers are now decreasing.  As corporate earnings fall, so do public revenues.  In addition, declining asset values affects both the size of the liability in pension accounts, since the return estimate now has to be higher to reach the same goal, and declining asset values also squeezes the tax base for public employers who count on property tax revenues.  Lastly, the general mood today is to dial down risk in these portfolios, away from private and public equities.  Such a combination of events is certainly a recipe for disaster, particularly for baby boomers who will be living longer than their parents if the stress from the current crisis doesn’t shorten their lifespan.

All this aside, the market is taking note.  Anyone who trades in taxable municipal bonds is seeing the first warning shots that fewer investors want to own debt linked to public pensions.  It is only a matter of time before debt holders of public companies wake up to this significant risk.   After all, senior secured debt holders of public companies still come second in line to employees who have priority when it comes time to pay the piper.

The current bailout is going to help address the current crisis, but if it fails dramatically,  there will be a number of other follow-on effects, one of which would likely be massively underfunded or even bankrupt pensions.

Taxable Municipal Bond, Accessed February 7, 2009


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