Assessing the Credit Quality of America’s Cities – Part Three: Long-Term Liabilities beyond Pensions
By Richard A. Ciccarone
Pensions aren’t the only big liability facing America’s cities.
Add to the list bonded indebtedness, other post-employment benefits (OPEB), derivative or synthetic debt instruments and deferred infrastructure replacement as other sources of future claims to the public purse.
Pensions and bonded debt are at the forefront of municipal indebtedness concerns. Together, they represent the most obvious and legally binding liabilities relative to either their repayment schedule or funding adequacy. Other significant liabilities sometimes exist that may be less visible, less definite as to their explicit exposure and often their day of reckoning more easily deferred.
In Part Two of this series, we discussed the scope and trends involving pension burdens. Now, we move beyond them to focus on the broader implications of combined liabilities that pose a burden to U.S. cities — and a potential threat to their ability to respond to the financial priorities of tomorrow.
The Hard Core Liabilities
Bonded debt and pension liabilities are the two most concrete long-term hard costs related to city finances because the ultimate requirement to pay debt service or pension benefits is expected to be timely and not easily breakable. Although pensions have long been viewed as a soft liability since annual payments to cover actuarial funding are not held to an ironclad timetable contribution standard, the outcomes of the bankruptcies in Stockton, California and Detroit demonstrated the practical barriers to reducing benefit terms. Despite the fact that bankruptcy judges in those cases held that pension terms could be altered in a federal Chapter 9 case, retiree plans were mostly kept intact as political pressures and social responsibilities proved to be a strong counter-force. For that reason, it makes sense to treat both debt and pensions together as hard core liabilities for the purpose of fiscal planning and analysis.
When you examine the combined outstanding debt and unfunded pension liability burden for all cities relative to economic resources, the trend has not been friendly. For example, an analytical ratio, based on data from Merritt Research Services, that measures the median for cities’ Net Direct Debt plus its Unfunded Pension Liability in proportion to the total Full Market Value (all taxable real estate property) shows a growth rate of 45% from 2008 to 2013. By contrast, the taxable real estate base (median full value per capita), which is the first line of support to enable cities to cover their debts, fell by 6% during the same period.
The total debt/pension burden weighs even more heavily for big cities than cities as a whole. Big Cities (23 cities over 500,000 persons reporting at least one single employer pension plan) registered more than twice the total debt/unfunded pension burden ratio in 2013 at 3.6% to Full Market Value vs. 1.6% for all cities. Philadelphia, Chicago and New York report net direct debt plus unfunded pensions of more than 10% of their full market taxable real estate values. Curiously, the rating agencies, by and large, don’t seem to mind that much since nearly 90% of the nation’s largest cities are rated in the AA category or higher (see Part One of this series).
The fundamental danger of higher annual payments to cover both debt and pensions clearly weakens a city’s flexibility to respond to ongoing operations and capital funding for infrastructure, especially if the magnitude of the combined numbers spirals upward. The pressure on current and future taxpayers becomes even more acute if non-discretionary expenses relating to payments on long-term liabilities are related to services already performed or infrastructure that has outlived its useful life. When that happens, future taxpayers are saddled with legacy costs that provide little or no benefit to them. At the same time, their ability to respond to existing or new demands on resources is limited unless they are able and willing to pay more.
The fundamental danger of higher annual payments to cover both debt and pensions clearly weakens a city’s flexibility to respond to ongoing operations and capital funding for infrastructure, especially if the magnitude of the combined numbers spirals upward.
Debt observers need to keep an eye on governments that have taken on complex debt instruments, commonly called derivatives, that in recent years have added to debt costs, rather than lowering them or acting as a hedge as intended. Too large of an exposure can have serious detrimental consequences to a local government if expected assumptions and conditions go haywire, such as in Jefferson County, Alabama, which filed for bankruptcy in 2011.
The use of derivatives, also called synthetic debt instruments, was far more common before the Credit Crisis of 2008, when the financial world relied more heavily on economic and market trends that were used in their models to projected expected outcomes. Most derivatives are intended to be hedge instruments, such as interest rate swaps, to mitigate the potential adverse impact of higher interest rates on variable rate debt. The extreme market conditions that transpired during the Credit Crisis caused many borrowers using them to incur significant negative results and higher overall debt costs. Many governments that used derivatives have refinanced or reduced their positions in these forms of debt. In some cases, the penalty costs to voluntarily terminate the transaction are substantial, inhibiting their ability to extract themselves from the deal. In situations where the city’s ratings fall below certain thresholds, the consequences of an accelerated termination to cover a negative position are more problematic and can pose more significant issues if it isn’t able to renegotiate the terms, particularly if the city has low cash reserves.
While derivatives are not frequently used by most cities, they are more likely to found among bigger units of governments. While these debt instruments are disclosed in official documents and audits, their market value and benefits to a city can fluctuate widely and their ultimate impact can be altered or deferred if the parties involved are able to negotiate a change of terms.
Other Post-Employment Benefits
The financial responsibility to cover other post-employment benefits (e.g. medical, dental, life insurance) is well known by insiders and experts as another big-number liability for state and local governments. But it wasn’t until after 2006 that governmental accounting began to assess on the balance sheet state and local liabilities for OPEB.
The total actuarial liability for OPEBs is huge. For fiscal year 2013, the aggregate actuarial liability for OPEB debt shown by Merritt Research Services for 1,233 U.S. cities was $116.9 billion. That’s a pretty hefty pill to swallow when you consider that the total amount of long-term debt shown on the balance sheet of 1,602 cities for the same year was $234 billion. State and local pension funding gets far more attention in the media because most governments don’t view their OPEB promises as intractable and legally protected as pensions. Moreover, OPEB funding has generally been done by U.S. cities on a pay-as-you-go basis rather than through proactive funding to their actuarial requirement. Consequently, the median for OPEB expenditures as a percentage of the general fund for all cities amounted to only 1.5% of the general fund. On the other hand, the median for pension contributions to the general fund in the same year represented close to 10%, which made pensions more of a here-and-now higher priority.
While public pension funding has been taking center stage headlines, the price of procrastinating on OPEB could be costly.
Making matters worse, OPEB liabilities are commonly being deferred and pushed back, therefore, growing larger each year based on actuarial requirements unless dramatic cutbacks or reforms are made for these liabilities. Legal experts point out that most states don’t provide the strong constitutional or statutory protections to OPEB promises as they do for pensions. That means that when the rubber hits the road, cities are probably more likely and more able to cut back other pension benefits under the OPEB umbrella. The City of Chicago, for example, is in the third year of a transitional program to transfer its responsibility for medical benefits for its active workers over to the State of Illinois insurance exchange created by the Affordable Care Act. On the other hand, when the state tried paying premium subsidies for its retiree health program, a July 2014 State Supreme Court ruling overruled it by saying that health care benefits were part of the state’s pension plan so cutbacks were not allowed as part of the overall state constitutional protection clause for pensions.
While public pension funding has been taking center stage headlines, the price of procrastinating on OPEB could be costly. Governments need to step up now and make changes to these programs to reduce the scope of these benefits or they had better start to go beyond the pay-as-you-go approaches to fund them. Local governments in Michigan stand out as one of the few states in the country that has been treating OPEB liabilities as an issue in need of immediate attention. In a number of cases, they have turned this soft liability into a hard one by issuing OPEB obligation bonds to fund them. New York City has the highest OPEB liabilities reported by far as shown on its 2014 balance sheet with a total liability of $89.5 billion. Houston had the second highest liability of $1.2 billion.
The Big Squeeze
The risk of squeezing out budget allocations for essential services, such as public safety and infrastructure maintenance, intensifies as a city ties itself up with commitments to pay off long term liabilities — particularly debt, pension and OPEB liabilities. Despite the fact that most cities have held their actual cash payments to cover the combined long-term liability costs generally in check, the threat that these obligations might become more onerous over the next ten years remains a real concern. This risk is especially true for cities that extend or backload their repayment or funding schedules well into the future. By that time, projects may have already served their useful life or workers are long past providing services to a city.
As a matter of principle, debt and liabilities are best justified when payments to cover them are structured so that taxpayers or ratepayers still receiving benefits pay for those services. This best practice should apply regardless of whether the liability relates to capital assets or human services. If future taxpayers are left holding the bag to pay for infrastructure that has already outlived its useful life or pension costs relating to firefighters who have already retired, then it squeezes their ability to pay for their essential services or capital improvements.
Measuring the Squeeze
Using Merritt Research Services data, we chose to compare these long-term liability expenditures against three different approaches to city expenditures in order to gauge the severity of the squeeze on operations.
As a matter of principle, debt and liabilities are best justified when payments to cover them are structured so that taxpayers or ratepayers still receiving benefits pay for those services.
Against the General Fund, typically a city’s largest discretionary operating account, the long-term liability squeeze appears to be most challenging. The combination of debt service, total pension contributions (including to state multi-employer plans) and OPEB contributions amount to 25% of general fund expenditures for all cities on a median basis. The weight of these embedded costs is even more onerous if you focus only on the nation’s largest cities of over 500,000 persons. For them, the annual debt and retirement cost burden to general fund expenditures increases to a median of 38% using fiscal year 2013 figures. In FY 2013, Detroit, for example, this ratio accounted for 61% of the general fund.
Taking a more moderate approach, the pressure on the total budget comparing long-term liability is lower but still highly evident. The broader Governmental Activities Accounts, which encompasses all governmental type accounts, includes the General Fund, Special Revenue funds, Capital Improvement Funds and Debt Service. From this perspective, actual spending on debt service, pension contributions & OPEB accounts for a little more than 17% of all governmental activities expenditures. While that’s a significant piece of the budget pie, the good news is that the ratio has risen only modestly since 2009 when the median stood at 16.7%. The bad news is that there is significant minority of all cities (22% in FY 2013) that spent at least 25% of their total governmental activities expenditures to pay for these long-term liabilities. Moreover, the noose gets tighter for big cities, which spent more than 22% of governmental activities expenditures on annual payments for their debt and retirement liabilities in FY 2013, up from 20.4% in 2009.
Using the General Fund or Governmental Expenditures as benchmarks for sizing up a city’s sensitivity to a “hard cost” squeeze might be too conservative if a city operates enterprise operations. The third comparative approach encompasses the broadest potential governmental resources base because it includes not only all governmental activities functions but also any municipal enterprises, such as a city-owned water-sewer system or airport operations. As a best practice, pensions for city enterprise workers shouldn’t be paid just out of general purpose taxes; rather, it makes sense to cover their share of pensions from the enterprises with which they are associated. By recalculating the ratio substituting the broader primary government expenditures as the denominator instead of the general fund, then the committed annual liability burden isn’t as much as much a strain. The median city annual funding requirements to pay debt, pensions and OPEB costs from all primary expenditure activities (governmental and business enterprises) amounts to 12.8% for all cities and nearly 15.8% for all big cities with populations over 500,000. In either case, the highly rated big city group shows more vulnerability to its liabilities than all cities in general.
Regardless of which approach you use as to measure the median fiscal squeeze, individual city exposures to severe strain can fall well outside the norm. Be on the guard for cities that aren’t paying their Actuarial Required Contributions or Actuarial Determined Contribution under the new GASB pension reporting rules. If these cities paid what they should have been paying all along, the burden on future taxpayers would be more tolerable. The City of Chicago is a prime example of a government which contributed far less to its plans than what a city using best practice actuarial standards would have been setting aside.
The combined burden of debt service, pensions and OPEB expenses to total governmental spending could have been worse. While median pension and OPEB expenses have been rising, the overall debt and pension/OPEB squeeze has been softened by the effect of lower interest rates, refunding and the restrained issuance of new money bonds. For the past ten years, bond yields have been at or near their lowest levels since World War II.
The Other Long Term Liability — Often Deferred and Neglected — Infrastructure
There’s one more liability that isn’t clearly recognized on the face of the city’s books; but, is every bit an obligation of the city to its citizens if it hopes to survive as a physically viable entity. That responsibility: infrastructure. The concept of deferring capital replacement and repair is an ever-present problem these days, especially in light of the political reluctance to prune spending and issue new debt as city leaders are sensitive to holding down taxes and fees.
We consider the backlog of infrastructure rebuilding as a long-term liability because for every year that a road is not repaved, a bridge not fixed, utility pipes not replaced or buildings not repaired, the price tag for the project is susceptible to becoming more costly due to further deterioration, inflation or adverse economic impact to the community.
During the Great Recession and Credit Crisis, many cities put to the side expenses covering liabilities which could be deferred. While actuarial funding of pension requirements often took a back step during those years, infrastructure spending from debt issuance and from current resources probably took a much bigger hit. Since there is no set timetable as to when infrastructure funding must take place, allocating an actual spending schedule to cover repair and replacement becomes only a guess or best estimate based on an opinion of necessity given by an engineer.
Cutbacks and delays for capital improvements have long been one of the politically easiest to cut during lean times. Holding public officials accountable for infrastructure requires greater use and appreciation of methods to assess capital plant liabilities. One means of measuring the deferred and neglected trend for the depreciable assets of the city, such as roads, streets, bridges and public buildings is to examine the average age of infrastructure ratio that is derived from depreciation data that the Government-wide financial presentation provided under GASB Statement 34, which was introduced at the turn of the millennium.
For many cities, older infrastructure only complicates already high debt and pension burdens.
Using this ratio, the trend is clear, steady and uninterrupted. Merritt Research data shows that from 2006 to 2013, the median for average age of infrastructure climbed from 11.5 years to 14.4 years, a 25% increase. More than 17% of all cities show an average age of infrastructure over 20 years. However, the important finding here is not about the absolute number associated with the average age, but, instead the trend is what’s most critical. As long as the age number continues to rise, cities aren’t investing enough in their physical plant to keep up with the annual expected depreciation of its infrastructure. It becomes inevitable that the delay in funding these improvements will eventually have to be met with capital investments from debt or surplus funds in order to at least maintain the status quo. As mentioned earlier, deferring capital investments often means paying higher costs tomorrow to do the same project today.
Cities squeezed by high debt, pension and OPEB liabilities are especially vulnerable during cyclical downturns or over time in line with long-term structural economic decline. Although there is no conventionally used threshold to say what is too high or too low, the median number as well as the trend are good proxies as to whether a city is well positioned to handle its costs that are preset relative to debt or commitments already in force.
For many cities, older infrastructure only complicates already high debt and pension burdens. Among cities with populations of over 100,000 whose 2013 average age of infrastructure ratio registers over 20 years old, you will find New Orleans at 26.0 years, Jackson, MS at 23.9; Milwaukee, WI at 23.8; Montgomery, AL at 23.6; Islip Town, NY at 23.5 and Pittsburgh, PA at 23.3. These age numbers inevitably will translate into future spending, frequently in the form of a new debt issue, sooner or later. That’s why we consider them a true liability. The longer a city waits to act, the more costly the projects become.
Long-Term Liabilities Should Be Designed to Serve the Long-Term Vision
The growth in long-term liabilities has been swelled in recent decades by the run-up of unfunded pension and benefit liabilities, deferred infrastructure and, in some cases, faulty debt practices. More than any other reason, governments have often neglected to cover their appropriate share of long-term liabilities because they have opted to pass the cost along to future taxpayers. The combined obligation of pensions, OPEB and debt weighs heavily on a host of cities but certainly not all. Many of those feeling the most pain tend to be cities left with legacy worker costs and older infrastructure that have seen better days in the past. But newer cities can find themselves in a similar predicament if they are inclined to kick the proverbial can down the road by inordinately shifting the cost to the uncertainty of the future. When public officials and taxpayers take a pass on their fair share of the costs of government today, they make it harder and more expensive to afford a better vision for tomorrow.
Richard A. Ciccarone is a Co-Publisher of MuniNet Guide. He is also President and Chief Executive Officer of Merritt Research Services, a municipal bond credit database and research company that primarily serves institutional investors, investment dealers and bankers.
Did you see the earlier installments of this series?
Part One: Focusing on Bond Ratings?
In the third part of our series on city credit quality, we examine other liabilities besides pensions that pose a threat to the fiscal health of U.S. cities. Bonded indebtedness, other post-employment benefits (OPEB), derivatives and deferred infrastructure replacement can also result in a budget squeeze.