Underfunded liabilities loom as a threat to governments' finances.

    Tread carefully with municipal bonds over the next decade. Many city and state governments face mounting problems from underfunded pension plans and/or health care liabilities that could hamper financial strength.
    Cities like Detroit, Pittsburgh and San Diego have massive pension shortfalls that could lead to Chapter 9 bankruptcies. Chapter 9 of the U.S. bankruptcy code lets municipalities continue to deliver services while adjusting or refinancing debts. A city may remain under federal court protection while developing a plan to cut debt.
    Other cities with major underfunded pension liabilities include, for example, Fort Worth, Texas; Dearborn, Mich.; Syracuse, N.Y.; Hanover, Pa.; Houma, La.; and Houston.
    States are also in a pickle. Colorado needs about $500 million to make up its shortfall. Illinois has a $35 billion shortfall. Last year, Illinois cut contributions to five state pensions by $3 billion to avoid a budget crisis, while selling billions in "pension obligations" to the public. Still, experts believe it may still need to cut another $20 billion.
    Nationwide, Standard & Poor's estimates that pension shortfalls are running more than $280 billion, including states, cities and counties. And if interest rates stay low and the stock market declines, the amount of underfunded liabilities should climb.
    If there is some good news, it's that governments can't go out of business. They can negotiate with creditors and use their taxing power to improve debt levels. Residents of all these cash-strapped cities face potential service cutbacks, layoffs and rising property taxes.
    Many states often issue bonds to cover pension shortfalls. For example: California, Illinois, Kansas, New Jersey, Oregon, West Virginia and Wisconsin issued bonds to cover state and local underfunded liabilities in 2004. In 2005, New York authorized local governments to issue bonds.
    Meanwhile a number of states, such as Massachusetts, Connecticut, and Florida, increased contribution rates by statute. California also is considering a similar measure to ease the state's burden. Some bankruptcy attorneys say that the problems with underfunded pensions and health care liabilities could lead to a large number of Chapter 9 bankruptcies.
    Wilshire Research in Los Angeles found that 94% of 109 state retirement systems it analyzed were underfunded. Its 2005 study, based on 2004 data, indicated the funding ratio-or the ratio of assets to liabilities-was 77%. That's less than the 83% funding ratio of cities and counties nationwide. Those funding ratio shortfalls, however, declined in 2004 over 2003 due to a strengthening stock market.
    The report also says that state pension funds, for example, had 67% of assets in stocks. The Wilshire study results may be a harbinger of things to come. A report on public pension problems by Lord, Abbett & Co. of Jersey City, N.J., says that the underfunding of public pensions is even worse than it appears. The report cited Standard & Poor's data that indicate the nation's 2,000 state municipal pensions owe a present value of $2.37 trillion in retirement benefits to 14 million workers and six million retirees.
    These liabilities, under current accounting rules, are 17% or $284 billion more than the value of assets in these plans. However, if public pension plans used the same accounting procedures as corporations, the shortfall would be $700 billion. "The figures that are available for public funds show that their pension and health care finances are as tenuous as those of many beleaguered corporations, maybe more so," says the Lord Abbett report.
    The underfunded pension problems are function of several factors. Public employees get better pension and health benefits as a tradeoff for earning lower wages than private sector employees. But the tradeoff is backfiring due, in part, to the aging baby boomers and poor financial decisions by state, city and county officials. To keep baby boomer workers who are eligible for early retirement from leaving their jobs, many public pension plans permit people to continue working while also collecting pensions.
    The combination of longer life expectancies and early retirement options are causing liabilities to balloon. In cities like Houston, public employees with 25 years experience can retire at 45 years and receive 90% of their final salary and receive a 4% annual cost of living increase.
    As legal obligations of the state or municipality, public pensions typically are defined benefit plans. These plans pay retired workers a guaranteed annual payout regardless of the value of pension assets. In the 1990s, there was no problem due to the bull market in stocks. Most pensions were in the black. Cities, counties and states dramatically increased workers' benefits to retain employees and attract new talent. But the necessary extra contributions were not made to fund those future liabilities. The stock market crash from 2000 to 2002, which saw the S&P 500 decline more than 45%, dramatically reduced the value of pension fund assets.
    Today's low bond yields also are a problem. Lower interest rates used to discount cash flow streams result in higher present values. In other words, a pension must have more money up front to cover pension payouts in the future due to lower interest rates.
    In addition, the recession of 2001 reduced state revenues. That made it difficult for public entities to fund pensions, even though they needed increased contributions. Public entities have no requirement like corporations, which must kick in money when pension plans are 20% underfunded.
    Other factors resulting in underfunding of public entities' pension plans: Public pension payouts are indexed to inflation. It's a widespread practice in some public sectors, particularly school systems, to give employees nearing retirement a salary increase. This results in higher pension payouts based on defined benefit plan formulas.
    So how are these problems impacting the municipal bond market? The underfunding of pension and health benefits by public entities are reflected in the current price of their bonds, says Zane Brown, director of fixed income at Lord Abbett. Brown does not anticipate a lot of municipal bankruptcies, but he expects some credit downgrades.
    The investment company, which manages more than $5 billion in municipal bonds in mutual funds and separately managed accounts, has 70% to 80% of its municipal holdings in revenue bonds. The proceeds of these bonds are tied to specific revenues, not the taxing authority of the issuer. 
    In the near future, however, Brown believes municipal bond rates could rise. The reason: Governments will issue tens of billions of dollars in general obligation or pension obligation bonds rather than cut services or raise taxes. "The sense on Wall Street these days is that this extra flow of debt will, in general, put upward pressure on municipal bond yields," he says.
    Wall Street, he adds, also looks for insured bonds to outperform uninsured bonds. He expects revenue bonds, which are tied to specific projects such as roads or sewers, to outperform general obligation bonds.
    Over the longer term, however, Brown expects municipal bond issuers will gain greater control over pension and health care liabilities. The Governmental Accounting Standards Board is requiring 50 states and 200 municipalities to reduce pension and health care liabilities starting in June 2008. The new standards are referred to as GASB 45-Other Post Employment Benefits (OPEB). They apply to state, cities and county governments as well as specialized public organizations, such as school districts, hospitals, colleges and universities.
    Currently, government employers report the cost of health care and other non-pension benefits as "pay as you go." In other words, money paid for benefits is considered an annual expense-with no other liabilities or funding requirements.
    But under GASB 45 standards, state and local governments must report the annual cost of other post-retirement benefits the same way as they report pension costs.
    The end result of GASB 45, according to Parry Young, analyst with Standard and Poor's New York: governments will have to cut costs. Public employees will be contributing more toward their pension and health care expenses. More entities may shift to defined contribution plans instead of defined benefit plans. It's possible that government employers could implement tax-deductible health savings accounts. There may also be some tax increases and/or service cutbacks.
    Young says that investors can expect to see some less-than-stellar-rated municipal credits downgraded. Variables Standard & Poor's use to determine its credit ratings include under funded pension liabilities, but not health care liabilities.
    "Triple A credits tend to have these (pension) liabilities in check compared to lesser credits," Young says. "Pensions are starting to stabilize. The contribution rates are higher and manageable. State revenues are strong."
    Young says, however, that there are other problems that could affect the financial strength of issuers in the near future. Among those:
    Rising state budgetary stress due to increasing pension fund contribution demands when costs, such as Medicaid, also are escalating.
    Rising funding shortfalls due to poorer-than-expected investment returns, changes in actuarial assumptions, changes in benefit levels and demographics. This, despite the fact that improved investment returns over the near term may cause under funded pension liabilities to decline.
    Underfunded health care liabilities could be a massive problem. Young cites estimates that in June 2008, GASB-45 reports of underfunded health care liabilities could hit $1 trillion. Already, he says, preliminary estimates of liabilities in California, Maryland, New Jersey and Michigan total $140 billion.
    "The extent of heath-care liabilities is unknown," he says. "We do not envision any wholesale downgrades at this point. Any diminution of credit quality across the industry could affect bond issuers. If the liabilities (health care) are very large and unmanageable, it could affect ratings.
    On the investment side, Thomas Spalding, senior investment officer with Nuveen Investments in Chicago, recommends that financial advisors:
    Build a portfolio around core holdings in essential services bonds, such as water and sewers and bonds backed by property taxes.
    Avoid problem states like Michigan and Ohio due to the problems in the U.S. auto industry.
    Diversify geographically in the Sunbelt states of the Southwest and Texas, Florida and Nevada, which have a growing need to fund primary and secondary schools and growing populations.
    Pick up yield by investing at the inflection points on the municipal bond yield curve.
    Invest based on relative values.
    Spalding says concerns about under funded liabilities could provide buying opportunities. "The strong will remain strong and the weak remain weak," he says. "Municipal bonds have a long-term track record of being the safest investment, except for U.S. Treasury bonds. The municipal bond issuers pledge their full faith and credit to the payment of obligations. To do that, they will raise taxes. Municipal utilities will raise rates to pay off bonds."