Pub. 5 2016 Issue 1

l e a d i n g a d v o c a t e f o r t h e b a n k i n g i n d u s t r y i n k a n s a s 24 MUNICIPAL BONDS AND PENSION LIABILITIES: REPORTING CHANGES AHEAD By Dana Sparkman, Vice President/Municipal Analyst, The Baker Group M UNICIPALBONDSAREAKEYCOMPONENT of most bank investment portfolios. In recent years, credit risk and credit risk analysis for municipal issuers have become hot topics for bankers and regulators alike. Since 2009, concerns regarding the lack of transparency of pension liabilities have surfaced as a handful of large municipalities cited unfunded pension liabilities as the main cause of their financial distress. In response to these concerns, the Governmental Accounting Standards Board (GASB) prepared two new statements in June 2012 to replace the prior statements regarding pension reporting. Together, these new statements will require the following: 1. A more realistic discount rate to be used when calculating pension liabilities 2. The net pension liability will be reported with other long- term liabilities on the balance sheet 3. Better comparability between plans The bad news for some municipalities is that their liabilities reported on the balance sheet will likely increase. For now, it’s too early to gauge the full impact of the changes as the GASB statements were fully implemented for fiscal years ending in June 2015 or later. The good news is that increased transparency and comparability triggered by the new reporting requirements will allow analysts to gather pension data in a much easier and more reliable manner. As pension liabilities prove to be a central component of municipal credit worthiness, it is crucial that investors obtain pension data as a part of their credit analysis process. Below are a few examples of the pension credit metrics that we suggest investors monitor on an ongoing basis: • Required Contributions/Governmental Fund Expenses (Benchmark=10% or less) This ratio provides insight into the burden pension contributions place on the municipality by comparing the amount that needs to be contributed to fully fund the plan over time to total governmental expenses for a given year. • Amount Actually Contributed/Required Contributions (Benchmark=90% or more) If this ratio is 100%, it means the issuer is paying the necessary amount to amortize their future liability. If it is less than 100%, the municipality may have trouble meeting future obligations. Some plans are structured as “Pay-As- You-Go” (PAYG) plans meaning that the municipality only contributes what actually has to be paid out of the plan that year as opposed to also putting aside money for the future. In this case, this ratio will be much less than 100%. • Funded Ratio (Benchmark=60% or more) This is the percent of actuarially accrued liabilities covered by actuarially accrued assets. The actuarial accrued liabilities figure is the estimated amount needed to pay off future pension liabilities. Due to the nature of PAYG plans, it is common to see a 0% funded ratio for them because the payments only cover current costs rather than current and estimated future costs. • Unfunded Actuarially Accrued Liabilities/Total Assets (Benchmark=20% or less) This ratio gauges the size of the unfunded liability relative to the asset size of the municipality by showing the percent of assets needed to pay off the liability today if necessary. • Pension Bonds (Benchmark=0) Pension bonds represent debt issued to fund pension or OPEB liabilities. Most of the time, the proceeds from the issuance of pension obligation bonds are used to pay current retiree pensions because the municipality has not been putting aside the required amount each year during the retirees’ employment. This is a way to defer the costs until future years. The proceeds can also be used to prepay the required pension contributions resulting in a net pension asset. The current regulatory environment for banks requires a municipal credit analysis process that includes pre-purchase