Pub. 9 2018 Issue 1

www.wvbankers.org 30 West Virginia Banker Public pensions weren’t always a risk to the municipal mar- ket. In fact, 15 years ago, the average government had no unfunded liability at all as plans had enough assets to fund future benefits. But generous investment assumptions may have sugar-coated the true risk behind these promises. Plan managers had been spoiled with hefty historical returns and commonly assumed continued gains of 8% or higher when discounting future payouts. But then came the dot com bust and, six short years later, the Great Recession. That stretch of big losses left governments with massive investment shortfalls and a “new normal,” low-rate regime that made recovering previous return estimates near impossible. Unlike the private sector, where employees bear much of the risk of investment performance in 401(k) plans, governments with defined benefit plans are responsible for funding a set level of benefits. This spells problems when returns fall short of projections - as they have by an annual average of almost 2% since 2001 - because governments are on the hook to make up the difference between what they assume they will earn and what is actually realized. Making up a shortfall is not a simple process. Securing voter approval for new taxes or finding expense savings across already Public Pensions: An Update on the Municipal Market’s Fastest Growing Risk By Abigail Urtz, FTN Financial Capital Markets Municipals have undergone a transformation over the past decade that has left the market almost unrecognizable since the years before the financial crisis. Municipal insurance, which once covered 57% of issuance and served as investors’ sole source of credit analysis, now enhances just 6% of bonds coming to market. The implementation of Dodd-Frank in 2013 overhauled the way banks approach municipal investing. Bankruptcies erupted across the country. And now, growing risk of public pensions could become the next credit challenge for investors. Public Pensions: An Update on the Municipal Market’s Fastest Growing Risk By Abigail Urtz, FTN Financial Capital Markets Municipals have undergone a transformation over the past decade that has left the market almost unrecognizable since the years before the financial crisis. Municipal insurance, which once covered 57% of issuance and served as investors’ sole source of credit analysis, now enhances just 6% of bonds coming to market. The implementation of Dodd-Frank in 2013 overhauled the way banks approach municipal investing. Bankruptcies erupted across the country. And now, growing risk of public pensions could become the next credit challenge for investors. Source: Plan CAFRs, FTN Financial Public pensions weren’t always a risk to the municipal market. In fact, 15 years ago, the average government had no unfunded liability at all as plans had enough assets to fund future benefits. But generous investment assumptions may h ve sugar-co ted the rue risk behind these romises. Plan managers had been spoiled with hefty historical returns and commonly assumed continued gains of 8% or higher when discounting future payouts. But then came the dot com bust and, six short years later, the Great Recession. That stretch of big losses left governments with massive investment shortfalls and a “new normal,” low-rate regime that made recovering previous return estimates near impossible. 60% 65% 70% 75% 80% 85% 90% 95% 100% 105% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Funded Ratio, State and Large Local Government Plans GASB- recommended level Source: Plan CAFRs, FTN Financial Source: Plan CAFRs, FTN Financial Source: Plan CAFRs, FTN Financial Unlike the private sector, where employees bear much of the risk of investment performance in 401(k) plans, governments with defined benefit plans are responsible for funding a set level of benefits. This spells problems when returns fall short of projections - as they have by an annual average of almost 2% since 2001 - becau e gov r ments are n the hook to make up the differe ce between what they assume they will earn and what is actually realized. Making up a shortfall is not a simple process. Securing voter approval for new taxes or finding expense savings across already lean departments is not only time-consuming but politically sensitive. Governments in many areas are finding it increasingly difficult to get the necessary consensus for these changes. As a result, when governments faced losses during the 2001 and 2007-2009 recessions, their response was not to increase payments into plans as required by actuaries, but to short contributions. Shorting contributions meant lower-than-projected asset growth and, as a result, higher required contributio s in subsequent years to reduce growing unfunded liabilities. -15% -10% -5% 0% 5% 10% 15% 20% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 1yr Return Avg. Discount Rate ('01-'16) Avg. Return ('01-'16) Investment Performance, State and Large Local Government Plans 6% avg. return vs. 7.8% avg. discount rate