States, Cities Tackle Pension Liabilities; Watch Illinois, Detroit for Lessons

Employee Benefits News examines legal developments that impact the employee benefits and executive compensation employers provide, including federal and state legislation, rules from federal...

By Michael Bologna, Nora Macaluso and Marvin Anderson  

March 25 --Throughout his first four years in office, Illinois Gov. Pat Quinn (D) gave a consistent stump speech--a pledge to overhaul the worst-funded public sector retirement system in the country.

Quinn honored his vow in December 2013, when he signed a sweeping new law projected to bring the state's five public pension system to full funding in 30 years and slash Illinois's long-term pension obligations by $160 billion.

S.B. 1 (Illinois Public Act 98-0599) aims to achieve its goals by injecting new state dollars and cutting retiree benefits. But the greatest savings will be realized under provisions that replace automatic annual cost-of-living adjustments (COLAs) with a new formula linked to retirees' years of service.

“This is a serious solution to address the most dire fiscal challenge of our time,” Quinn said during the bill-signing ceremony where the Democratic governor stressed that the state's financial future was indelibly linked to reforms codified under the legislation.

Three months later, S.B. 1's place in Illinois history is uncertain at best.

Four lawsuits have been filed by public employee unions and retiree associations challenging the constitutionality of the new law. By all accounts, the future of S.B. 1 will only be determined after the challenges are hammered out by the Illinois Supreme Court.

Illinois, with about $100 billion in unfunded pension liabilities, is not alone in this struggle. Across the country, cash-strapped states and municipalities are taking different measures to control public employee pension obligations, which have escalated in recent years, for many different reasons.

Identifying the Problem

The “immediate cause” of most pension systems' problems was the stock market collapse of 2008, said Stephen Eide, senior fellow at the Manhattan Institute's Center for State and Local Leadership.

During the boom years of the 1990s, “a lot of systems were skimping on contributions or increasing benefits, because they thought the good times were going to continue indefinitely,” he said. “California was notorious for that.” At the same time, the systems moved their funds into riskier investments, believing the higher returns would allow them to pay their benefits, he said.

Despite raising employee contributions to pension plans, cutting benefits or renegotiating pension contracts, many jurisdictions may be failing to inject enough of the kinds of mechanisms that would bring the significant changes needed to achieve long-term fiscal stability, and that leaves many places, along with those counting on their pensions for retirement, still at risk.

“All of the underlying factors are still there,” said Jeffrey R. Brown, a professor of finance at the University of Illinois College of Business and an expert on retirement security issues, in an interview March 13 with Bloomberg BNA.

“We are still underestimating the problem. We are still invested in very risky portfolios that will go bad if we hit another downturn. Many states are still not making good on their fundamental commitment to invest money. States have undertaken reforms, but I don't think we are out of the woods at all.’’

What's at Stake?

State and local government retirement systems cover more than 14 million workers, about one-sixth of the U.S. workforce, and more than 8 million beneficiaries, according to a January report from the Nelson A. Rockefeller Institute of Government.

With about one-fourth of state and local government workers not covered by Social Security, these workers and their families largely rely on their public pensions for retirement security, according to said the report, “Strengthening the Security of Public Sector Defined Benefit Plans.”

Aside from the millions of families affected, the situation also extends into the world of investors, who pour money into municipal bonds, which help fund public pensions. And now court rooms across the country are seeing legal challenges to state and local efforts to cut public pension liabilities and must decide whether these jurisdictions even have the ability to reduce COLAs.

“The funding system is very seriously flawed. It allows things like understatement of liabilities, giving a false sense of security, increasing benefits on the mistaken belief that a system is well funded,” said Don Boyd, senior fellow at the Nelson A. Rockefeller Institute of Government, and co-author of the January report. “Governments, really particularly at the state government level, have the ability to underpay even what the actuaries ask for. And what the actuaries ask for often is both too low and smoothed out in ways that postpone obligations to the future.”

Looking for Solutions

Illinois ranked as the state with the largest pension burden in fiscal year 2012, according to Moody's Investors Service report, “U.S. State Pension Medians Increase in Fiscal 2012.” After Illinois, are Connecticut, Kentucky, Hawaii, Louisiana, Maryland, Massachusetts, Maine, Texas and Kansas according to the report released Jan. 30, which said its adjusted net pension liabilities (ANPLs) in FY 2012 may have reached its cyclical peak.

Moody's Associate Analyst John Lombardi, who wrote the report, said the widening in ANPLs in FY 2012 was mainly the result of minimal investment returns and a decrease in the interest rate used to derive the present value of liabilities.

States with the lightest pension burdens by the same measure were Nebraska, Wisconsin, New York, Tennessee and Washington, the report said. In aggregate for all the states, the adjusted net pension liability rose 24 percent to $1.2 trillion in FY 2012, up about 20 percent from $998 billion in FY 2011, the report said.

Meaningful Change Needed

U. of Illinois's Brown said the seeds of this public sector pension crisis were sewn long before the financial markets collapsed in 2008.

While states varied in their approaches, Brown said many engaged in patterns of mismanagement and underfunding for decades. The loose practices included: frequent “pension holidays,’’ weak accounting practices that permitted system underfunding, overpromised benefits, unrealistic assumptions about investment performance and failed investment strategies.

Those structural deficiencies, Brown said, came into sharp focus when the “great recession’’ triggered massive unfunded pension liabilities for dozens of states.

“This is a problem that has developed over decades, although the extent was different for different states,’’ Brown said. “So these problems existed but they were not fully revealed until the financial crisis came along.’’

Luke Martel, senior policy specialist with the National Conference of State Legislatures, said 48 states have enacted significant revisions to their public retirement systems since 2009, with several states enacting multiple pension overhaul laws. Only Alaska and Idaho have bucked the trend.

“Of course the great recession represented a sea change in the state pension world,’’ Martel told Bloomberg BNA in an interview March 12. “It had tremendous effects on pension funding levels and really the great recession's impact has been long lasting.’’

Changes range from:

• replacing traditional public pension plans with 401(k)-type plans for new hires,

• increasing employee contributions,

• raising age and service requirements before achieving full retirement benefits and

• cutting post-retirement benefits, including COLAs, for active employees and retirees.


Brown applauded recent efforts to shore up bruised pension programs and said some state pension burdens have lightened during 2013. But at the same time, Brown attributed the improving conditions to the rebounding financial markets and said states have failed to implement the kind of meaningful change to achieve long-term fiscal stability.

Specific State Retirement Systems

In Florida, Republican leaders in the 2013 legislature advocated a drastic public pension overhaul to close the pension plan to all new employees and sign them up for defined contribution investment plans instead. The proposal passed the state House but failed in the Senate. The idea is being revived for the 2014 legislative session but with new cash balance or hybrid plan options and with exemptions for special-risk employees, such as police officers and firefighters, who would still be allowed to sign up for the pension plan (32 PBD, 2/18/14; 41 BPR 407, 2/25/14).

The Florida Retirement System saw 10 years of surpluses evaporate in the 2008 stock market crash, as assets dropped and left the system with an unfunded liability of $15.4 billion in 2009, yet still a relatively healthy funding ratio of 88.5 percent. Since then, liabilities have grown slightly faster than assets, as the state has revised the system and looked for ways to cut its annual spending on retirement benefits. Through June 30, 2013, the unfunded liability stands at $21.6 billion, with assets of $131.7 billion and a funding ratio of 85.9 percent. The retirement system covers approximately 620,000 members, with more than 80 percent of those in the pension plan and the rest in an optional 401(k)-style defined contribution plan.

The state has been overhauling its retirement system one step at a time since Gov. Rick Scott (R) took office in 2011. That year, the legislature passed a law to deduct 3 percent from state employees' paychecks going forward to cover much of the state's contribution to the retirement system (123 PBD, 6/27/11). The law faced a legal challenge that made its way to the state Supreme Court, which sided with the state (14 PBD, 1/22/13; 40 BPR 259, 1/29/13).

The state also has reduced automatic COLAs that retirees are promised under the pension plan.

With 2014 as an election year for the governor and many state legislators, there is some question as to whether any controversial pension overhaul can pass this year.


The California Public Employees' Retirement System, the largest U.S. public pension, which has an unfunded pension liability of $103.6 billion, will begin phasing in higher rates to account for the increased costs of longer life expectancies for retirees (34 PBD, 2/20/14;41 BPR 419, 2/25/14).

CalPERS is 69.6 percent funded based on the latest data available from June 2012. Investment returns of 13.2 percent in the fiscal year that ended June 30, 2013, were the highest since 2006 and pushed the fund above its pre-recession value of $253 billion to $284 billion. The 2013 returns are not yet reflected in CalPERS' funding status figures.

The pension fund's value dropped to $183 billion in 2008 when CalPERS suffered investment losses of 27.8 percent, but has been climbing back steadily from the recessionary hole with an average return of 11.3 percent over the past three years.

Under reforms adopted by lawmakers and included in collective bargaining agreements for most state workers, state employees hired after Jan. 1, 2013, must contribute at least half of their annual pension benefit cost each year and will have less generous retirement pay formulas (171 PBD, 9/5/12; 39 BPR 1702, 9/11/12). The Public Employees' Pension Reform Act of 2013 would apply to about 3,000 public employers and public pension plans and is expected to save between $42 billion and $55 billion over 30 years (171 PBD, 9/5/12; 39 BPR 1702, 9/11/12).


Public pension systems in Texas, with more than 2.45 million active and retired members, are just over 80 percent funded as of February 2014, according to the latest data from the Texas Pension Review Board, a state agency mandated to oversee the soundness and compliance of all Texas public retirement systems, both state and local.

The system includes the state's largest pension systems, the Teacher Retirement System of Texas (TRST), and the Employees Retirement System of Texas (ERST). As of February 2014, the actuarial value of all Texas pension assets is $219.4 billion; total actuarial accrued liability is $271.96 billion. The shortfall or unfunded liability totals $52.5 billion.

Legislation was passed in the 2013 session, which increased member contribution rates in steps for fiscal years 2014-2017 and beyond, among other changes, for the ERST and the TRST.

Under the measures, the TRST member contribution rates increased incrementally each year from 6 percent in FY 2014 to 7.7 percent in FY 2017, and from 6 percent in FY 2013 to 7.5 percent in FY 2017 for members of the ERST.

The bill reduced the interest paid on retirement account balances from 5 percent to 2 percent and provided a one-time COLA adjustment of 3 percent (with a maximum of $100 per month) to all annuitants of the TRST plan who have retired since Aug. 31, 2004, and to all ERST annuitants who have retired for 20 years or more.

The biennial Texas legislature isn't in session in 2014 to consider any new legislation affecting pensions.


The state had accrued pension liabilities of $165.4 billion against assets of $68 billion in FY 2013, according to a report by the Illinois Commission on Government Forecasting and Accountability, a bipartisan legislative research arm of the state's government.

The report examined each of Illinois's five public retirement systems for FY 2013, which ended June 30, 2013. The calculations, which were based on the market value of assets, pointed to an unfunded liability of $97.4 billion for Illinois.

In January, a coalition of Illinois labor unions filed a class action on behalf of hundreds of thousands of state employees and retirees, asserting that the new law makes major changes to the public pension system, which violates key principals of the Illinois Constitution (19 PBD, 1/29/14; 41 BPR 276, 2/4/14).

Under the new legislation, the state must contribute $364 million in FY 2019 and $1 billion annually thereafter through 2045 or until the system reaches full funding. The state must also contribute 10 percent of the annual savings resulting from the pension overhaul beginning in FY 2016 until the system reaches full funding (233 PBD, 12/5/13).

The legislation replaces automatic annual COLAs with a new formula based on the retiree's years of service. The formula multiplies a retiree's years of service by $1,000 ($800 for those also receiving Social Security) and provides a 3 percent annual increase based on that amount.

The $1,000/$800 level will be adjusted each year based on changes to the consumer price index. Also, current state employees will miss annual adjustments depending on age. The age for retirement will also increase on a graduated scale for workers age 45 and younger.


The two largest pension plans in the Connecticut Retirement Plans and Trust Funds (CRPTF) are the Teacher's Retirement Fund (TRF) and the State Employees' Retirement Fund (SERF). Together those funds represent 90.8 percent of the CRPTF and as of their last valuations had combined underfunded liabilities of $25.1 billion.

Established in the 1970s, the system had a plan that called for state funding to be phased-in and envisioned full funding by 2032, which still remains the case. But lawmakers over the next several decades implemented changes that delayed full funding and increased the unfunded liability of the pension accounts, said Connecticut State Treasurer Denise L. Nappier.

“As a consequence of the repeated delays in the phase-in rate, the burden of meeting this time schedule will require ever increasing annual appropriations in future years,” Nappier told Bloomberg BNA March 14.

Nappier said a number of reforms have been put in place and other steps taken to improve the financial strength of the pension plans.

“The reality is we cannot earn or invest our way out of the unfunded pension liabilities without taking on undue risk. And that won't happen under my watch,” she said.

In his most recent budget proposal, Gov. Dannel P. Malloy (D) recommended directing $100 million of the state's projected surplus to the pension plans.

Fixing the Funding Problems

Amy Monahan, a professor of law at the University of Minnesota Law School and a frequent commentator on the legal issues around public pension reform, said lawmakers must focus their overhaul efforts on strategies that diminish the possibility of underfunding.

She said that the states and municipalities currently in crisis failed to impose structures ensuring adequate levels of annual funding.

In line with that view, she said states must enact rules that prevent state and local units of government from taking “pension holidays” and honor their obligations to make annual required contributions.

“It is important to make changes to the law to force annual funding,’’ she said.

“The reason we are talking about changes now is because these plans were never adequately funded. So another role for the law to play is to ask, 'how do you get money into the plan in the first place?' That is going to solve a lot of problems. We need to be clear about the costs and make sure they are funded. There is a lot of room for improvement in the current legal environment.’’

Other solutions to help fix the funding system include requiring much better reporting of the true liabilities of the system, something hated by many governments and pension fund unions, said Boyd, “but it would be a way to make it much clearer what is owed.”

The system encourages risk taking--risks that pension funds believe are prudent. Risks borne by taxpayers, citizens and others, Boyd said.

“There's no clear reporting on what those risks are, how volatile the finances of pension funds have become. It's very possible to get into a situation where you have to make big increases in contributions because you had big declines in asset values,” he said.

Reporting Transparency

Steps to improve transparency and prevent surprises about underfunded pensions are about to gain speed.

Under new reporting standards from the Governmental Accounting Standards Board, state and local governments for the first time are required to calculate their pension and post-retirement health-care obligations as liabilities and disclose them along with assets on their financial statements (48 PBD, 3/12/14; (41 BPR 620, 3/18/14).

The change “will improve the decision usefulness of pension obligations,” GASB spokesman John Pappas told Bloomberg BNA on March 11. “Citizens will get a clearer picture of the size and nature of those pension obligations,” he said. “It's going to increase transparency and comparability.”

Governments are required to implement the new accounting standards for fiscal years beginning after June 15.

Yet the change, which may cause liabilities to be reported as higher than in the past, could come as a shock to some, especially local governments, school boards, city councils or county commissions that “may not be acquainted with the finances of the pension plan that they're sponsoring,” Keith Brainard, research director at the National Association of State Retirement Administrators, told Bloomberg BNA March 3.

“It may be a wake-up call to folks like that to understand the size of their pension obligations,” he said.

Lessons From Detroit

While pension underfunding was not the cause of Detroit's problems, the city faced a virtual perfect storm of financial disasters, with a declining tax base, corruption, pension fund mismanagement and a recession all leading up to the bankruptcy filing. There are nevertheless lessons for other cities to learn as the bankruptcy process continues, analysts said.

The city became the largest last July to file for bankruptcy protection and is being watched as a potential case for other municipalities, school districts and public entities with large pension obligations (In re City of Detroit, Bankr. E.D. Mich., No. 13-53846).

Detroit is “really a lesson about what happens in extreme circumstances,” said Rockefeller Institute's Boyd. “As Detroit plays out, there will be lessons.”

If the current version of the city's plan of adjustment, which includes cuts to pensions, is approved by the bankruptcy court, there will be a greater incentive for unions and pension managers to ensure better funding, perhaps negotiating smaller wage or benefit increases to help shore up fund finances, he said.

Detroit is calling for retirees who are part of the city's main pension plan to face 34 percent cuts in their pension benefits, and retired police and firefighters to see 10 percent of their benefits slashed under a plan of adjustment filed Feb. 21 with the court overseeing the city's bankruptcy proceedings (41 BPR 439, 2/25/14; 41 BPR 439, 2/25/14).

“Detroit is extreme in many ways,” said the Manhattan Institute's Eide to Bloomberg BNA on March 4.

“It's a situation where everything has gone wrong, fiscally speaking,” so it is important to be careful about drawing conclusions from the situation, he said.

Detroit's bankruptcy is also unique in that a group of philanthropic organizations, aided by the state, has pledged to contribute hundreds of millions of dollars to shore up pensions if a mediated settlement is reached.

It is hard to imagine this same deal happening with other cities, Eide said.

In some respects Detroit is a one-off, in the sense that they have lost so much of their population and their tax base, said Brainard.

The “core problem” in Detroit was a declining population, which resulted in a lower tax base, which in turn hurt the city's ability to fund its pensions, Brainard said. “That's not to say Detroit didn't have some pension challenges, but the pension challenges were not the primary driver of the city's fiscal problems,” he said. “It was the other way around.”

There are some “best practices” pension plans can follow to avoid spiraling into a Detroit-type situation, Brainard said.

“First and foremost is to fund the pension plan, make your annual required contribution,” he said. “Another is to manage your liability. That means to not provide the level of benefits that you're not willing to fund.”

Some smaller, less well-funded pension plans are merging with larger plans to pool their resources, Brainard said.

Denver Public Schools Retirement System merged into a bigger, statewide plan, and the Wisconsin Retirement System is “the product of a merger of dozens or hundreds of local retirement systems,” he said. Texas, Missouri and Illinois all maintain municipal retirement plans, optional for cities, that are “regularly adding new employer members,” he said.

Protecting Pensions

State protections of pensions are also coming under scrutiny, and the Detroit bankruptcy case is highlighting the issue. Judge Stephen Rhodes, who is overseeing the case, found that federal bankruptcy law trumps the Michigan Constitution's clause preventing pensions from being impaired. The issue is being appealed in federal court.

“It's a big area of debate,” Boyd said. “I would guess those laws will be tested.”

In California, which has a law prohibiting local governments from making changes to pension benefits, local governments are in a “very, very difficult situation,” Eide said. “Their only choice is to jack up their contributions,” and many systems “are not doing a good job of contributing,” he said. “They're stuck” either raising taxes or cutting services, he said.

San Jose's Mayor Chuck Reed (D) pushed a statewide measure for the 2014 ballot that would give local officials authority to reduce future pension benefits for municipal employees but postponed it to the 2016 election after suing the state because of the attorney general's title and summary of the measure (37 PBD, 2/25/14; 41 BPR 470, 3/4/14).

Reed lost the court ruling, and now Moody's Investors Service said postponement of the ballot measure, which could help contain the rising cost of public employee pensions, is a “credit negative” for municipalities (56 PBD, 3/24/14).

Two California cities, Vallejo and Stockton, risk a “return to insolvency” if they fail to reduce their pension liabilities, Moody's Investors Service said in a Feb. 20 research note. A third California city, San Bernardino, could challenge the state protection in court, using the Detroit decision as a “non-binding precedent” to support the case for cutting pensions, the report said.

CalPERS recently received approval to challenge the legality of San Bernardino's bankruptcy (40 PBD, 2/28/14; 41 BPR 508, 3/4/14).

It may be easier for public entities to cut benefits for current workers, cutting COLAs for example, or making them contingent on the status of plan funding, said Boyd.

“The law, and a lot of people's opinions, seem to be moving toward the notion that a COLA is much less of a promise” than other pension obligations, and therefore “much more possible to break or restructure without a feeling like you have done great damage,” he said.

Debate Shifting

Cities and states are grappling with the their public pension fund obligations, with varying degrees of success. “Basically every state has passed some sort of pension reform since 2009,” Eide said.

He said debate is shifting in a very important and beneficial way.

“Many Democrats have decided to take up the issue of pension reform,” he said, singling out democrats Rhode Island General Treasurer Gina Raimondo, Chicago Mayor Rahm Emanuel and San Jose's Reed as examples. “It became clear this was not some kind of right-wing ideological crusade,” he said.

Governors in blue states as well as red are having difficulty expanding services and programs while keeping up with pension obligations, he said.

While “more politicians get it than don't get it,” most pension changes haven't been significant enough to weather another recession, Eide said.

“As pension costs rise at a rate above revenues, you still have a problem there,” he said. “Each time you put a budget together, you still have to increase contributions to pensions. Then you still have a problem.”

Getting Sued

Monahan said efforts to revise state and municipal pension systems are complicated by two intractable features of the current climate: virtual certainty that the state or municipality will be sued, and high levels of uncertainty about the potential outcome in such litigation.

“No matter what the law is in your state, if you change pension benefits you are going to get sued,’’ Monahan told Bloomberg BNA. “It tends to be a divisive issue and it tends to be a roll of the dice as to what a court will decide.’’

While legal battles are brewing in Illinois by public employee unions and retiree associations that have filed four lawsuits challenging the constitutionality of the new law, courts around the country are already issuing rulings on pension changes.

Other states that have already enacted pension laws and are counting on savings by reducing COLAs have been taken to court, where decisions vary, making it difficult to predict whether these cuts are a possible option, according to the Institute for Illinois' Fiscal Sustainability, which created a summary of state cases related to pension COLAs for current employees and retirees.

Monahan said that protections pertaining to state employee pensions are a function of state rather than federal law, and the authorities of states to revise their pensions systems vary widely.

She said that some states acknowledge only a “property interest’’ in statutory retirement benefits. In general, these states can revise their pension systems for current employees if they can demonstrate the action is rationally related to a legitimate state interest. State employees, however, are protected against system reforms if they can demonstrate the state's conduct was arbitrary and capricious.

Monahan said a second group of states view employees' rights in a public retirement system as contractual, protected against substantial impairment by the state. Several of these states, including Arizona and Illinois, have added specific constitutional protections.

For example, Illinois describes participation in a public retirement system as, “an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.’’

Public employee unions take great comfort in these provisions, objecting to virtually any pension system adjustments that require concessions from their members.

“Illinois and Arizona have very explicit constitutional provisions,’’ said Hank Kim, executive director and chief counsel for the National Conference on Public Employee Retirement Systems, which advocates for employees participating in public sector pension systems.

“We feel very confident that the courts are going to make their decisions based on those provisions of the constitution.’’

Little Precedential Value

Kim said that view was validated in a recent unanimous decision by the Arizona Supreme Court in which the court voided a 2011 state law that cut retirement benefits promised to participants in the Elected Officials' Retirement Plan.

The court specifically found that the law violated the pension clause of the state constitution, because it sought to diminish and impair benefits earned by the plaintiffs (Fields v. Elected Officials' Ret. Plan, Az., No. CV-13-0005-T-AP, 2/20/14).

But Monahan said the legal protections referenced in these state constitutional provisions are more complicated than they appear. Even Kim acknowledged that the extent of these constitutional protections haven't been fully tested, and the decision in Arizona holds little precedential value in other states.

Monahan said relevant case law suggests a substantial impairment to a state retirement system may still survive a constitutional challenge if the state can demonstrate that its enacted reforms were “reasonable and necessary” to serve an “important public purpose.” She said, however, that states would also have to demonstrate no other “less drastic” adjustment could have been implemented to solve the state's problems, and the state could not have achieved its important public purpose without the retirement system reforms.

Monahan said this “reasonable and necessary” justification for reform hasn't been adequately tested in the context of the current public pensions funding crisis.

Many legal scholars and pension administrators had expected litigation objecting to the Rhode Island Retirement Security Act of 2011 to generate a full judicial review examining the authorities of the state to diminish retirement benefits against the backdrop of a financial crisis.

But Monahan said such legal guidance now appears unlikely.

The state of Rhode Island reached agreement with public employee unions and retiree coalitions in February 2014 on a proposed settlement accord that resolves a series of lawsuits challenging recent changes made to the state-administered pension system (Council 94, AFSCME v. Chafee, R.I. Super. Ct., No. C.A. No. 10-2859, settlement announced 2/14/14). The deal retains the structural elements of the Rhode Island Retirement Security Act and includes a move to a combined defined benefit and defined contribution plan, an increased retirement age and a COLA suspension until the system is determined to be at a stronger funding level (33 PBD, 2/19/14; 41 BPR 442, 2/25/14).

Illinois Case Study

In the absence of a Rhode Island precedent, Monahan said pension watchers are now fixated on Illinois.

“My intuition is that Illinois is going to come down--entirely--to whether the changes made were reasonable and necessary, and whether the changes were the least drastic method for achieving the policy goal,” Monahan said.

“So I think Illinois will be a really fact-intensive inquiry into whether the benefit cuts were the least drastic way to solve the financial situation. And of course courts can have very different perspectives on that.”

How Are Investors Affected?
Municipal Bond Investors

While underfunded public plans may cause jitters to states and local municipalities, some investment advisers remain unshaken about putting money into municipal bonds and say that as a whole, they remain a safe investment.

Underfunded pension plans aren't always a deterrent when considering the purchase of a municipal bond, said Lyle Fitterer, a managing director at Wells Capital Management.

Understanding a municipality's ability to repay debt is of more importance, Fitterer said.

“It's a credit market and you need to do your credit work,” Fitterer said. “This is no different than any other marketplace.”

Municipal bonds are taking a hit now that credit agencies factor unfunded pension plans into ratings, analysts said, but the effects are marginal.

Still, that news can rattle individual investor confidence. Media reports on public pension plans and city bankruptcies can cause unnecessary investment fears of defaults.

“You hear it in the news every day,” said Jean-Pierre Aubry, assistant director of state and local research for the Center for Retirement Research at Boston College. “It's this albatross hanging around the governments' neck. We, at the center, don't believe that.”

The center concluded in their February 2011 publication “The Impact of Pensions on State Borrowing Costs,” that pension plans have a small influence on the yield spread, said Aubry, who worked on the study. The yield spread, the difference between the yield of a municipal bond and Treasury bond of similar maturity, could vary from 3 to 7 basis points.

“But the influence of pension funding on bond ratings may already be changing,” the study said.

Possibility of Default

Before the study was released, Standard & Poor's cut New Jersey's bond rating in February 2011, because of pension obligations. New Jersey's net pension liability is the fifth-highest among U.S. states, according to Moody's Investors Service (29 PBD, 2/12/14; (41 BPR 358, 2/18/14).

More recently, the Securities and Exchange Commission also charged Illinois in 2013 with securities fraud for misleading municipal bond investors on their approach to fund pension obligations after selling more than $2.2 billion worth of bonds. In settling the charges, Illinois neither admitted nor denied SEC's allegations. The state agreed to cease and desist from future violations of federal securities laws but wasn't required to pay any penalties (49 PBD, 3/13/13; (40 BPR 727, 3/19/13).

“If you're in one of the states with the SEC coming at you,” Aubry said, “that's a whole different story.”

But still, the possibility of default is real, Fitterer said. That varies by municipalities, and the factors that contribute to that are many, from legislation to budget mismanagement.

“Each state is different,” he said. “The constitutions are different. The law is different. A GO (general obligation) bond in Illinois is different than what it means elsewhere.”

Investors have grown more concerned with unique situations in bankrupt municipalities like Detroit, where the city's emergency manager, Kevyn Orr, proposed treating pension and general obligation bond debt as unsecured, paying about 10 cents on the dollar for claims that in Chapter 9 bankruptcy have traditionally been treated as senior to other unsecured claims (196 PBD, 10/9/13; 40 BPR 2402, 10/15/13). Orr later changed his proposal to 46 cents on the dollar for general obligation bonds backed by the city's unlimited taxing power.

In January, Detroit sued a set of corporations it created in 2005, seeking to nullify certificates of participation that were sold to investors to finance the retirement obligations (26 PBD, 2/7/14; 41 BPR 333, 2/11/14).

The city is intent on placing pensioners first and payment to bondholders second, Fitterer said.

“For every Detroit, there's 100 other good credit markets,” Fitterer said. “As a bondholder, I have to think of all areas.”

Regaining Investor Confidence

One of those areas is Saginaw County, Mich., 100 miles north of Detroit, where officials had a successful $54 million pension obligatory bond sale in January, said Timothy Novak, the county's treasurer.

It is a reversal in the Michigan bond market after news of the Detroit bankruptcy forced Saginaw County to postpone a pension obligation bond sale of about $60 million in 2013.

“The bond market wasn't moving,” Novak said. “Investors were cautious, and that was understandable for anything in Michigan. It was because nobody knew what the Detroit bankruptcy would be.”

The market was unfriendly and unfavorable at the time, Novak said, and Saginaw County's officials did the only thing they could to regain investor confidence at the time.

“We waited,” he said.

In time, investors distinguished a difference between a fiscal problem isolated to Detroit and not neighboring local municipalities, Novak said.

Waiting It Out

That is what it will take for most investors to move beyond the shock of what news they have heard, said Priscilla C. Hancock, a managing director at J.P. Morgan Asset Management.

“We've had a lot of headlines in the past years,” she said of the coverage municipals bonds and pension plans receive. “These are headlines that create some amount of reactionary selling.”

Nearly 70 percent of municipal bonds are owned by individuals, Hancock said, who are more susceptible and invest in different manners based on news they encounter. That is why municipalities like Saginaw County may have a difficult time because of nearby local governments that are unable to balance their budgets or renege on payments.

“It's not their fault,” Hancock said. “Individuals are just very sensitive to names.”

Hancock said she owns bonds from the University of Chicago, that some investors would be reluctant to purchase because of Chicago's unfunded pension obligations and past problems with SEC.

Chicago faces $590 million in additional pension payments in 2015 and had its general-obligation grade cut by Moody's Investors Service the week of March 10 to three levels above junk (50 PBD, 3/14/14; 41 BPR 612, 3/18/14).

“There's no risk,” she said, “but bonds have a name recognition impact.”

Differences in Cities

Even with massive debt and unfunded pensions, municipal bonds may still be a worthwhile buy for some investors in a city like Chicago.

“It's the economic car of the Midwest,” said Rachel Barkley, an analyst at investment research firm Morningstar Inc. “The city has a lot going for it.”

Chicago has been compared to Detroit in many reports, but there is a vast difference between the two economies, said Barkley, who works on pension liabilities.

Chicago and other cities, unlike Detroit, have robust economies, a solid tax base and legislators who have been vigorous in enacting general finance reform, she said.

“There's some light at the end of the tunnel for Chicago,” she said. That is something an investor should consider with any state.

But analysts will give more consideration to pension plans in Chicago, and other municipalities, when considering credit ratings. It is an element that is far more important today in the market than it was 10 years ago, she said, but the bonds remain a solid investment.

“Just because there is some weakness on the pensions side, it doesn't mean the overall credit health can't be positive,” she said. “Municipal bonds as a whole are an exceptionally safe investment class.”


--With assistance from Martha Kessler in Connecticut, Laura Mahoney in California, Chris Marr in Georgia and Susanne Pagano in Texas

To contact the reporters on this story: Mike Bologna in Chicago at, Nora Macaluso in Michigan at and Marvin Anderson in Washington at

To contact the editor responsible for this story: Sue Doyle at

Text of the Nelson A. Rockefeller Institute of Government report is at The latest annual report from the Florida Retirement System is available at Text of the Arizona Supreme Court decision is at Text of the Center for Retirement Research at Boston College's “The Impact of Pensions on State Borrowing Costs” is at

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