This paper was presented at the 2018 Municipal Finance Conference on July 16 & 17,2018. The conference is a collaboration of the Brookings Institution’s Hutchins Center on Fiscal and Monetary Policy, the Brandeis International Business School’s Rosenberg Institute of Public Finance, Washington University in St. Louis’s Olin Business School, and the University of Chicago’s Harris Institute of Public Policy. It aims to bring together academics, practitioners, issuers, and regulators to discuss recent research on municipal capital markets and state and local fiscal issues.
State governments with large unfunded pension liabilities are paying more to borrow from capital markets than are other states, according to Chuck Boyer of the University of Chicago Booth School of Business. In the paper, “Public pensions, political economy and state government borrowing costs,” to be presented at the 2018 Municipal Finance Conference at Brookings this week, Boyer argues that markets view states with large pension deficits as riskier investments. His evidence suggests that states are already paying for municipal government’s unfunded pension liabilities in the form of higher borrowing costs. He asks two questions: 1) how are state governments’ borrowing costs affected by unfunded pension obligations? and 2) do states with political constraints face higher borrowing costs? Boyer constructs a panel dataset using each state’s Comprehensive Annual Financial Reports for the period 2005 to 2016. He focuses on balance sheet variables—revenues, expenses, assets, and liabilities—to capture a state’s financial health and credit default swap (CDS) spreads – the premium paid to protect buyers from an issuer defaulting – to measure borrowing cost. The author reasons that CDS reflects market sentiments better than market yields because CDS are more liquid, and because they are standardized, whereas market yields may be affected by additional features of a particular bond.
“[I]nvestors see pension liabilities and bonded liabilities similarly when assessing state level default risk.”
Boyer’s results suggest that markets believe states with a higher liability-to-GDP ratio are riskier. He finds that states with lower deficits have lower CDS spreads: a one standard deviation change in the ratio is associated with a 0.18 percentage point change in CDS spreads. “This implies investors see pension liabilities and bonded liabilities similarly when assessing state level default risk,” writes the author. Boyer also proxies a state’s political constraints by examining whether its pensions are protected by constitutional provisions, the degree of union membership, and the state government’s involvement in municipal bankruptcies. The author reasons that, “[I]n a state with more ‘senior’ pension liabilities, the government is likely to default on bonded debt before pensions.” Boyer finds evidence, albeit weak, that investors see political constraints on unfunded pension liabilities as contributing to default risk. In another paper on pensions to be presented at the same conference—“When needed public pension reforms fail or appear to be legally impossible, what then? Are unbalanced budgets, deficits and government collapse the only answer?”, James Spiotto of Chapman Strategic Advisors LLC describes the ways public pensions have been treated in municipal bankruptcies and efforts, sometimes restrained by the courts, by state legislatures to reform the process. “This is not the case of unwillingness to pay,” writes the author, “which never is an acceptable excuse for not funding public pension obligations. Rather, this is the financial and practical inability to pay and still provide the services that are mandated by the vital mission of government.” Spiotto proposes four alternatives to current law for balancing the interests of bondholder, taxpayers, citizens, and municipal employees:
- Structure a prepackaged Chapter 9 bankruptcy plan with several steps to restructure pension obligations.
- Create a special federal bankruptcy court that determines whether the local government employer’s proposed plan for reform adequately balances the interest of all affected parties.
- Create a quasi-judicial government commission that has the power to modify proposed recovery plans and bind all parties to the approved plan.
- Change state laws to better balance general welfare with pension obligations.