A higher inflation and interest rate environment will exacerbate pension risks for investors in U.S. state and local government bonds, putting those risks back at the center of the municipal market as the direct impacts of the pandemic of COVID are easing.
From a bondholder’s perspective, pension risk refers to the possibility that pension costs will increase to the point of harming an issuer’s ability to repay debts: risk increases as unfunded liabilities and the budgetary requirements to pay them increase.
The annual survey of municipal analysts conducted by Tom Kozlik of HilltopSecurities ranked retirement issues as the number one concern for investors for most of the 2010s – until the pandemic hit and cash-flow worries ran out. term are beginning to emerge.
The pendulum begins to swing back. Consideration of pension risk in municipal credit analysis is especially important today, after a long period of low interest rates and low inflation in the global economy. . In 2021, we started to see a rise in inflation, which reached 40-year highs in 2022 and can drive up unfunded liabilities by increasing pension fund liabilities and decreasing asset values.
With respect to plan assets, although markets are unpredictable, an economic environment characterized by higher interest rates and higher inflation sets the stage for less favorable investment returns for bond and equity markets, particularly in contrasts with the environment of low interest rates and low inflation in the United States. the recent past.
This theoretical assertion has certainly been confirmed in the last 12 months or so. Many issuers whose bonds are insured by Build America Mutual have June 30 fiscal years; for the year ending June 30, 2022, the S&P 500 lost 11.92% and the Bloomberg US Aggregate Bond Index fell 10.25%. (This performance has eroded the asset gains seen in the years ending June 30, 2021 – which seems so long ago – when pension fund investment returns above 20% were not uncommon. )
If the performance of pension fund assets is less favorable than expected by the plan’s valuation actuary, all other things being equal, the unfunded liability and contribution requirements will increase. It is important to note here that the experience of assets is measured against expectations. For example, if the pension plan’s investment return assumption is 7% (currently around the national median assumption) and the plan’s actual return is negative 11%, the actuarial loss reflected in unfunded liabilities is negative 18%.
The impact of inflation on pension liabilities and employer contributions depends in part on the length of the inflation period. Two key items that are affected by inflation and that could be used to increase pension plan liabilities are wage growth and cost of living adjustments (COLAs) for retirees.
Most public sector pensions are calculated on the basis of salary-related formulas. If the period of higher inflation were to last only a few months, there might be little or no impact on employee wages. The longer the period of high inflation lasts, the more likely it is that actual wage increases will exceed those assumed by the actuary, which would serve to increase projected pensions.
On the other hand, COLAs that are indexed to inflation will be more sensitive to a period of high inflation and will likely be higher than assumed by the actuary. If higher inflation lasts for an extended period, actuaries may increase their salary increase and COLA assumptions when calculating plan liabilities. Changes in actuarial assumptions tend to delay actual experience until the actuary notices a developing trend and has reason to believe that the trend will continue in the future.
In short, there could be one or two increases in liabilities, first when adverse plan experience (higher than expected salaries and/or COLAs) occurs over a period of time, then when actuarial assumptions are updates to anticipate higher inflation – over the same period plan assets may underperform expectations.
Although revising actuarial assumptions to better reflect future inflation may result in a high assessment of short-term pension risk, not revising assumptions and allowing the impact of inflation to affect liabilities and plan costs as higher than expected inflation occurs is ultimately a greater risk factor. The first approach allows for a gradual repayment of liabilities related to rising inflation, while the second approach opens the door to cost deferral and possible nasty fiscal surprises.
Other factors to consider when assessing the impact of rising interest rates and inflation on retirement risk include:
- Sponsors of public sector pension plans could react to a scenario of rising inflation by recognizing the erosion of the purchasing power of the pensions of current retirees. To the extent that pension schemes do not already provide cost-of-living adjustments to retirees’ pensions, or only provide them on an ad hoc basis, it is possible that unions or retiree groups will push for unpaid COLAs. planned. Adding pension liabilities creates a need for additional employer contributions, which can add to fiscal pressures caused by pensions. Therefore, such an increase in benefits would be considered negative from a credit perspective.
- Public sector plan sponsors can respond to increased pension budget demands by contributing less than the actuarially determined contribution. In this case, the number of years required to repay unfunded liabilities may increase, and there may be a higher incidence (or acceleration) of projected pension plan insolvencies (exhaustion dates). BAM views failure to repay unfunded debt over a reasonable period of time as a significant negative risk factor for pensions.
We don’t know how long the current rise in inflation will last. This article has outlined some issues that BAM considers when assessing the impact of credit risk from different trends that may arise based on a higher interest/inflation environment.
Ultimately, the environment of higher interest rates and higher inflation will affect different bond issuers differently, and municipal bond analysts and investors should continue to apply granular analysis when assessment of credit prospects for specific assets.