March 2017 Update: Dallas We've Had a Problem

“Houston, we’ve had a problem here.”  – Jack Swigert (Apollo 13 astronaut)

It was April 13, 1970, and the Apollo 13 mission to the moon was approaching the point at which the lunar lander was preparing for descent.  All of a sudden, an oxygen tank exploded which crippled the service module and effectively aborted the mission.  It was only after great effort and sacrifice that the crew of Apollo 13 was able to return the spacecraft safely back to earth.  In many ways, we believe that the Apollo 13 mission is a useful metaphor for the state of the US pension system.

What does Apollo 13 have to do with the pension system, and why should you care?  Just substitute “Dallas” for Houston and the metaphor will translate well.  For those that haven’t been watching what is happening in the city of Dallas, there’s reason to be interested…..especially for municipal bond investors.  Here’s a brief summary of what has happened.

The $2 billion Dallas Fire and Police Pension (DFPP) Fund finds itself at ground zero of the brewing pension issues on the horizon.  Essentially, DFPP made some bad real estate investments on behalf of its pensioners in the mid-2000s to include Hawaiian villas, Uruguayan timber and undeveloped land in Arizona.  These poor investments caused the pension fund to incur average annual losses of -1.5%/yr for the last five years, as opposed to the assumed return of 8.5%, to cover promised benefits.  These losses created a ~$7 billion shortfall that caused Moody’s and S&P to downgrade the credit rating of Dallas in early January.

Sensing that the pension was in crisis, many beneficiaries opted to take out lump sum distributions in lieu of the monthly payment.  This snowballing of fear caused ~$500 million in lump sum distributions in just the first few weeks of 2017, exacerbating the shortfall and causing the mayor of Dallas to halt all lump sum payments.  Now the city of Dallas/DFPP are in grueling negotiations to try and figure out where to go from here.

This brings us back to our original questions posed above:  What does Apollo 13 have to do with the pension system, and why should you care?  In short, we believe many investors are (1) overlooking large, unfunded liabilities, and (2) still relying on credit ratings and simplistic rules of thumb when making investment decisions on municipal bond offerings.  I’ll hear phrases like “I don’t have to worry about XYZ city because it’s a general obligation bond” or “this bond is AAA, so why would I be concerned”.  These are dangerous phrases to throw around.  In the case of Dallas, Texas, Moody’s has downgraded its general obligation (GO) bonds from Aa1 to A1 (three levels) in under 12 months due to pension concerns.  At Gratus, we approach a municipal bond portfolio with risk as a primary consideration.  To that end, below are a few considerations we keep in mind when constructing a municipal bond program.

1. Financial deterioration can happen quickly. Rarely is it the case that a municipality or state will jump from a high quality to low-quality bond overnight.  Yet, details are important to monitor.  One detail that we find useful is the rate of return (a.k.a discount rate) assumption being used by a municipal pension.  According to Piper Jaffray & Company, the median rate of return assumption being made by most municipalities is 7.75%.  In other words, the municipality is expecting the pension asset pool to earn 7.75% in perpetuity.  Obviously, this is far too high given where interest rates currently sit.  The problem, however, is more insidious.  If the municipality lowers its return assumptions, this increases the unfunded liabilities amount given that more assets are needed to generate the same return.  The table below illustrates this dynamic well. 

Discount Rate 7.6% 7% 6% 5% 4%
Total Liabilities ($tn) 4.5 5.1 5.8 6.6 7.5
Assets ($tn) 3.4 3.4 3.4 3.4 3.4
Unfunded Liability ($tn) 1.2 1.8 2.5 3.3 4.1

All this is to say, when interest rates were higher, there was more margin for error on investment returns.  Now with interest rates hovering around historically low levels, there is far less margin for error.

2. You can’t outsource your due diligence to a credit rating agency. While one would think companies providing insurance to municipal bonds have learned a valuable lesson in the credit crisis, we never rely on this insurance when making a municipal bond investment.  Certainly, the quality of municipal insurers has improved since 2008 with the entrance of behemoths such as Berkshire Hathaway, White Mountains Insurance and others.  Yet municipal bond insurance is often a reason I hear for not doing credit analysis under the idea that if Berkshire Hathaway is insuring the bond then it’s as good as an obligation of Berkshire.  Certainly, this will be the case longer term, but if an investor is relying on timely principal and interest payments as part of their income, any disruption (whether for a month or six months) to a payment can be difficult to endure.

3. Most municipalities display warning signals in advance of distress. As Wayne Gretzky once said, “A good hockey player plays where the puck is.  A great hockey player plays where the puck is going to be.”  Our thought on the current pension situation is simply to avoid investing in municipalities/states where the unfunded liabilities are large relative to the size of the pension and tax base.  Furthermore, to reduce the risk of a pension disaster, we can look at essential service bonds which have zero pension/benefit obligations.  An example of this would be a municipal bond whose principal and interest is derived from a utility bill or special purpose tax.  Good examples of municipalities that were displaying warning signals well in advance of bankruptcy were:  City of Detroit (2013), City of Stockton (2012), City of Vallejo (2008), Puerto Rico (2016).

Current municipalities flashing warning signals include the following:  State of Illinois, City of Chicago, Cook County, Marshall Islands, American Samoa, State of Connecticut, City of Hartford, State of Rhode Island, City of Providence, State of New Jersey, among others.

In summary, our point in publishing this article is not to scare clients into thinking that there is some action that needs to be taken; it’s merely to describe the new world order in the municipal marketplace.  In our opinion, rules of thumb can be dangerous.  As with the Apollo 13 mission, the problem is not terminal, but it’s pretty close to dire for certain municipalities.  Unless dramatic and swift action is taken at the municipal level to right-size pension obligations, there will be identifiable losers over the medium term:  bond holders and pensioners of the problem issuers.  We are (and have been) proceeding with caution in the municipal marketplace as we see certain geographies that could have problems in the future.

Post Script:  After I wrote the piece above I looked into the situation for union pension plans.  As it turns out, the first union pension plan declared bankruptcy (NY Teamster Local 707) earlier this year.  According to industry estimates, a further 200 union plans are on the brink of insolvency. 

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The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.