On January 27, 2011, the New York Times reported that Moody’s Investors’ Service has started to recalculate the States’ debt burdens to include the unfunded pension obligations owed to State employees. To date, States have not shown their unfunded pension obligations on their audited financial statements. Among the states with the largest per capita liability for unfunded pension benefits are Connecticut, Hawaii, Illinois, New Jersey, Kentucky, Massachusetts, Mississippi, Rhode Island and Alaska, according to the Times’ report. The change comes at a time when investors have grown increasingly wary about investing in state and local municipal bonds.
Moody’s new approach will add a State’s unfunded pension obligations to the value of its outstanding bonds when determining a State’s total obligations. This is similar to the approach that ratings services traditionally use to rate private sector corporate debt. Since States are reluctant to raise taxes on already stressed taxpayers, State and local governments will be under increased pressure to reduce pension obligations, both present and future, when they bargain with the public employee unions that represent many governmental workers. Some States may try to shift on a prospective basis away from a defined benefit approach to a defined contribution approach.
States with large pension deficits have reason to be concerned that the change in the ratings system may lower the rating of State debt obligations, many of which already have ratings that are below investment grade. Lower ratings on State debt would require States to pay higher interest on State and State-backed bonds to compensate investors for the additional perceived risk presented by lower ratings. The sale of bonds has traditionally been a viable alternative to raising State taxes or cutting back on State services. With the increased debt service burden that lower bond ratings would impose on States whose budgets already are financially stressed, however, raising funds through the sale of bonds, even given their State-level (and sometimes local level) exemption from income taxes, may simply become unaffordable.
Since "governmental" plans are not subject to ERISA’s anti-cutback rule, however, one way in which States with large public pension liabilities might seek to improve their bond ratings and thereby reduce required interest payments, would be to cut back on pension liabilities for public workers by reducing retirement benefits, an option generally unavailable to private sector plans due to the application of ERISA’s "anti-cutback" rule.
States that seek to go this route to shore up their bond ratings, however, face certain obstacles, which differ from State-to-State based upon State law and other considerations. Many States, for example, are required to negotiate any such benefit cutbacks or decreases in the rate of future benefit accruals with the various public sector unions that represent State and municipal employees. Furthermore, several States have provisions in their constitutions or in State statutes that protect public sector employees’ pension benefits. Connecticut and New York, for instance, have rules that function similarly to ERISA’s anti-cutback rule. In addition, some States, although their plans are not technically subject to ERISA, have written their pension plans in an ERISA-compliant manner to give public sector employees similar rights to participants in private sector ERISA plans, incorporating anti-cutback rules within the plan document itself.
Notably, some States that strongly protect their workers’ pensions against benefit cutbacks do not extend similar protections to public employees’ retiree medical benefits, another significant strain on State budgets. This is the case in New York. In states like New York, this may shift the financial battleground to negotiating for cutbacks in public employee retiree medical benefits.
Also, from a political standpoint, some States may face a very practical obstacle to taking action to reduce their pension and retiree medical liabilities: the fact that often the very top State officials responsible for negotiating benefit cutbacks are themselves State employees covered under these plans.
Nonetheless, in an era where tax increases are highly unpopular and cutbacks in municipal services can greatly reduce residents’ quality of life and a State’s ability to attract businesses and new residents, pension and retiree medical benefits for public sector employees are one area where States with the largest budget shortfalls may look to reduce their budget deficits.
Michael Jacobster (New York Office), Allan Friedland (Hartford Office) and Michael Kushner (White Plains Office), contributed to this article.