Economics
What kind of debt counts as debt?
Jan 31st 2011, 16:43 by A.S. | NEW YORK
HERE'S a scary statistic: if you properly account for American states' unfunded pension liabilities, you get a figure more than 4.5 times all the outstanding municipal debt. With this in mind, it seems long overdue that Moody's will now consider pension liabilities when rating municipal debt. Moody's will use the same liability calculations the states do. These calculations involve accounting conventions which, though perfectly legal, vastly underestimate how under-funded the pension obligations are (an 8% discount rate!!!). Even still, it's a big step in the right direction. States like Illinois may expect a downgrade.
It's a contentious issue whether or not pension liabilities should be included in state or sovereign debt measures, in addition to outstanding bonds. Despite America and Europe's onerous entitlements, these promises are not included in their debt figures, though rating agencies claim to account for entitlements when they give sovereign debt ratings. But these promises are accounted for differently than other obligations because future entitlements are subject to revisions. Here's Moody's, on how they factor different sources of debt into ratings:
How likely is the debt to rise abruptly due to a shock or crisis of some kind? The structure of the debt matters, especially from a liquidity risk standpoint. We attempt to differentiate between dangerous and benign debt structures. Dangerous debt structures are characterized by a lack of granularity (front-loaded debt, or a very uneven repayment schedule), and different types of indexation (to interest rates or exchange rates).
Likewise, debt can rise abruptly when, for instance, a government has to take the cost of a banking crisis onto its balance sheet. It is therefore important to assess the degree of conditionality of liabilities "“ actual financial debt obligations should be weighted much more heavily than contingent ones (such as the risk of a banking sector bail-out) or even more implicit, longer-term liabilities (such as unfunded pension liabilities). Indeed, contingent liabilities must be discounted by their likelihood of materialization "“ which is easier said than done "“ and future liabilities should be taken into account only in so far as we can appreciate their cash impact.
The point here is that we take into account implicit liabilities such as public pension system deficits only to the extent that they will materialize into an actual debt or payment obligation; governments have many ways to alter the net present value of pension liabilities, such as postponing retirement age, increasing contributions and lowering pensions.
Governments have the option of cutting back on pension or health benefits, and this partially justifies why entitlements usually aren't lumped with other promises. Benefit cuts are a form of default; it's perhaps not as damaging as missing a bond payment, but it is still not delivering on a promised payment. There's also a limit to how much benefits can be cut and taxes increased (most politicians will not leave their elderly population destitute), so at a certain point paying entitlements could mean other obligations are not paid. I am not sure exactly how entitlements should be included, but it seems they should be in some way
But pension promises from American states should be in a different category than Social Security or Medicare. Pension and health benefits in many states are guaranteed by the state constitutions. That means reducing benefits is very difficult, if not impossible. According to Josh Rauh and Robert Novy-Marx that guarantee means that states may default on their municipal debt before they don't pay or reduce state benefits. It suggests that state pension obligations should not only be factored into ratings, but they should also be included when states calculate their outstanding debt.
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If for no other reason than so state governments can no longer treat pension promises as free, I agree.
If for no other reason than so state governments can no longer treat pension promises as free, I agree.
First, I distrust any document that uses buzzwords like "granularity".
Second, I laughed out loud when I read that rating agencies will consider pension liabilities "only to the extent that they will materialize into an actual debt or payment obligation; governments have many ways to alter the net present value of pension liabilities, such as postponing retirement age, increasing contributions and lowering pensions."
Isn't this true for ANY AND ALL government debt?? Couldn't the United States theoretically do what Russia and Latin America did, and simply refuse to honor its bond debt and declare default?? Couldn't the United States simply do what Zimbabwe tried, and print banknotes like they were toilet tissue?? If the benchmark for calling debt "debt" is 100% certainty that it will be paid off, then shouldn't rating agencies declare the U.S. to be debt-free?????
Look....Why can't 'debt' simply be defined for governments and business in the same way it is for individuals?
An obligation to pay or render an outstanding amount of monies. You owe it. You have to pay it. Its DEBT.
Accounting boondoggles utilised by government and business have to stop. For example;
What the hell is 'off balance sheet debt?' and why is such a scam allowed to exist? Even the term is an affront!...What is it, in effect, saying?
"In order to negate transparency and lessen clarity in our accounting procedures , we are going to put a heap of our liabilities over here where you can't see them"
Accounting devices and ploys like this are ridiculous...If markets supposedly rely on transparency in order for investors, speculators, and customers to make informed choices ...how does such accounting actions serve capitalism?
You wonder why the system keeps crashing? We can't even agree what constitutes debt! What do you expect?
states have hidden how upside down they were in promises to unions for a long time. that at least some of that duplicity is being unravelled is for the good.
Do the states have the cash to pay for it now? Are they legally obligated to pay it? If it's no to the former and yes to teh latter, then it is debt.
Of course, I try telling my significant other that my credit cards aren't actually debt, because I plan on winning the lottery and paying them off. Judging by her skepticism, perhaps she should run a rating agency rather than Moodys.
Whoa, hoss. The paper, which I've read, says that 8% as a rule of thumb for discounting the liabilities is too high and then jumps from that to say that a "risk free" method is the only correct discount rate. That pumps up the value of the future liabilities substantially. They don't offer any reasoning other than "certainty" and so they mentally equate certainty with no risk at all. That's nonsensical from an actuarial perspective. They might as well say the liability is infinite because the dollar might fold and then we'd never pay any of this. If they had said, "We should look at a range from the 8% used as a rule of thumb down to treasuries, then we'd get a broader picture of the problem." But they didn't; they just assert the biggest number is the best number.
I'm no defender of public employee boondoggles - as for example, the many practiced by the firemen in big cities like Boston - but it's important to think about pensions without heat and light:
1. Take teachers in Illinois, a state which chose for 15 years to underfund pensions. Those pensions average 40K after 30 years, which is a premium of about $12k over Social Security - and they don't get Social Security. Is the idea that we should expect to attract quality teachers while not offering them more than Social Security? That would be a disincentive to our educational system. Maybe a problem is that they aren't in Social Security and thus the state funds the entire pension but that speaks to design, not dollar amount.
2. Using historical rates of return - which the paper did not discuss - you get much lower numbers. There are analyses of this easily available. I believe CBPP did one recently. The 8% number was the historical rate for about 2 decades; it wasn't picked out of thin air.
3. Funding of long-term obligations isn't done in some Tea Party manner where you put all the money aside now - like cut the entire deficit this year. You fund to a level that gives leeway. Pensions in some states have dropped below the sensible level. Others have not and those values have recovered somewhat with the markets.
This simply isn't an OMG issue as it's made out to be. There are many problems and a lot of abuses - think LIRR! But the overall issue is being whipped up into something it is not.
But then reason doesn't sell well.
@ jomiku,
I'm not sure what pile of sand you've been hiding your head in, but the pension system IS the OMG issue it is being whipped up to be. I'll leave Buttonwood the heavy lifting of explaining the pension crisis in the upcoming article on pensions, but to address your three points:
1. Your Illinois teachers are not receiving Social Security because they apparently do not pay into Social Security and their benefits exceed what they would otherwise receive from Social Security. The federal government passed the Windfall Elimination Provision (WEP) in Social Security to prevent anyone who did not pay into Social Security from reaping an extra "windfall" from the federal government. This does not completely exempt a retiree from getting benefits -- it is a pension offset provision that reduces your Social Security benefit the higher your pension is. Your teachers are receiving $12k more than SS, so they don't receive any SS benefits.
2. I have no idea where you got an 8% historic rate of return from, but that is not automatically appropriate to use as a discount rate for a pension. Pension funds can get invested in a variety of investment vehicles, some more risky than others, but prudent pension funds recognize that they must preserve principle which is why they typically invest in bonds and other low-risk vehicles. The historic rate of return on those conservative investments is well below 8%. I would also caution that the rate of return CURRENTLY is well below that rate now and is likely to stay low for quite some time.
3. Some entities (like the Bank of England, as Buttonwood pointed out) fully fund their pensions. Most municipalities cannot afford to do so, and therefore only fund their pensions to cover their expected payouts in the immediate future. It is this practice that is causing much of the OMG problem -- the size of the workforce is not increasing as fast as the size of the retiree population, which means that pensions are being depleted more rapidly than the coffers are being refilled. This is the same problem that Social Security is facing. There are ZERO states and municipalities that can comfortably say their pensions are adequately funded, without forcing more contributions from their existing workforce and/or cutting benefits. This is why you see many governments making the switch or discussing the switch to defined contribution plans instead of defined benefit plans.
jomiku wrote: Jan 31st 2011 6:40 GMT The paper "jumps from that to say that a "risk free" method is the only correct discount rate. That pumps up the value of the future liabilities substantially. They don't offer any reasoning other than "certainty" and so they mentally equate certainty with no risk at all. That's nonsensical from an actuarial perspective."
No, this makes perfect sense. They are claiming that the discount rate should be set a level that corresponds to a "risk free" investment portfolio (i.e. guaranteed no loss of principal, plus a minimal rate of return). This is because the pension benefits are guarranteed, so the pension fund cannot afford to gamble on speculative investments that might wipe them out. With such a conservative "risk free" investment strategy, the rate of return is extremely low, therefore the discount rate used for calculating future liabilities must be set extremely low. This means that the value of the future liabilities is significantly higher than what is advertised with an 8% discount rate.
The accounts of the pension funds are scary too. Look at the alphabetical investment strategy here:
http://www.aqueousadvisors.com/blog/?p=507
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