The State of Connecticut: Impact Laggard to Leader
Connecticut faces ongoing and increasing structural budgetary deficits, weak job growth and population out-migration. These serious issues are further compounded by the state’s growing unfunded pension liabilities that pose the greatest long-term risk to financial stability. When Moody’s, Standard & Poor’s and Fitch all downgraded the state’s ratings over the last few years (from Aa3 to A1, AA to A+ and AA- to A+, respectively), each agency noted the increasing pension funding gap as a key credit factor in their action. This year, the state is taking a fresh approach to address the issue; transferring state-owned qualified real assets to the pension funds’ investment portfolios has improved funding ratios created new opportunities for nonprofits, foundations and private enterprises put underutilized assets to work. This gives us a reason to be optimistic about Connecticut’s future credit quality.
The State of Play: Bonds and Pension Liabilities
Connecticut sponsors five pension plans: State Employees Retirement System (SERS), Teachers Retirement System (TRS), Judges’ Family Support Retirement System (JFS), Probate Judges Retirement System (JRS) and Municipal Employees’ Retirement System (MERS). While the state is obligated to make annual contributions to each plan, years of deferred payments have resulted in substantial funding deficits.
The problems started from the get-go, dating back to 1917 when TRS started offering benefits, and 1939 when SERS was founded. At that time, no money was saved to pay for future benefits and existing benefits were paid for from the annual budget. These legacy costs ran up for decades until true actuarially-based prefunding began, first for SERS in 1972 and later for TRS in 1980. But by then, it was too little too late to true-up years of neglected endowment.
At the close of FY 2016, SERS had a $22.9 billion funding gap, TRS has a $14.2 billion gap and JRS was short $0.24 billion. Correspondingly, funding ratios for SERS, TRS and JRS (FY2016) were 31.69%, 52.26% and 43.76% with a combined net pension liability of $37.3 billion and Employee Contributions of $2.49 billion. It’s worth noting that while the state is now making its required annual contributions, it is not making additional payments towards reducing the liability. Compounding the problem, the real rate of return on investments in the pensions underperformed the assumed rate of return.
Another problem is the state’s Other Post Employment Benefits (OPEB) liability — predominantly health care coverage — that totals $20.7 billion. The combined pension, OPEB and debt service payments comprise nearly 30% of state revenues — among the highest fixed cost ratios for state and local government in the nation, leaving the overall long-term liability per capita at $21,500 for every man, woman and child in the Nutmeg State.
The State’s Two-pronged Response
Connecticut announced its intent to utilize two strategies for liability management. In addition to using methods frequently applied by other state and municipal pension funds (such as increasing employee contributions or offering hybrid plans), the state’s second strategy is to use existing assets on the public balance sheet to reduce underfunding.
Transferring public assets for the benefit of state pension systems is a complex venture, but the potential positive outcomes make it compelling. Contributing public land, buildings, enterprises and other infrastructure to the pension fund portfolio will reduce the underfunding as the assets gain value.
In addition, asset repurposing can offer long-term cash flows and asset appreciation consistent with the long-term liabilities of the pensions. And the gain is more than just an accounting recategorization of book value to market value: by developing, repurposing and renovating underutilized assets, the assets managers create new value. This in-kind contribution of state owned property to its pension funds could serve as an immediate credit against unfunded liabilities based on the fair-market valuation of the assets, as well as a corresponding boost in pension and OPEB funded ratios.
The Connecticut Pension Sustainability Commission of the Connecticut General Assembly is reviewing the necessary requirements to implement this funding plan. An initial estimate shows that Connecticut has more than 7,000 real-assets that could be reviewed for inclusion with an overall value in the multi-billions. If the state were to include certain state enterprises, such as the toll-roads, that number could be even higher.
Without much domestic precedent to go by (pensions owning interests in state infrastructure are far more common in Europe), the establishing law needs to offer guidance. There are also some practical considerations to take into account: assets need to be identified and appropriately valued, and since the investors would not hold the assets directly, determining the business structure and management must also be vetted. To that end, the Committee formed subgroups on actuarial, legal and capital asset selection. It may take another two years before the first asset transfer is executed but the material relief brought about by these in-kind asset contributions in lieu of cash is readily apparent.
Positive Economic Impact
The broader social and economic impact of taking unused land or underutilized buildings and converting them to highest and best use could provide much-needed local stimulus that will be felt across the state. Opportunities open for collaboration with foundations and nonprofits to repurpose properties to address needs in high-impact sectors such as affordable housing, preschool education, community medical care and senior care. Private entrepreneurs could also develop business incubators or satellite offices. Clean energy and LEED certification are another component of retrofits, which could include matching Federal or foundation grant dollars for clean energy installations such as solar panels microgrids. Finally, solar panels installed on unused highway right of ways can offset existing energy sources.
Progress towards stability
With billions of unfunded liabilities stemming from fifty year old legacy issues, no immediate solution will bring funding to 100%. That said, the recent actions of the Governor and the legislature show a compelling intent to address the issue, and also quantifiably improve pension funding and future budget planning for the state. While we expect to see some disagreement politically on this approach, any progress — albeit initially modest — is a better alternative to stagnation. These actions serve to stabilize Connecticut’s credit transitioning and the result is improved value for investors.
About Neighborly Investments: doing well by doing good
Neighborly Investments, a wholly-owned subsidiary of fintech platform Neighborly Corp., is a technology-driven investment manager offering optimized financial returns for customized impact portfolios. Using pioneering software to augment deep municipal market expertise, Neighborly Investments efficiently sources, values and analyzes the breadth of the market’s offerings, and executes according to each client’s objectives. In addition to earning competitive returns, each client portfolio tells a unique impact story, reflecting individual goals and passions. Neighborly Investments is an institutional municipal bond manager based in Boston, MA, serving high-net worth investors, registered investment advisors (RIAs) and institutional investors such as community banks and not-for-profit organizations that want to engage impactfully with their local communities.
Disclaimer:
This article is for informational purposes only and is not intended to solicit an investment, nor constitute investment advice. Investment in securities involves varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy will be profitable or equal to any historical performance levels. The information being presented has been compiled from both internal and external sources. Such information may include charts, news, and research data prepared by third parties and provided by us or obtained from sources we believe to be reliable, but we cannot and do not guarantee the accuracy, timeliness or completeness of such information for any particular purpose. We assume no liability for damages resulting from or arising out of the use of such information. From time to time, Neighborly Investments’ clients may hold security positions or other interests in companies, issuers or borrowers mentioned herein.
