The Center for Retirement Research at Boston College has published a new brief that looks at the relationship between pension funding and the cost of government borrowing. Recently Moody’s announced it would look at states’ unfunded pension liabilities along with outstanding debt in its evaluations. (When they did so, Moody’s found Connecticut, Hawaii, Illinois, Kentucky, Massachusetts, Mississippi, New Jersey, and Rhode Island topped the list of state indebtedness).
Authors Alicia Munnell, Jean-Pierre Aubry and Laura Quinby have taken a look at Moody’s ratings process and find that the agency puts more emphasis on the state’s management and finances, than on its economy and debt when assigning ratings, thus pension funding is “underweighted.”
A regression analysis tests the extent to which pension funding (percent of the Annual Required Contribution paid) affects the spread between yields on state-issued bonds and Treasury bonds. They find that it does, and that increasing the percent of the annual contribution paid (by one standard deviation) reduces the required interest rate on state-bonds by 3 basis points – a small impact relative to other factors.
The authors conduct another regression to see what effect Moody’s ratings have. They find that Moody’s incorporation of pensions into their analyses hasn’t had a significant impact on bond ratings.
They caution that as pensions become a larger part of state budgets the magnitude of the ARC’s effect on the spread could increase.