Moody s Adopts State and Local Pension Adjustments

Moody s Adopts State and Local Pension Adjustments New England States GFOA Manchester Village, VT Marcia Van Wagner Vice President Senior Analyst, US Public Finance

Pensions are a growing source of credit pressure» Liabilities and costs continue to grow across the public sector Reasons include demographic trends, imprudent benefit increases, contribution shortfalls, and lost decade in the stock market On reported actuarial basis, unfunded liabilities in 2011 were $800 billion, more than doubling since 2005 Negative credit impact is compounded by recent years slow recovery of tax revenues Credit rating downgrades of several states and locals attributable mainly or partly to pension pressures 2

Liabilities have risen sharply while revenues stalled While unfunded pension liabilities more than doubled from 2005 to 2011, tax revenues experienced their sharpest downturn in many decades and only a weak/moderate subsequent recovery» 2012 state tax revenues ($800bn) up nominal 3.2% from peak in 2008» 2012 local tax revenues ($592bn) up nominal 2.6% from peak in 2009» Calendar 2013 will be the first full year that state revenues exceed prerecession levels on an inflation-adjusted basis, according to NASBO and the Rockefeller Institute. Data on calendar year basis from US Census Bureau, and includes tax rate increases 3

Increase in pension liability relative to revenue is a negative credit factor» accrued unfunded pension liabilities are similar in nature to debt» amounts are significantly larger than bonded debt in many jurisdictions» complex and difficult to manage, especially at the local level» continue to grow if not prudently funded and amortized» can become a heavy burden on operating budgets and drain liquidity» may be on legal parity with GO debt in some jurisdictions 4

Pensions are one of many rating factors» Pensions are just one of many factors in a government credit rating For example, 10% weighting in our state and local government rating scorecards» For majority of governments, pension obligations remain manageable in context of revenues, resources, and budget-cutting powers Most have taken needed actions to accommodate increased pension costs and balance budgets Reforms are lowering employer normal costs, and in some cases reducing accrued liabilities But, more rating actions possible where pension pressures continue to rise 5

Moody s adjustments to state & local reported pension data» Adopted in April 2013, following Request for Comment in July 2012» Published data for states in July 2013» Data for largest locals forthcoming» Purpose of adjustments is to provide greater transparency & comparability of liability measures for use in our rating analysis» Provide a balance sheet measure, similar to that in private sector» Not intended as a guide, standard or requirement for state or local governments to report or fund their obligations 6

Four principal adjustments to as-reported pension data» Allocate liabilities of cost-sharing plans to participating government employers based on their proportionate shares of total plan contributions» Discount accrued actuarial liabilities (AAL) using a high-grade (Aa quality) corporate bond index rate as of the date of valuation» Use fair or market value of assets (MVA) instead of smoothed asset value to calculate Moody s adjusted net pension liability (adjusted AAL minus MVA) Although we are using AVA for local governments until MVA is disclosed» Calculate a standardized annual amortization metric related to the adjusted net pension liability, on a 20-year level dollar basis 7

Why are we making these adjustments?» To improve the transparency and comparability of pension information across state and local governments for use in our credit analysis of public sector entities» To create a balance sheet liability concept that is similar to that used in the private and not-for-profit sectors and comparable to measures of debt as of a specific point in time» To address the fact that government accounting guidelines allow for significant differences in key financial assumptions that can make statistical comparisons in the sector very challenging Our adjustments are not intended as a guide, standard or requirement for state or local governments to report or fund their obligations 8

Bond index discount rate provides a balance sheet measure» Our approach is similar to private sector standard set by FASB» Discounts the promised benefit payments using current market interest rate Treats pension benefits as bond-like obligations Liabilities are measured independently of asset mix or performance Liabilities of identical pension plans (government, hospital, or manufacturer) measured on the same day should be identical» Contrasts with public sector approach focused on funding Discounts using assumed investment rate of return based on asset mix Estimates the PV of employer contributions, if assumptions are met Market risk in this approach increases as the return assumption increases 9

Disclosure improvements may allow future refinements» Some adjustments will serve in an interim capacity until new GASB 68 guidelines are implemented.» Relevant additional reporting items include: Government shares of cost-sharing plan liabilities Sensitivity of liabilities to 1 percentage point change in discount rate (i.e. plan-specific estimate of liability duration) Components of pension expense (such as normal cost) 10

2011 ANPL for New England States State Reported UAAL ANPL Rank ANPL/Revs Rank Connecticut 20,069,660 41,587,093 7 189.7% 2 Maine 2,688,100 5,656,940 32 76.6% 14 Massachusetts 16,752,915 44,732,443 6 100.4% 9 New Hampshire 4,273,547 2,748,931 44 56.4% 21 Rhode Island 4,094,109 5,273,598 34 91.3% 12 Vermont 1,191,646 2,436,052 45 49.2% 24 Median 8,322,277 45.1% Average 18,880,577 60.6% Excludes some small pension plans 11

Ratings implications of pension adjustments» No state ratings were downgraded because of the changed methodology» This is primarily because we had already taken rating actions for the states with the greatest pension pressures: Illinois, Connecticut, Kentucky, New Jersey, Hawaii (and Puerto Rico)» Rhode Island has a negative outlook largely because of the unresolved nature of its pension reform» We put 29 local governments on review for downgrade. Of those, we have downgraded ratings for 18, including Chicago, Cincinnati, Minneapolis, Portland, OR and Santa Fe, NM. We have also downgraded a number of Chicago-area credits that were not on the review list, including Cook County and Chicago Public Schools Most of the downgrades were in the Midwest. None in New England!» Additional downgrades could result from our proposed local government GO rating methodology, which increases the weighting on pensions and debt 12

APPENDIX 13

Proposed and final adjustments to pension data 14

Sample discount rate adjustment $billions Reported AAL $50 Assumed investment rate of return Citibank Pension Liability Index AAL projected forward 13 years at 8.00% 8.00% 5.47% $136 Discounted at 5.47% $68 15

Adjusted pension liabilities for the 50 states and rated local governments FY 2011 ($billions) 50 States Rated Local Governments Reported AAL 1,427 1,577 Reported AVA 1,019 1,203 Median discount rate 8.00% 7.50% Market value of assets 873 n/a* Moody s adjusted pension liability Moody s adjusted net pension liability Median discount rate for Moody s adjustments 1,817 2,114 944 911 5.67% 5.54% ANPL as % of US GDP 6.35% 6.22% *Note: For local governments, the introduction of MVA rather than AVA is dependent on more consistent reporting of MVA in accord with the new GASB standards. 16

State rating methodology scorecard debt and pension metrics» Distinct metrics and breakpoints reflect our analytical view that pensions are debt-like but not the same as bonded debt Sub-Factor Measurement Aaa Aa1 Aa2 Aa3 A Baa and below Debt (10% weight) Net Tax Supported Debt/ Total Governmental Fund Revenues Less than 15% 15%-30% 30%-50% 50%-90% 90%- 130% Greater than 130% Pension (10% weight) 3 Year Average Adjusted Net Pension Liability/ Total Governmental Fund Revenues Less than 25% 25%-40% 40%-80% 80%- 120% 120%- 180% Greater than 180% 17

Local government rating methodology scorecard debt and pension metrics DEBT/PENSIONS (20%) Very Strong Strong Moderate Weak Poor Very Poor Aaa Aa A Baa Ba B & Below Weight Net Direct Debt / Full Value < 0.75% 0.75% n < 1.75% 1.75% n < 4.00% 4.00% n < 10.00% 10.00% n < 15.00% > 15.00% 5% Net Direct Debt / Operating Revenues 3-Year Average of Moody's Adjusted Net Pension Liability / Full Value 3-Year Average of Moody's Adjusted Net Pension Liability / Operating Revenues < 0.33x 0.33x n < 0.67x 0.67x n < 3.00x 3.00x n < 5.00x 5.00x n < 7.00x > 7.00x 5% < 1.13% 1.13% n < 2.63% 2.63% n < 6.00% 6.00% n < 15.00% 15.00% n < 22.50% > 22.50% 5% < 0.50x 0.50x n < 1.00x 1.00x n < 4.50x 4.50x n < 7.50x 7.50x n < 10.50x > 10.50x 5% Utilize Moody s adjusted net pension liability metrics Three-year average is used to smooth the volatility inherent in the metric Debt breakpoints more restrictive than pensions reflecting the fixed nature of debt obligations; pension measures are estimates, may be volatile across years and can be renegotiated and reduced 18 18

Contact: Marcia Van Wagner 212-553-2952 marcia.vanwagner@moodys.com

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