While defaults in municipal finance have been rare, we are starting to see some potential concerns. As background, if one goes to MuniNet Guide, which provides various municipal bond data, you can find historical statistics on how frequently cities, towns, villages and counties go bankrupt.
From the data, we learn that municipal filings are pretty rare. Since 1937, there have been 680 Chapter 9 municipal bankruptcy filings. For the past few years, the default rate has declined. There have been three so far in 2018, six in 2017 and 2016, and three in 2015. Since 1980, Nebraska has had the most Chapter 9 filings with 65, followed by California (49) and Texas (40).
So why be overly concerned? A report from investigators at Harvard show that U.S. states — which are not allowed to go bankrupt — have a propensity to over-promise pension returns and might have to raise state taxes to meet their debt and pension obligations. A statistic known as the funded ratio, the amount of investments on hand compared to the future cost, range from the high 90’s for Wisconsin, South Dakota, and Tennessee to around 30% for New Jersey, Kentucky, and Illinois. In other words, the “30% states” have only funded 30% of the future cost.
In many situations, local municipalities are in even worse shape. They are also forecasting high rates of returns on assets that are invested – probably beyond what most professional advisors would suggest. For example, according to research from the Center for Retirement Research at Boston College, local and state governments are assuming their pension investments will produce annual returns of 7.5%. Many investment advisors suggest that a 5% return would be more reasonable for the next ten years.
Underfunded pensions and unrealistic future return expectations is a recipe for disaster. While raising taxes maybe an option for state and local governments, what is to keep its citizens from moving to the city (or state) down the road? It is hard to imagine that we will not see an increase in Chapter 9 bankruptcy filings over the next several years.