There are some concerns that the new GASB statements for municipal bonds will impact retirement plans. Here is our response to your concerns, so that you can distinguish the true indications from the surrounding media noise.
Due to the changes to GASB statements no. 67 and 68, how will retirement plans be impacted by recent and potential future downgrades to municipal bonds?
To understand how the municipal bonds are affected by the changed accounting measures, it is wise to first understand the changes to the accounting itself. GASB statement numbers 67 and 68 mandate governmental balance sheets reflect unfunded pension liabilities. In other words, municipal governments are required to indicate what pension liabilities they are not able to pay for; previously off-balance sheet liabilities are now indicated on the balance sheets.
➢ Statement number 67 is effective for plans beginning after June 15, 2013.
➢ Statement number 68 is effective for plans beginning after June 15, 2014.
The regulations require states and municipalities to use a correct interest rate assumption, not the “ideal.”
The key issue surrounds Pension Obligation Bonds (POBS), which have been somewhat obscured in the balance sheets. Created in the 1980s as an arbitrage tool, they are still used today to issue government bonds to improve funding ratios for state and municipal pensions.
What is the greatest fear?
The biggest fear surrounding this is that the downgraded bond rating assigned to some state and municipal bonds will lead to a mass flight of certain bond markets, thus reinforcing the problem of underfunded pension plans. A downgrade may also mean an increased cost to debt financing and harsh budgetary initiatives to maintain public confidence and access to financing.
However, this fear is more demonstrative of media misunderstanding of accounting and/or municipal bonds themselves. Ratings agencies, including Standard & Poor’s, indicate that they have been aware of the liabilities through their own investigations and the previous balance sheets. These regulations are a re-representation of the same information that is more accessible to the public, but experts are still aware of what they’re looking at.
What is the worst possible outcome?
If there is enough risk in these bonds to downgrade their current bond rating, some investors may sell their bonds while other investors may buy more bonds because of the lower rating, leading to higher returns on the bonds themselves.
High yield muni bonds are not unknown. Wise investors will simply keep what they have and re-balance their portfolios to include investment-grade muni bonds from an area with less risk, perhaps from another geographic area, but these should already be in place.
What does this have to do with retirement plans?
The tax shelter on interest from municipal bonds is not applicable within a tax-sheltered qualified plan like a 401(k). Every dollar that is withdrawn from a tax-deferred plan (i.e. pre-tax 401(k) deferrals and earnings) is taxed at an individual’s ordinary income tax rate, whether the dollar was earned as a capital gain or a tax-exempt dividend from a municipality. As a result, there should be little, if any, impact to investment options within retirement plans.
Do you have questions on or expertise to add to this conversation? What do you hope to hear about? Add to the conversation on LinkedIn or email me directly at Katherine@CastleRockInvesting.com.
[1] Mark Lassee and Marc Liebermann, “Impact of New Pension Rules on Government Bond Ratings” Pensions and Investments (Scottsdale, Arizona: April 15, 2014), link: http://www.pionline.com/article/20140414/PRINT/304149996/impact-of-gasbs-new-pension-rules-on-government-bond-ratings
Castle Rock Investment Company, formed in 2006, is an independent woman-owned SEC-registered investment adviser located in Castle Rock, Colorado. We specialize in individual financial plans and qualified service plans.