Q: How can you tell when a municipality's pension liability is getting too large for them to handle? Are there red flags or a rule of thumb?
A: There is no given "Rule of Thumb." However, a practical approach is to review the municipality’s enterprise-wide Statement of Activities over the past two or three years and determine if the Change in Net Assets is deteriorating, stable, or improving.
There is a continuing concern about the extent of municipalities’ unfunded pension liabilities and whether they are sufficiently large and threatening to cause severe debt service problems. GASB 68 and GASB 71 attempted to clarify the computation and presentation of unfunded pension liabilities, but there is considerable controversy about the proper discount rate to use for future pension obligations and the proper rate of return to use on investment of pension assets. As a result, think tanks, such as the Brookings Institution, have suggested that the best approach to assessing the severity of pension obligations is an assessment of a municipality’s income statement – or Statement of Activities – over time to determine its prospects for covering all costs, including annual pension expense and debt service.
The key to any practical assessment is use of the enterprise-wide financial statements for a municipality, which are reported on an accrual basis according to GAAP. The use of fund accounting statements requires numerous adjustments to approximate a cash flow statement that allows assessment of a municipality’s ability to meet all operating costs, as well as pay its debt service as scheduled.
Q: We have bonds where we have a pledge of dedicated tax revenues. The bond resolution indicates that P&I payments are payable prior to the payment of any operating expenses. Our analysts are looking at the debt service in relation to the specific dedicated tax revenues (prior to operating expenses). We have a school district that had decreases in net assets every year and almost no real liquidity. Given the bond terms, how realistic is this situation? How much confidence should the dedicated tax and priority over operating expenses provide?
A: A few comments and questions to consider.
If the school district has diminishing operating cash flow, that should be of concern.
The bond's payment priority appears to be a subordination clause. Whether the district honors the clause will only be apparent after the fact.
If all bond interest charges are met without delay, that is good news. However, does the district have a short term credit line and is it using it more as time passes? If so it may be relying on short term debt to service long term debt.
Are there any funds transfers to the school district from other funds and business operations controlled by the associated municipality? (Assuming the school district is not a stand alone entity.)
Finally, all of the above is further complicated since the financial data is usually stale by the time it's public.
Course overview: Fund Accounting and Municipality Analysis: Part I of II