There are four main components when calculating the American GDP: personal consumption expenditures, business investment, government expenditures and net exports. Of these four components, consumer spending makes up 70% of the GDP calculations.

Now, with the current reality of COVID-19, the shelter-in-place orders throughout America are serving the biggest blow to this 70% component of the American GDP. In addition, we have mounting unemployment numbers, businesses are unable to sustain the financial pressures, and there is fear of the unknown pandemic until we have a viable vaccine or treatment in place.

For the local and state governments, we have started to see governors and local elected officials putting forward budget cuts due to the lost revenues and increased expenditure to tackle the COVID-19 threat. One important component that ties the struggles of all three levels of governments – federal, state and local – is again the consumer spending that in-turn generates the sales tax revenues. The revenue loss and lackluster performance of the financial markets is going to worsen the pre-existing issues for local governments. The main one being the unfunded pension liabilities.

In this article, we will take a closer look at how an economic recession can impact the unfunded pension liabilities for local governments in the United States.

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Many of the state and local governments around the United States are members of pension funds that run their respective pension plans for local government employees. These public pension plans typically provide pensions based on members’ years of service and average salary over a specified number of years of employment. Many members also receive cost-of-living adjustments that help maintain the purchasing power of their benefits in retirement.

In understanding the unfunded liabilities, let’s take an example of an employee who started their career at the age of 25 with a local government. That local government, with the help of an actuarial accountant, would work out the monthly pension liability of that employee based on their current age, and make a few assumptions about their number of projected years of service and earnings. These projections help the local government come up with a final pension number that they will need to meet for this employee upon their retirement. Furthermore, the local governments, with the help of an actuarial, discount this future liability at a “discount rate” to come up with a current pension liability number that they would need to fund to ensure that they will have this person’s retirement benefits fully funded by the time they retire. This present value of the future benefit is primarily funded by the local or state government, and a small portion is contributed by the employee.

Now, the local or state government typically runs into the issue of unfunded liability when the pension fund isn’t able to generate enough returns in accordance with the discount rate. For example: if the future value of an unfunded liability was discounted at the rate of 7% to come up with the present value of pension contribution, it assumes that the current and future contribution must earn at least 7% to get to the desired “predetermined” future value. If the pension fund is unable to return the 7% annual return on its portfolio, it will mean that either the employee or the employer will need to come up with the difference to make sure that the future number is met.

For example, CalPERS, the largest U.S. public pension fund, has been struggling to meet the expected discount rate of return for the past few years and has already told participating agencies they will be obligated to increase required employer contributions to the retirement fund. The burden to meet the shortfall for the future pension benefits falls primarily on the employing local or state government, which needs to increase the current pension liabilities significantly for these employers.

This is bad news for taxpayers in states and localities where government workers have been promised far more in pension benefits than politicians set aside to pay them. Like mentioned earlier, most states have strong protections for promised pension benefits, meaning there is little prospect of reducing a pension benefit or asking employees to contribute more to it.

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An economic downturn is the biggest impediment for a local government to meet its pension obligation and 2008 recession was a perfect example of this. An economic downturn can manifest into several issues as far as pension obligations are concerned as discussed below.

• Consumer spending often decreases due to unemployment and other economic factors. This affects the local government’s ability to generate sales tax and/or other revenues to the prior-year levels. Depending on the local government’s economic downturn preparedness, you would often see some serious cut in services, such as police, fire, nurses, school teachers, healthcare workers, and food banks, plus other essential services. It’s also important to note that an economic downturn often adversely impacts a wide range of revenues for local governments.

• Speaking of pension obligation, the economic downturn also impacts the financial markets, which have a direct correction and adverse impacts on a pension fund’s ability to generate desired returns on its portfolio. This further puts the burden on local governments to come up with additional funds to meet its pension obligations.

• Furthermore, many small cities and government agencies are often the hardest hit with an economic recession because their revenue sources are often not diversified enough to withstand a financial recession.

• Local agencies also include many transportation districts throughout the United States. With COVID-19 and Shelter-in-Place orders, many of the transportation districts are facing serious ridership challenges – which may be a key revenue source for them. This can lead to some serious financial troubles beyond meeting their unfunded pension liabilities.

Want to know the potential impact of COVID-19 on local and state governments? Click here to know more.

As many investors have already seen, credit rating agencies are very busy nowadays working on re-assessing their rating criteria and financial outlook for many of the local governments around the United States. These outlooks are a strong indicator on how things are currently going and what they will look like in the future.

The economic impacts of the current crisis will certainly be felt in the upcoming quarters and into 2021 and investors should carefully assess all the risks associated with the municipal debt instruments. Investors should also consult with their financial advisors and tax experts before making investments.

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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.