Rating Agencies and Retirement Benefits – How are You Being Evaluated?

BOTTOM LINE UPFRONT

• Bond ratings are a way to measure how creditworthy bonds are which helps potential investors evaluate the risk of purchasing
• Rating agencies are placing a greater emphasis on pension and OPEB liabilities when determining bond ratings
• Improving your pension and OPEB liability management will increase your credit rating and reduce your borrowing costs

As part of our services, we often help clients manage their employee benefit plans. Beyond the desire to offer sustainable plans, we’ve discovered that most clients are also concerned with understanding how their liabilities affect their bond ratings.

The purpose of this article is to provide some insight into how both your pension and OPEB obligations affect your bond ratings.

What is a bond rating?

Bond ratings are a way to measure how creditworthy bonds are. Similar to a credit score, a bond rating helps a potential investor evaluate the risk of purchasing a particular bond. Unlike a credit score, these ratings are assigned a letter grade by private bond rating agencies like Moody’s, Standard & Poor’s (S&P), and Fitch Ratings.

The higher the rating of a bond, the stronger the financial strength is deemed, leading to lower interest rates and reducing your borrowing cost.

Why do bond ratings matter?

The government entity or bond issuer sells bonds to investors when it needs to complete a major capital project. Think of it as using a credit card for a purchase, where the bond issuer is the cardholder and the investors are the bank. Those who purchase bonds are lending money to the issuer which will be repaid with interest. 

A bond rating determines how much interest the government entity will pay on its bonds. It also provides an investor with an overview of how risky it would be to buy a bond from the issuer. If you have a poor rating, you may have a hard time finding buyers for your bond issuance or you’ll have to offer a much higher interest rate.

Now that you have an idea of the importance, let’s dive into how your pension and OPEB liabilities play a role in determining your bond rating. 

How much weight do rating agencies place on pension and OPEB liabilities?

While the exact weight varies by agency, rating agencies have placed greater significance on these liabilities as concerns about their affordability grow. In comparison with each other, rating agencies emphasize pension plans because OPEB plans are easier to modify to limit liabilities.

How do rating agencies evaluate pension and OPEB liabilities?

Below is a list of items reviewed by rating agencies to evaluate pension and OPEB liabilities:

• The size of the bond issuer’s current and future liabilities relative to potentially taxable property (grand list) and income, expenditures, and revenue.
• Actuarially determined pension contributions and annual OPEB payments as a percentage of expenditures.
• The management and governance of the issuer. Do they have unpredictable revenues and expenditures and, if so, are they minor or substantial?
• Fund balances as a percent of operating revenues. This ratio will be evaluated in relation to the stability of the issuer’s revenue.
• Review the issuer’s ability to make unreduced payments in the face of economic hardship.
• Review the existence (or lack thereof) of a plan to address these liabilities (funding policy, investment policy, benefit changes, etc.)
• Review the reasonableness of actuarial assumptions used to calculate liabilities.
  • If these are not deemed reasonable, rating agencies will adjust liabilities accordingly and they may view these unrealistic assumptions negatively.

How can we improve our bond rating and reduce borrowing costs?

It comes as no surprise that both pension and OPEB liabilities directly impact your bond ratings, therefore improving your liability management will increase your bond rating and reduce your borrowing costs. Here are a few of our recommendations:

• Review your OPEB plan design (e.g., benefit formula, eligibility, Medicare prescription drug benefit, etc.) and look for options to reduce costs both short-term and long-term.
• If your pension plan has a defined benefit structure (most do), look at the compensation definition (e.g., Does it allow for pay spiking? Does it count overtime & bonuses? How many years are considered? etc.), employee contributions and early retirement subsidies to ensure they meet your objectives
• Develop a clear funding policy – consider utilizing a dedicated funding source (similar to what is done for a revenue bond)
• Develop an investment policy that recognizes these long-term liabilities, but aligns with your risk tolerance
• Speak with your auditors to ensure that the assets you set aside are in a qualified trust
• Coordinate with your auditor and actuary to ensure that the assumptions you are using are reasonable

Your bond rating is dependent on many factors as noted above. As for what can be done for pension & OPEB plans, our best advice is to take action and establish plans to fully fund both your pensions & OPEB plans in order to reduce your total liabilities as these are often the largest liabilities on an issuer’s balance sheet. By following our recommendations above, you’ll be able to better understand your liabilities, make improvements to your funding policy, and enhance your bond rating while decreasing your borrowing costs.

For further information on what impacts your bond rating, please contact an Odyssey Advisors team member today or fill out the form below.