Congress must plan for states to go insolvent.

A number of states, including large ones like New Jersey, Illinois, and Ohio, could become insolvent during the next decade.

These states are burdened with underfunded pensions and other post-retirement benefits (mainly health care) that will impose a growing burden on governments as more baby boomers retire. At the same time, the states’ ability to fund these pensions will be compromised by two factors. The first is a long-term fall in the labor participation rate, requiring younger workers to bear a heavier burden of funding legacy costs. The second is a decrease in long-term growth rates, which will cause both tax revenues and returns on pension investments to fall below expectations.

Reforms are needed to restore fiscal solvency.

It is not too early for Congress and the next president to start planning for a state to go insolvent. Both the Detroit and Puerto Rico bankruptcies were preceded by years of denial in the face of inevitable facts. Given the combination of high unfunded liabilities, slow growth, deadlocked politics and, in some cases, legal barriers to reform, some states are likely beyond the point of saving. Illinois is a good bet to go first, but five or 10 states are in similar positions.

One approach is for Congress to pass legislation dealing with the specific state involved. This need not be a bailout. In fact, a bailout would be extremely unwise. It would tax states that had managed their finances responsibly, reward unions and bondholders who had enabled poor government, and eliminate any pressure to deal with the problems early. However, the legislation must contain enough financial assistance to restore both short-term liquidity (the ability to pay bills now) and long-term solvency (the ability to stay afloat). This assistance need not cost the taxpayer much. Indeed a careful combination of loan guarantees conditioned on significant structural reforms may be all that is needed. This process would resemble that followed in New York City and Washington, D.C., both of which are widely regarded as successes.

A benefit of this approach is that it allows for continued financial supervision of the state’s finances, thus maximizing the chance of overcoming barriers to reform and ensuring a return to long-term solvency.

A large problem with this approach is that it may not be able to reduce the state’s debt burden. Congress’ ability to erase debts may be limited legally to the formal bankruptcy process. Although governments may use a combination of economic and legal pressure to encourage creditors to settle their claims for less than par, it would have a much more difficult time forcing holdouts to accept losses. In such circumstances, it could be that the political and economic burdens of making all creditors whole are just too great outside of the bankruptcy process.

The odds of a state becoming unable to pay its obligations grow every year. Many state retirement plans are significantly underfunded and are unlikely to meet their investment goals over the next decade. The financial demands on state budgets will increase significantly. At some point, making a concerted effort to catch up imposes too much political pain and only delays the inevitable. When the end game happens, it usually comes as a surprise to many.

Congress can nevertheless prepare for insolvency by choosing its strategy now. The ideal solution would treat holders of unsecured debt the same as unfunded pensions, it would impose enough losses to ensure that the state regained its financial solvency, and it would condition debt relief on significant reforms. Ideally, the process would be available long before a state technically became insolvent but after it was willing to make significant reforms. Unfortunately, political resistance and unrealistically exuberant projections may prevent a state from taking advantage of any solution before insolvency.

City Should Consider Using P3s to Bolster Pension Plan and Water System, Observer Says

Last week we wrote that Municipalities’ should Consider Using P3s to Bolster Pension Plans and Water Systems. Lewis Solomon, a professor emeritus at George Washington University Law School in an Aug. 8 Herald Tribune op-ed. says P3s can produce revenues that could keep municipal pension plans solvent.

A solid pension plan should be 80 percent to 90 percent funded but Sarasota Florida’s general plan is only 71 percent funded and is projected to incur a $54 million unfunded liability in the years ahead, wrote Solomon.

To keep its underfunded pension plan afloat, the city is reducing cost-of-living adjustments and other plan benefits and limiting the number of workers who can enroll. The city should instead consider investing the plan’s funds in a P3 project that can serve the dual purpose of producing good returns for the plan while rehabilitating Sarasota’s struggling water and wastewater system, Solomon suggested.

“Rather than these palliatives, Sarasota could monetize its water and sewer system by entering into a public-private partnership for these assets. By providing access to private capital, this approach would quickly help the municipality achieve the general plan’s 80 percent funding target and substantially lessen the millions in current, annual contributions to pay down the plan’s unfunded liabilities,” he wrote.

Robert Poole of the Reason Foundation recently made a similar suggestion, pointing out that pension funds looking for relatively safe investments would do well to consider buying into existing or “brownfield” infrastructure P3 projects than in new “greenfield” ones.

By leasing its water system — representing more than $100 million in water and sewer projects — to a private developer for 20 to 30 years, Sarasota could obtain private financing for and rehabilitation of 175 miles of water pipes and its deteriorating lift stations, Solomon estimated.

More than 2,000 communities use P3s to fund and conduct vital water-related infrastructure projects, Michael Deane, executive director of the National Association of Water Companies has noted.

One example is the Bayonne (N.J.) Municipal Utilities Authority, which leased its ailing water and wastewater system to Kohlberg Kravis Roberts and United Water in 2012 for 40 years, Solomon pointed out. Through the deal, the authority received $150 million from the developer, which also agreed to invest $107 million in the city’s water system and provide technical expertise to rehabilitate it.

“This infusion of capital was critically important to the city because it eliminated $130 million of existing debt and improved both the authority’s finances and Bayonne’s credit rating,” according to a June 10, 2015, article on two successful municipal water P3s published by the Wharton School at the University of Pennsylvania.

Although it is not yet common for pension plans in this country to invest in public infrastructure projects, interest is growing. For instance, the California Public Employees Retirement System announced recently its purchase of a 10 percent share — at least $330 million — of the company that operates and maintains the Indiana Toll Road.

Pension fund managers in Canada have figured this out. Several are invested in such projects internationally and the Trudeau government is encouraging them to do so domestically.

Increased Private Ownership of Public Water Systems On Horizon?

According to Bluefield Research, a dearth of public funding coupled with municipalities’ growing needs to repair or replace aging water and wastewater systems militates in favor of substantial private investment.

Although an investment of more than $532 billion will be needed over the next decade to meet the nation’s water infrastructure needs, federal funding for municipal water projects has dwindled steadily over the past four decades forcing municipalities to foot the bill to an increasing extent.(See: Bluefield Research) . For example, the Congressional Budget Office estimates federal spending on water utilities has dropped by 75 percent since 1977, reported Politico.

Only 15 percent of the 49,000 water systems in the United States are privately owned. Most P3s in the sector have involved operation and management agreements. However, recent merger and acquisitions (M&A) activity presages a growing role for private ownership. More than 19 pending or finalized deals worth $384 million were recorded during the first half of 2016, and, the number of water system M&As in Illinois, North Carolina and Virginia are increasing as well.

Pending projects in California, Florida, Indiana and Texas involving desalination, water treatment and wastewater plants also reveal growing public interest in these types of agreements. Meanwhile, the highest level of growth in this area is likely to occur in New Jersey, California and Pennsylvania, predicted Bluefield.

Despite these promising developments, obstacles to increased private investment in the sector, “including public pushback, asset bankability and debt financing remain, however, the broader, national focus on infrastructure upgrades is opening the door to more private participation,” said Keith Hays, Bluefield Research’s vice president. “There is no silver bullet to solving the infrastructure challenge. Stakeholders must deploy a range of solutions including alternative financing, operations management and innovative technologies,” he added.