Moody’s Investors Service recently made a major change in how it will calculate a state’s credit rating. Oklahoma policymakers should take notice. In a nutshell, Moody’s will now include a state’s unfunded pension liability, along with the traditional net tax-supported debt, when determining a state’s credit rating. This change is particularly significant for Oklahoma.
Under the traditional net tax-supported debt (NTSD), mostly general obligation bonds, Oklahoma’s debt burden is quite low. Oklahoma’s NTSD as a percent of Gross Domestic Product (GDP) in 2009 was 1.4 percent, which ranks on par with neighboring states and significantly below the national average of 3.3 percent.
Moody’s methodological change now brings Oklahoma’s mammoth unfunded pension liability into the picture. Oklahoma’s unfunded pension liability as a percentage of GDP in 2009 was 8.6 percent. This was more than three times higher than in neighboring states (2.6 percent), and more than twice as high as the national average (3.3 percent).
Unfortunately, when the NTSD and unfunded pension liability are combined, the advantage that Oklahoma held under the traditional NTSD metric not only vanishes but now becomes a significant liability. Oklahoma’s combined debt as a percentage of GDP is 9.9 percent. This was more than twice as high as in neighboring states (4 percent), and significantly higher than the U.S. average (6.5 percent).
Therefore, as a result of Moody’s methodological change, Oklahoma can expect to see a decline in its credit score relative to neighboring states and the U.S. as a whole. This means Oklahoma will have to pay higher interest rates for all state debts, which ultimately means higher interest payments. In the end, taxpayers will have to contend with reduced services or higher taxes due to the crowding-out created by higher interest costs.
But wait, there’s more. Moody’s takes the official pension costs at face value when, in fact, there is an ongoing debate as to whether or not the “official” estimates dramatically understate the pension burden. Moody’s even admits to this possibility: “Moody’s uses valuations of assets and liabilities for pension funding as reported in audited financial statements for states according to GASB [Government Accounting Standards Board] reporting standards. Use of other assumptions and valuation methods would likely lead to higher unfunded liabilities than are currently disclosed.”
Using estimates pioneered by Joshua Rauh (Northwestern University) and Robert Novy-Marx (University of Chicago), Oklahoma’s unfunded pension liability could be as high as 14.5 percent of GDP. This is more than three times higher than in neighboring states (4.7 percent), and more than twice as high as the national average (5.7 percent).
In conclusion, Moody’s methodological change is an important first step in bringing needed transparency to the pension system. For far too long, states have been given free rein to provide bloated pension benefits—and then shirk their responsibility to fund those benefits—while facing few economic repercussions. Now profligate states will face the prospects of a lower credit rating and paying higher interest rates on all their debt.
For Oklahoma, this change is especially problematic since its debt burden is significantly higher than that in neighboring states or in the U.S. as a whole. With combined debts soaring to 15.9 percent of GDP, the status quo is simply not sustainable.
Oklahoma policymakers need to take steps to lower the state’s unfunded pension liability, such as moving to a defined-contribution system, before Moody’s is forced to cut the state’s credit rating.
About the authors:
Economists J. Scott Moody (M.A., George Mason University) and Wendy P. Warcholik (Ph. D., George Mason University) are research fellows for the Oklahoma Council of Public Affairs (www.ocpathink.org).