Public pension fund ratings.

• Author: Young, Parry
• Position: Includes related articles on pension fund terms and California and Tennessee retirement system case studies

Over the past several years, interest in the use of public pension fund ratings has increased. A pension fund rating, like other credit ratings, is an opinion on the capacity of the retirement system to meet its financial obligations. One of the major credit rating agencies uses two basic types of pension fund ratings: credit enhancement program ratings and counterparty or issuer ratings. Public pension funds are using the credit enhancement program ratings to support credit enhancement strategies and activities that help to maximize use of their assets. Counterparties use issuer ratings on public pension funds to quantify counterparty risk related to complex financial transactions.

Credit Enhancement Program Ratings

A number of public pension funds have engaged in credit enhancement activities through which they substitute the fund's creditworthiness - its ability to meet its obligations under an enhancement program - for the credit rating of another entity, either public or private. Such transactions can function in the same way as a letter of credit from a commercial bank or an insurance policy from a bond insurance company; however, they are based on the creditworthiness of the pension fund instead of the bank or insurer. In return for the extension of credit, the fund receives a fee, generally on an annual basis. These fees are a source of incremental income, over and above the normal investment and contribution revenues of the fund.

The primary reason to engage in this activity is to generate additional income for the retirement system, thereby enhancing its total return and ultimately lowering the contribution cost of its sponsors.

A collateral benefit of credit enhancement programs may be the stimulation of general economic activity in the region where enhancement is provided, such as the state or county. Although this outcome is not a primary objective of retirement systems, such related benefits may serve other public policy goals, including those of the systems' sponsors. For example, increased credit enhancement competition could help lower the cost of building schools, roads, or factories, thereby promoting these projects. The debt guaranteed under the California State Teachers' Retirement System (CalSTRS) enhancement program has helped create or preserve 3,000 jobs in California. One CalSTRS transaction provided $25 million of the liquidity guarantee for the Port of Long Beach expansion project. The Tennessee Consolidated Retirement System provides liquidity for the state's general obligation notes. The notes finance construction and improvement for the state and various departments and agencies, including the Tennessee Board of Regents and the University of Tennessee.

Credit enhancement programs are a natural extension of a pension fund's activities. Because of their strong credit characteristics, many public funds may earn high ratings (AA or AAA categories), thus giving them the ability to guarantee the debt of lower-rated entities, both public and private. With a rated credit enhancement program, the higher program rating of the fund is substituted for the lower rating of the debt being guaranteed, thus lowering the interest cost to the issuer. It is for this enhancement...