Pension Liabilities, Not Counted By Ratings Agencies, May Soon Be Included

from The Economist:

HERE’S a scary statistic: if you properly account for American states' unfunded pension liabilities, you get a figure more than 4.5 times all the outstanding municipal debt. With this in mind, it seems long overdue that Moody’s will now consider pension liabilities when rating municipal debt. Moody’s will use the same liability calculations the states do. These calculations involve accounting conventions which, though perfectly legal, vastly underestimate how under-funded the pension obligations are (an 8% discount rate!!!). Even still, it's a big step in the right direction. States like Illinois may expect a downgrade.
It's a contentious issue whether or not pension liabilities should be included in state or sovereign debt measures, in addition to outstanding bonds. Despite America and Europe’s onerous entitlements, these promises are not included in their debt figures, though rating agencies claim to account for entitlements when they give sovereign debt ratings. But these promises are accounted for differently than other obligations because future entitlements are subject to revisions. Here's Moody’s, on how they factor different sources of debt into ratings:

How likely is the debt to rise abruptly due to a shock or crisis of some kind? The structure of the debt matters, especially from a liquidity risk standpoint. We attempt to differentiate between dangerous and benign debt structures. Dangerous debt structures are characterized by a lack of granularity (front-loaded debt, or a very uneven repayment schedule), and different types of indexation (to interest rates or exchange rates).
Likewise, debt can rise abruptly when, for instance, a government has to take the cost of a banking crisis onto its balance sheet. It is therefore important to assess the degree of conditionality of liabilities – actual financial debt obligations should be weighted much more heavily than contingent ones (such as the risk of a banking sector bail-out) or even more implicit, longer-term liabilities (such as unfunded pension liabilities). Indeed, contingent liabilities must be discounted by their likelihood of materialization – which is easier said than done – and future liabilities should be taken into account only in so far as we can appreciate their cash impact.
The point here is that we take into account implicit liabilities such as public pension system deficits only to the extent that they will materialize into an actual debt or payment obligation; governments have many ways to alter the net present value of pension liabilities, such as postponing retirement age, increasing contributions and lowering pensions.

Governments have the option of cutting back on pension or health benefits, and this partially justifies why entitlements usually aren't lumped with other promises. Benefit cuts are a form of default; it's perhaps not as damaging as missing a bond payment, but it is still not delivering on a promised payment. There's also a limit to how much benefits can be cut and taxes increased (most politicians will not leave their elderly population destitute), so at a certain point paying entitlements could mean other obligations are not paid.  I am not sure exactly how entitlements should be included, but it seems they should be in some way
But pension promises from American states should be in a different category than Social Security or Medicare. Pension and health benefits in many states are guaranteed by the state constitutions. That means reducing benefits is very difficult, if not impossible. According to Josh Rauh and Robert Novy-Marx that guarantee means that states may default on their municipal debt before they don't pay or reduce state benefits. It suggests that state pension obligations should not only be factored into ratings, but they should also be included when states calculate their outstanding debt.