(Bloomberg) -- The Puerto Rico legislature’s move to keep the commonwealth’s teacher pension from running out of cash by freezing benefits and raising worker contributions shows how U.S. municipalities are addressing a $1 trillion retirement- funding deficit by reining in once-ironclad promises.

The measure covering about 80,000 current and retired teachers goes to Governor Alejandro Garcia Padilla. With the pension projected to run out of money by 2020, the 42-year-old chief executive had pushed for the legislation and is expected to sign it after Moody’s Investors Service said Dec. 11 it may cut the commonwealth’s general-obligation debt to junk if the island, with $70 billion in general-obligation and public-agency debt, continues to deteriorate.

“Reforming the commonwealth’s Teacher Pension System is an important step forward in making the structural changes Puerto Rico needs to strengthen its long-term fiscal health,” García Padilla said in an e-mailed statement. “Teachers can retire with confidence in the long-term economic viability of our pension system.”

Yields on some Puerto Rico debt dropped following the vote. Commonwealth general obligations maturing July 2039 traded today with an average yield of about 9.88 percent, down from 10 percent the day before, data compiled by Bloomberg show.

“Generally speaking, the market views this positively,” said Chris Mauro, head of muni strategy at RBC Capital Markets in New York. “It’s certainly more desirable to see a state be proactive in this regard than to ignore the problem and just let it ride,” he said in a telephone interview.

Puerto Rico’s fiscal health is a concern for the $3.7 trillion municipal-debt market because more than three-quarters of U.S. muni mutual funds hold its securities, which are tax- free nationwide.

Capitol Protest

While the senate and house debate over the pension measure was greeted by clashes between protesters and police outside the capitol in San Juan, the vote mirrors similar recent actions by legislatures in Rhode Island, New Jersey and Illinois to address widening gaps in pension funding that may overwhelm budgets and threaten credit ratings.

In Detroit, meanwhile, a federal judge has ruled that Emergency Manager Kevyn Orr can proceed with his plan to cancel $3.5 billion in obligations to the insolvent city’s retirement system and $1.4 billion in bonds issued in 2005 and 2006 to fill a hole in the plan.

Estimates of states’ combined pension deficit have ranged from $1 trillion to as much as $4 trillion, according to Bloomberg data. From 2007 to 2012, the median funding level for state retirement systems fell to 69 percent from 83 percent, Bloomberg show, as the longest recession since the 1930s devastated portfolios and pushed some officials to forgo pension allocations as tax revenue sank.

Not Enough

Even with investment returns rebounding, many states -- as well as Puerto Rico, a Caribbean U.S. territory -- failed to set aside enough to fill the gap. In Illinois, Pennsylvania and New Jersey, credit ratings have been slashed since 2011 in part because of pension burdens.

While pension promises have been viewed by public-worker unions as sacrosanct and even enshrined in some state constitutions, fiscal pressure on local governments is bringing on a broad reassessment of past pledges.

A move this month by Illinois, the lowest-rated state, to repair its pension system included limiting annual cost-of- living allowances and increasing some workers’ retirement age. The measure projects $160 billion of savings over 30 years and was greeted by a 29 percent reduction in extra yield on state general-obligation debt, Bloomberg data show.

Second Change

Puerto Rico’s move to limit teacher pensions follows similar changes earlier this year to help sustain the island’s Employees Retirement System for public workers, the worst-funded plan among U.S. states. Without yesterday’s change to the educators’ system, the self-governing commonwealth’s annual payment to the program would be short $500 million each year.

Under the new legislation, teachers will receive a defined- contribution plan and pay more for their pensions. Future retirees won’t receive bonuses. The move also increases the retirement age to 55 for current workers, and 62 for future teachers, from as low as 47 for some now.

While the governor said teachers’ monthly retirement contributions will increase by 1 percent the average pension check for certain educators will also rise.

The Teachers Retirement System had 17 percent of needed assets to pay current and future retirees and an unfunded liability of $10.3 billion as of June 30, 2012, according to the Government Development Bank. The bank helps the commonwealth issue debt.

Junk Threat

In addition to Moody’s warning, Fitch Ratings in November said it may lower Puerto Rico to speculative grade by June 30 if the commonwealth’s access to the capital markets continues to be limited. Puerto Rico aimed to borrow as much as $1.2 billion of sales-tax bonds in 2013. Record-high yields blocked those plans.

In the earlier measure shoring up the Employees Retirement System, Garcia Padilla also boosted the retirement age and increased worker contributions for pensions. The changes helped sustain a program that would have run out of assets in 2014. It had a funding level of 4.5 percent, as of June 30, 2012, lower than any state pension.

The governor, who took office in January, is working to keep Puerto Rico’s investment-grade rating. He’s raised corporate taxes and fees to help balance budgets and reduce deficit borrowing. Garcia Padilla also pledged to create 90,000 jobs by 2016 by expanding pharmaceutical and medical-device manufacturing, tourism and agriculture.

Economy Shrinks

An index that tracks the island’s economic activity contracted in October, compared with the same month in 2012, the 11th-straight year-over-year drop, according to the development bank. The gauge declined in six of the last seven fiscal years.

Investors are demanding more yield to buy commonwealth debt on concern that the island’s shrinking economy will make it difficult for Puerto Rico to repay its liabilities. Yields on tax-exempt general obligations maturing July 2041 traded Dec. 23 with an average yield of 9.26 percent, the highest since Sept. 11, data compiled by Bloomberg show.

Register or login for access to this item and much more

All Financial Planning content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access