In recent months, municipal market observers have grown more concerned about America’s rapidly aging population. All three major rating agencies have highlighted aging as a credit risk for state and local governments.1 Moody’s Investors Service and Fitch Ratings have downgraded the state of Vermont on the basis of weak demographic trends, and a recent poll revealed that 50 percent of municipal analysts now believe that “demographic shifts” are a top-five issue facing the market.2
In this perspective, we explore the relationship between population-aging and state and local credit risk. The U.S. population is rapidly growing older, and it is well established that aging negatively impacts state and local credit fundamentals. Nonetheless, we expect that most state and local governments will ably manage the challenge of aging.
The pace of aging varies significantly by region, and the issuers most immediately at risk are rural communities that issue limited amounts of debt. Other at-risk issuers include known weak credits (e.g., Connecticut and Illinois) where demographic headwinds exacerbate existing risks like high debt and pension exposure. Even here, though, experience suggests that issuers are likely to suffer only downgrades, not defaults. Immigration, productivity growth and increased labor force participation are also likely to mitigate aging in certain places. Fundamentally, the challenge of aging lends itself to bottom-up, rather than top-down, credit analysis.
In our view, there are two big unknowns regarding aging that market participants should consider. First, rapid aging is likely to weaken the federal government’s fiscal condition, possibly at the expense of state and local issuers. Second, large cities – which are often heavily indebted but have benefited from two decade’s worth of urbanization – are now showing signs of slowing population growth; funding public services in these communities may become more challenging in the future.
The Origins of U.S. Aging
Population-aging is widely understood to be a function of three variables: births, deaths and immigration. A society with a low fertility rate, rising life expectancy and low immigration will generally experience an increase in its mean age, over time.3
In the U.S., aging largely reflects the decline in fertility rates beginning in 1960, coupled with a jump in life expectancy since then. Pre-1960, the general fertility rate in the U.S. exceeded 110 births per 1,000 women of child-bearing age (the “baby boom”); today it is 59 per 1,000.4 Over the same time period, American life expectancy increased by nine years (from 69.7 to 78.6).5 There has been a substantial increase in immigration since 1960, but the jump has been too small to offset the impact of slowing fertility and increasing longevity. (Immigrants now make up 14 percent of the overall population, up from 5 percent in 1960.6)
The pattern of aging remains entrenched. The Census Bureau now projects that 21 percent of U.S. residents will be 65 or older in 2030, up from today’s already-historic high of 17 percent (Figure 1). Notably, in April 2019 the working-age population of the U.S. (defined as persons ages 15-64) began to shrink for the first time in 40 years (Figure 2).
Aging Is a Credit Negative for State and Local Governments
Aging degrades state and local government credit quality in three main ways: It slows revenue growth, pressures public spending and dampens economic vitality.
Revenues. Most categories of state and local revenues grow more slowly in an aging society. Peak earning years for most workers are between the ages of 45 and 64. At age 65, residents begin to leave the workforce, causing income- and consumption-growth to decline. Weaker income and consumption patterns typically flow through to state and local income and sales tax collections (Figures 3 and 4).
Revenue growth also slows with aging because many governments extend tax breaks to older residents. Twenty-two (22) states exempt pension income from state income taxes.7 Nearly all exempt prescription medicines from sales tax.8 Most states also extend property tax relief to older residents, and senior discounts on parks and recreation fees, transit passes and public utility charges are commonplace.9
Willingness to support tax hikes sometimes weakens with aging, as well. This phenomenon may prove a particular challenge for public school districts in coming years, given the rapidly diversifying population in the U.S. Studies suggest that seniors are less willing to raise taxes for K-12 schools compared to other age groups and that, absent concerted outreach, older taxpayers are less supportive of such hikes when the school-age population is more racially diverse.10 Importantly, seniors vote in local elections at a rate seven times that of younger residents.11
Spending. Aging places upward pressure on public spending, mostly in the areas of health care, pensions and new programs for the elderly.
Spending on Medicaid, employer-sponsored health plans and retiree health benefits tends to increase with aging. Medicaid spending accelerates because older beneficiaries utilize expensive prescription drugs and long-term care benefits at higher rates than younger beneficiaries (Figure 5).12 Employer-sponsored health plan costs rise just as in the private economy, but the challenge in the public sector is more acute because public sector workers are typically older than their private sector peers, and state and local compensation structures skew heavily toward benefits in exchange for lower salaries.13 Retiree health care obligations (also known as other post-employment benefits, or OPEBs) also pressure budgets as the population ages. Most OPEBs are paid directly out of a government’s operating budget. In some places, OPEB costs are a growing financial strain. For example, in the state of New York, 20 percent of school districts contribute 5 percent or more of their annual budget to retiree health care costs; this ratio is likely to rise as more teachers retire.14
Financing pensions also becomes more challenging as society ages. First, aging is associated with lower interest rates, which tend to increase asset prices and lower future expected returns on investments. Lower returns will generally compel government employers to contribute more to their pension funds, each year.15 Second, public plans benefit from a significant inflow of employee contributions each year. As more public sector workers retire – and are replaced with lower-cost employees or not replaced at all – the inflow from employee contributions should diminish. As a result, higher contributions from employers and taxpayers may be required.
Aging also creates demand for new social programs. Medicare, Social Security and Medicaid are the spending programs most commonly associated with aging. But state and local governments operate a variety of other programs to support the indigent elderly. Programs range from cash assistance to Medicaid add-ons to various housing programs.16 Some of these programs work in concert with grants from the federal government per the Older Americans Act.17
Economic growth. Apart from altering public sector revenue and spending patterns, aging is likely to dampen state and local economic growth prospects. By definition, economic growth is a function of (a) the number of workers in an economy, (b) each worker’s productivity per hour and (c) the total number of hours each works.18 Aging tends to weaken an economy’s growth potential because it is associated with slower growth in the working-age population; the pool of available workers sometimes even shrinks. Figure 6 below illustrates the relationship. It shows gross state product (GSP) and working-age population growth in the 50 U.S. states between 2010 and 2018. The data strongly suggests that, all things being equal, many state economies will grow more slowly in the coming years.
Implications for investors
Despite the well-documented relationship between aging and weaker credit fundamentals, we expect that aging will present only limited additional risk for investors in state and local bonds. This is true for several reasons.
First, the pace of aging differs across U.S. regions. Working-age population is expected to grow by 5 percent or more in 21 states between 2018 and 2030 (Figure 7). This includes six states with an accelerating trend (Delaware, Hawaii, North Dakota, Nebraska, South Carolina and Virginia). In these places, an expanding working-age population should mitigate some of the negative effects of aging on state and local budgets.
Second, rural issuers are likely to bear the brunt of weak demographic trends. Between 2010 and 2018, working-age population declined by 3 percent in U.S. counties with less than 50,000 residents but grew in counties with more than 50,000 residents. The largest counties – which represent the nation’s urban areas – grew the fastest (Figure 8).
The above numbers suggest that aging is likely to pressure credit fundamentals most in places where little debt is at stake. Rural issuers tend to have smaller populations and limited capital needs relative to non-rural peers, so they issue debt infrequently and in smaller sums. The experience of some rapidly aging rural states is illuminating in this regard. Debt makes up only 2 percent of Gross State Product in Maine and Vermont. In these states, 20 percent of the population is 65 or older and 61 percent of the population lives in rural areas.19 As mentioned, downgrades of Vermont by Moody’s Investors Service and Fitch Ratings are illustrative: Vermont’s low debt burden ensured a still-high rating of Aa1/AA+ from both agencies after the downgrade.20
Third, many of the large issuers most exposed to aging risk already exhibit underwhelming credit profiles and low ratings relative to peers. Take the examples of Connecticut (A/A1/A+) and Illinois (BBB-/Baa3/BBB). Connecticut lost working-age population at a rate of 0.2 percent per year from 2010 to 2018, and demographers expect that rate to more than double through 2030.21 Illinois is expected to lose over 5 percent of its population over the same time frame. Each state’s mix of high debt, slow growth and pension stress overshadow – or already incorporate – aging as a material credit factor.
Fourth, where aging worsens a large issuer’s extant credit stress, it is likely to result only in downgrades, not a default. As Figure 9 illustrates, several large issuers have weathered rapid declines in working-age population, over a one-, five-, and 10-year period. The biggest declines have been in Washington, D.C., Louisiana, several natural-resource rich states and Puerto Rico. Let’s take each in turn. Default was avoided in the District of Columbia because Congress appointed a control board to manage the district’s affairs (1995).22 Louisiana lost over 5 percent of its working-age population in 2006 after Hurricane Katrina, but no default resulted (partly because of federal support for New Orleans). Wyoming, North Dakota, Alaska and Oklahoma have largely avoided past credit challenges related to falling oil prices because they issue little debt and have capitalized reserve funds specifically designed to guard against commodity-price declines. Only Puerto Rico defaulted and, there, population decline was largely a consequence of the island’s insolvency, not its root cause.
Importantly, a variety of common municipal security and governance structures are likely to help demographically challenged issuers avoid credit events. These include state intercept and guarantee provisions for school district debt (e.g., New York State’s Act 99-B program), pre-default takeover statutes for struggling local governments (e.g., Pennsylvania’s Act 47 program and North Carolina’s Local Government Commission), and over-collateralized loan pool structures for smaller communities (e.g., state revolving loan funds). These programs are designed to ensure market access for weaker borrowers while simultaneously protecting investors. None of them entirely eliminate credit risks associated with rapid aging; they certainly didn’t prevent defaults earlier this decade in Detroit, MI, Stockton, CA, or Vallejo, CA. But they should reduce the likelihood that aging communities’ fiscal challenges translate into meaningful problems for investors.
Fifth, some communities with aging populations are likely to experience immigration, productivity growth, or an uptick in labor force participation over the next several years. All are known mitigants to the negative economic effects of aging. Recall the previously mentioned economic growth formula: Growth results from (a) the number of workers in an economy, (b) each worker’s productivity per hour and (c) the total number of hours each works. Immigration and growth in labor force participation increases the number of workers (a), and productivity growth increases each worker’s output (b).
- Immigration. Immigration is likely to increase in certain communities over the next decade, notwithstanding the current policy environment. By most measures, the U.S. needs more workers. There were 7.2 million available job openings in the U.S. in July 2019, and the unemployment rate is currently 3.5 percent.23
Notably, Americans remain broadly receptive to the idea of more foreign workers. In June 2019, the percentage of Americans supporting more immigration reached a record high. Over 70 percent of Americans currently believe “immigration is good for the country,” and 60 percent to 80 percent support allowing undocumented persons to remain the U.S. under some form of legal status, depending on how the question is worded.25 Even President Donald Trump has acknowledged that “we’re going to let a lot of people come in because we need workers.”26 This sentiment is consistent with experience from abroad. In rapidly aging and immigration-resistant Japan, officials have implemented a variety of policies to attract foreign workers.27
- Productivity. Aging is typically associated with weaker productivity growth in an economy, but within any given metro area or state there will be regions where more-productive workers reside.28 An affluent suburb of an aging and slow-growing city may experience growth in productivity even if metro-area growth is generally stagnant. This phenomenon can keep a local area afloat for decades despite demographic decline in the surrounding area. At the state level, Kansas and New Hampshire are good examples. Productivity grew by 2.4 percent in both states between 2010 and 2018, more than the change in working-age population, which declined in each by 0.7 percent and 0.5 percent, respectively.29 In short, gains in productivity allowed each state’s economy to grow despite demographic headwinds.
- Labor force participation. Labor force participation generally weakens alongside aging. But here, too, there is significant variation among regions and communities. For example, labor force participation is 54 percent in West Virginia and 70 percent in Minnesota.30 Since 2014, 10 states have managed to grow their labor force participation rates despite experiencing a decline in working-age population.31 These figures suggest that within and across metro areas, some communities will offset aging risk by increasing the participation rate. This seems particularly possible given that participation rates among the young remain weak, by historical standards (Figure 10).
For all these reasons, we think that aging risk is best analyzed through bottom-up credit analysis. Aging is plainly a headwind to credit fundamentals. When viewed in a macro context, it seems clear that revenues, expenditures and economic growth will be negatively affected. But a high degree of variation should be expected across the state and local sector. Many communities are likely to manage it capably.
Two unknowns: The federal government and the possibility that big cities have peaked
The conclusion that aging presents only modest additional credit risk to state and local bond investors presumes, at least in part, that aging presents a manageable fiscal risk to the federal government and the largest cities in the U.S. Both presumptions are less than airtight.
The federal government’s fiscal trajectory is unsustainable over the long term. One reason is population aging. The Congressional Budget Office estimates that federal debt-to-GDP will reach 105 percent by 2029 and 219 percent by 2049 under likely policy scenarios.32 Rising debt ratios reflect persistently large federal deficits that are driven, in part, by rising costs for entitlement programs that benefit the elderly, namely Medicare and Social Security. Outlays for Medicare and Social Security presently make up 41 percent of all federal spending. By 2029, they will make up 50 percent.33 Deficit projections also assume slower economic growth as a result of aging. As we have outlined in previous commentaries, an overly indebted federal government is more likely to pass austere budgets with respect to Medicaid and transportation funding. It is also more likely to raise taxes, thus competing with state and local authorities for scarce resources. (See Thoughts on Modern Populism & the Muni Market, August 1, 2016.)
Recent population growth in the nation’s largest cities may also prove unsustainable. Large cities are attracting fewer people than they were at the beginning of the decade. In the 87 largest U.S. cities, average annual population growth rates declined from 1.2 percent to 0.69 percent between 2011 and 2018.34 Some of the largest cities, including New York, Chicago and San Jose, have started to lose residents. The trend is notably acute with respect to working-age population. Recall Figure 8 above. Although counties with more than 250,000 residents experienced the largest increase in working-age population between 2010 and 2018, 38 percent of these counties lost working-age population between 2017 to 2018. This continues a trend of slowing growth in the nation’s urban areas for several consecutive years (Figure 11).
Weaker working-age population growth in urban settings reflects a variety of factors, including unaffordable homes, slower immigration and, possibly, the recent curtailment of the state and local tax deduction (SALT), which has increased the cost of living in large cities with high state and local tax rates. If growth of the working-age population in large cities stalls meaningfully, the credit quality of the market, broadly, might weaken. Unlike their rural peers, large cities issue a lot of debt. They are also home to some of the largest pension debts in the country and are generally highly rated. Inflows of young workers and immigrants have enabled the country’s largest metropolises to grow despite fiscal challenges. But the trend may not persist.
Demographic trends have always been an important component of municipal credit analysis. Current projections suggest that rapid aging will negatively impact state and local credit quality by retarding revenue growth, pressuring spending and dampening economic vitality. Rural issuers and several large, already fiscally weak states seem most exposed to the risk of aging. But overall, state and local governments seem relatively well-positioned to withstand risks associated with population aging. There is significant regional variation in the expected pace of aging, and many jurisdictions are likely to experience growth in working-age residents. Moreover, many governments have experienced rapid declines in working-age population but very few have defaulted. It’s also likely that some governments affected by aging will find ways to attract immigrants, increase worker productivity or grow the local labor force participation rate. Each tends to mitigate the negative impact of aging on economic growth. In our view, aging may have the greatest impact on state and local credit quality via the federal government. It’s also possible that large cities, home to a significant portion of municipal market debt, succumb to aging more quickly than is currently expected. Breckinridge believes that a bottom-up method for assessing credit fundamentals is the best approach to monitor aging risk. Fortunately, it is also our long-standing approach to investing.
 “U.S. States and the Growth Implications of an Aging Population,”Fitch Ratings, October 2018; “Aging states face less dynamic economies, lower revenue growth,” Moody’s Investors Service April 2018; and “U.S. States Face Possible Negative Revenue Effects Due to Aging Demographic Trends,” Standard & Poor’s, February 2019.
 The state of Vermont was downgraded by Moody’s Investors Service from Aaa to Aa1 in October 2018 and by Fitch Ratings from AAA to AA+ in July 2019; Smith’s Research and Gradings 5th Annual Municipal Bond Analyst Survey, 2019. Available at: https://www.smithsresearch.net/2019-analysts-survey/.
 Jonathan Vespa, “The U.S. Joins Other Countries with Large Aging Populations,” U.S. Census Bureau, March 13, 2018.
 Gretchen Livingston, “Is U.S. fertility at an all-time low? Two of three measures point to yes,” Pew Research Center, May 22, 2019.
 From 69.7 years to 78.6 years. National Vital Statistics Reports, Vol. 68, No. 7, Table 19, U.S. Centers for Disease Control and Prevention, Department of Health and Human Services, June 24, 2019.
 Jie Zong, Jeanne Batalova and Micayla Burrows, “Frequently Requested Statistics on Immigrants and Immigration in the United States,” Migration Policy Institute, March 14, 2019.
 Retirement Income Information Center. Available at: https://www.retirementliving.com/taxes-by-state.
 Alison Felix and Kate Watkins, “The Impact of An Aging U.S. Population on State Tax Revenues,” Federal Reserve Bank of Kansas City. Available at: https://www.kansascityfed.org/.
 “State Property Tax Freeze and Assessment Freeze Programs,” National Conference of State Legislatures, December 31, 2012. Available at: http://www.ncsl.org/research/fiscal-policy/state-property-tax-freezes-and-assessment-freezes.aspx.
 Sarah Sparks, “When Older Americans Outnumber Students (Which Is Soon), How Will Schools Connect?” Education Week blog, March 14, 2018.
 Mike Maciag, “Millennials Let Their Grandparents Decide Local Election,” Governing.com, January 2017, at https://www.governing.com/topics/elections/gov-voter-turnout-generations-millennials.html, and David Figlio and Deborah Fletcher, “Suburbanization, demographic change and the consequences for school finance,” Journal of Public Economics, Vol. 96, Issues 11-12, December 2012, p 1144-1153.
 Robin Rudowitz, Kendal Orgera and Elizabeth Hinton, “Medicaid Financing: The Basics,” Kaiser Family Foundation, March 2019.
 The median age for a “public administration” worker in the U.S. was 45.4 years in 2018. This is the highest median age of any major nonagricultural employment category. See Bureau of Labor Statistics Table 18b, Labor Force Statistics, Current Population Survey.
 Breckinridge analysis of Merritt Research Services data for FY 18.
 Douglas W. Elmendorf and Louise M. Sheiner, “Federal Budget Policy with an Aging Population and Persistently Low Interest Rates,” Journal of Economic Perspectives, Vol. 31. No. 3, Summer 2017, p 175-194; Andrea Papetti, “Demographics and the Natural Real Interest Rate: Historical and Projected Paths for the Euro Area,” European Central Bank, March 2019.
 For example, see Nicole Dube, “State Programs for the Elderly,” Connecticut Office of Legislative Research, July 17, 2009.
 The Older Americans Act is the major federal funding vehicle for services for older persons (OAA, P.L. 89-73, as amended).
 “U.S. States and the Growth Implications of an Aging Population,” Fitch Ratings, October 2018.
 Breckinridge analysis of 2018 census data (for ages 65+) and 2010 census data for proportion of rural population.
 We acknowledge that Maine and Vermont also exhibit elevated pension debt. In Maine, pension debt/GSP is 15% and in Vermont it is 16%, per Moody’s Investors Service adjustments. The point here, however, is that little bonded debt is at risk.
 University of Virginia’s Weldon Cooper Center for Public Service, Demographics Research Group; U.S. Census.
 Michael Janofsky, “Congress Creates Board to Oversee Washington, D.C.,” New York Times, April 8, 1995.
 Bureau of Labor Statistics reports, July 2019
 Jeffrey Jones, “New High in U.S. Say Immigration Most Important Problem,” Gallup.com, June 21, 2019.
 CNN Poll from June 28-30, 2019, showing that 80% support some kind of legal residency for certain undocumented residents, and NPR/PBS NewsHour/Marist poll from July 15-17, 2019, showing 64% support for a pathway to citizenship for undocumented persons; Quinnipiac University Poll, July 25-28, 2019.
 Peter Harkness, “America’s Demographic Destiny Can’t Be Ignored,” Governing.com, July 2019.
 Alastair Gale and River Davis, “The Great Immigration Experiment: Can a Country Let People in Without Stirring Backlash?” Wall Street Journal, September 11, 2019.
 Nicole Maestas, Kathleen J. Mullen and David Powell, “The Effect of Population Aging on Economic Growth, the Labor Force and Productivity,” NBER Working Paper No. 22452, July 2016. Available at: https://www.nber.org/papers/w22452
 Breckinridge analysis of Bureau of Economic Analysis and U.S. Census data.
 Breckinridge analysis of Bureau of Labor Statistics data.
 Breckinridge analysis of Bureau of Labor Statistics data.
 Congressional Budget Office publications: “Budgetary Outcomes Under Alternative Assumptions About Fiscal Policy,” August 2019, and “Long-Term Budget Outlook,” June 2019, p. 38.
 “An Update to the Budget and Economic Outlook: 2019 to 2029,” Congressional Budget Office, August 2019, and Breckinridge analysis of Tables 1-4 and 1-2. Estimate excludes Social Security disability insurance, which may benefit non-elderly persons.
 William Frey, “Big city growth stalls further, as the suburbs make a comeback,” Brookings Institution, May 24, 2019.
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