CHICAGO — The recession and market downturn has profoundly affected the funded status of state pension plans, driving up some states’ overall debt levels and putting some credits at risk, Loop Capital Markets LLC analysts
The overall level of state economic debt — made up of general fund deficits, bonded debt and pension obligations — has risen significantly. The 10 states with the highest level of debt experienced on average a 6.3% increase over last year, according to Loop’s 2009 special commentary on state pension funds. Analysts reviewed 241 individual plans.
“State pension plan liabilities are not given enough attention. As they continue to steadily rise, there is no doubt that something must done to cover these future guaranteed benefits. Unless these pension plans are revised to include, at a bare minimum, more realistic investment return assumptions, these liabilities will inevitably spin out of control with disastrous consequences for state budgets and taxpayers,” according to the report from Loop’s analytic staff, led by strategist Chris Mier.
While Loop found that the majority of states have underfunded their plans since analysts began their reviews in 2002, the range of funding ratios is wide. Plans with less than $1 billion in assets on average were 84% funded while ones over $1 billion averaged an 80% funded level.
Of funds reviewed both last year and this year, more than 60% saw their underfunded levels rise by an average of 4.3 %. The report found at least seven funds to be severely underfunded with a funding level of less than 40%.
As most governments across the country are struggling with budget deficits, the level of unfunded liabilities puts on further strain and can ultimately impact a government’s ability to access the market at reasonable rates.
“Pension plans, like state’s net bonded debt and general reserves, are all factors in credit rating. The lower the state’s rating, the more restricted their access to liquidity, and the higher the price to borrow. Therefore, seriously underfunded plans represent a credit risk,” the report reads.
Though the skyrocketing growth in unfunded pension liabilities looks dire, governments retain options in reducing the debt and would be better served to adopt solutions with a positive long-term impact rather than short-term fixes. Quick fixes the report frowns on include inflating future investment projections and lengthening the amoritization term of pension liabilities, or the number of years over which returns are smoothed out, to lessen the impact of poor returns.
The report says states should consider trimming benefits for future employees and increasing employee contributions as well as plan consolidations, investment diversification and more conservative actuarial assumptions.
The report puts some of the blame for the current crisis on a shift in investment strategies to riskier investments such as real estate, subprime mortgages and collateralized debt obligations.
“Changing investment strategies should not only be encouraged but is vitally needed to diversify asset allocation, with increased investments in safer assets like Treasuries and bonds, and reduced exposure to hedge funds, private equity, and any other high-risk investment classes,” the report reads.
A long-term solution like the issuance of pension bonds to pay down an unfunded liability has benefits and risks. Issuing a POB converts the funding process from a flexible one to a fixed debt structure with mandatory provisions and funding levels.
