Fitch Ratings will update its review of the long-term pension obligations of states and municipalities in its evaluation of public finance credits.
To better compare the fiscal health of different retirement systems, Fitch will create standardized investment return and asset-valuation scenarios. Pension systems vary greatly in contribution levels and the types of benefits offered, but Fitch believes standardizing those two key factors will help increase comparability and enhance its analysis of pension obligations.
For more than a year, the agency has been reviewing its strategy for incorporating funding ratios and pension liabilities into its review of state and local government credits in light of growing retirement obligations.
“Pensions have always been a part of Fitch’s tax-backed credit analysis and our criteria,” Fitch analyst Laura Porter said during a Friday teleconference. “Market losses in 2008 and 2009 highlighted the short-term and long-term challenges that pensions present for states and local governments.”
While most pension funds assume a rate of return on their investments ranging from 7.25% to 8.5%, Fitch will calculate funding ratios based on investment returns of 6%, 7% and 8%. In addition, when calculating a fund’s asset valuation, Fitch will look at a system’s funded ratio over a rolling five-year average of the assets’ market value.
“We’re doing that to remove the impact of the various smoothing methods that plans use which can really affect the asset values reported by systems,” Porter said.
Fitch will continue to review the size of a credit’s unfunded pension liability, its history of employer contributions, percentage of contributions compared to the annual required contribution, and whether operating budgets can absorb increased allocations to the pension fund.
The announcement is not a change in rating criteria. Fitch does not anticipate the new standardizations will result in a wide range of rating downgrades or negative outlook changes. Any potential negative credit actions would mostly apply to municipalities since labor costs account for a large part of local government budgets.
Of the 43 states that it rates, Connecticut, Illinois, Indiana, Kentucky, New Jersey, Oklahoma, Pennsylvania, and West Virginia have “challenged” pension funds, according to Fitch.
Fitch also notes that many retirement systems include a blend of both state and municipal employees or a local pension fund could be managed by the state. In such instances, Fitch will be looking for a state or municipality’s obligation towards the overall liability.
“As part of its enhanced framework, Fitch now will request from states that it rates a documented estimate of the portion of the unfunded liability of each state-run, cost-sharing multi-employer system that is attributable to the state itself and, if possible, to participating local government employers,” according to a Fitch report.
Fitch’s announcement follows a change in the way Moody’s Investors Service considers state pension obligations. Moody’s late last month said it would combine net tax-supported debt and unfunded pension liability calculations when evaluating state ratings.