CHICAGO – Less than half of state pension plans met Morningstar Inc.’s threshold for healthy status in 2012 with Wisconsin again ranking the strongest and Illinois the weakest, the research company reported in its second annual study of state pensions.

The company for the first time this year included the Commonwealth of Puerto Rico, which, if counted among the states, would displace Illinois at the bottom based on funded ratios. The analysis compared the health of the pension funds based on funded ratios and the total size of unfunded liabilities on a per capita basis.

Morningstar said 26 states and Puerto Rico in 2012 fell below the 70% funded ratio Morningstar sets as its threshold for being fiscally sound. A dozen states landed at a healthier 80% or higher ratio.

Overall, states averaged a 72.6% funded ratio with a per capita unfunded liability of about $2,600. In the per capita assessment, a total of seven states had an unfunded liability of less than $100 per capita while 13 states had a liability less than $1,500, the bar set by Morningstar to achieve a label of “good.” 

“We’ve seen the funded levels of state pension plans continue to decline during the last year, albeit modestly, and the bankruptcy filings of San Bernardino, Calif. and Detroit, Mich. may have significant effects on the national level,” said Morningstar municipal credit analyst Rachel Barkley.

“On the upside, recent data indicate that long-term investment returns are generally in line with assumptions used by most pension plans. Additionally, in recent years most states have implemented some level of pension reforms,” Barkley said.

Illinois’ funded ratio of 40.4% fell 3% from the previous year with its per capital liability increasing by more than $900 to $7,421.

Puerto Rico’s three pension plans carried a funded ratio of just 11.2% and a per capita liability of $8,900. The plans are headed to insolvency, although reforms adopted in 2011 and this year, could stave off the date.

“Morningstar views the recent reform package as a necessary first step to prevent the system from running out of assets within the next 10 years,” the report said. “However, we believe Puerto Rico’s large pension liability will remain a large fiscal burden for the foreseeable future.”

Though poorly funded, Puerto Rico and Illinois’ plans did not top the charts in the per capita rankings.  Alaska held the distinction of carrying the highest unfunded liability for the second year in a row at $10,000. Indiana had a funded ratio roughly on par with that of Alaska at 58.4% but its per capita liability was just $2,415.

“The substantial disparity in the apparent fiscal health of the systems highlighted by these two data points reinforces Morningstar’s opinion that the UAAL per capita needs to be taken into consideration when analyzing pensions,” the report said.

Wisconsin’s pension fund slipped slightly down to a 99.9% funded ratio with its liability per capita falling by $2 to $18 in 2012.

Overall, state pensions’ funded status continued to slip in 2012 but at a moderate pace of 2.1%. The growth in liabilities outpaced assets in part because of the continuing effect of the steep losses during the recession as most funds smooth investment returns over a period of years.

While returns have been volatile in recent years, the report noted that long-term returns have generally been in line with the 7% to 8% rates most plans assume.

The success of pension reforms across the country has been mixed. Many have adopted changes for new hires while some states have been challenged due to state constitutional protections for current employees’ accrued benefits.

The report assessed the potential impact of municipal bankruptcies on pension liabilities based on the status of various cases currently before the courts. Morningstar believes the San Bernardino and Detroit bankruptcies could have significant impacts on their respective pension plans as well as on pension liabilities on a national level.

“States are not able to file for bankruptcy under federal law, but we still think these local cases may have an effect on state-administered pension plans, particularly on multiemployer plans that include local governments,” the report reads.

Detroit’s emergency manager has proposed exchanging roughly $11 billion of the city’s $19 billion in debt and liabilities for $2 billion of limited-recourse notes on a pro rata basis, including an estimated $3.5 billion of unfunded pension liabilities.

In Michigan, pension benefits enjoy contract status. San Bernardino has missed approximately $13 million of its required contributions to CalPERS. Similar to Michigan, California pensions also enjoy strong state constitutional protections. 

“The bankruptcies of Detroit and San Bernardino have potentially far-reaching implications on how pension liabilities and state protection of benefits are viewed in bankruptcy proceedings,” the report reads. “If they are successful in trimming these liabilities, other entities that cannot afford to support operations, debt payments, and retiree costs at the same time may look to emulate their actions.”

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