Why states' pension burdens are likely to grow

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Sluggish growth in pension contributions looks likely to put financial pressure on municipalities for the foreseeable future.

A report by Fitch Ratings Tuesday adds to the evidence that defined benefit pension contributions represent a growing burden on state and local government finances.

While actuarial contributions to state and local government defined benefit pensions will continue to grow over time, the rate of growth has slowed in the past few years after rapid increases following the Great Recession, according to Fitch.

After hitting a high of 8.6% growth in fiscal 2011, median actuarially determined contributions (ADC) rose 3.5% in 2017 while actual contributions rose only slightly faster at 3.7% as governments continued to pay a larger share of what actuaries target for supporting pension systems, according to the rating agency.

However, pension contribution growth has been far faster than the growth in state and local tax resources, Fitch said. State and local tax resources are about one-third higher than a decade ago, while pension ADCs are 74% higher.
Though the pace has slowed, the contribution burden of pensions is likely to continue rising, according to Fitch Senior Director Douglas Offerman.

"ADCs must rise further to cover asset performance that over time is unlikely to match the investment return targets that plans set for themselves," Offerman said. "Slower ADC growth is taking place against a backdrop of longer-term unfavorable factors that will continue to push the carrying costs of pension liabilities higher over time."

Despite corrective actions to improve contributions, the willingness of states and local governments to make full contributions is generally cyclical, and Fitch sees that as a negative over time.

“The damage done by weak contribution practices is higher today compared to decades past because pension systems are more mature, with less favorable demographic and cash flow profiles,” Offerman said.

Unlike pensions in the private and not-for-profit sectors, where federal regulation generally compels less favorable calculations of liabilities and more rapid payoff of funding shortfalls, the absence of a uniform legal and regulatory environment for state and local defined benefit systems means that consistently paying an ADC may not result in funding progress over time.

Funding policies rely on numerous, disparate assumptions that differ materially from one system to another. Fitch considers strengths and weaknesses in the funding valuation assumptions to understand the expected amortization profile and budgetary demand of pensions over time.

Other organizations have also been watching the state of public pensions in the United States.

In mid-April, the Pew Charitable Trusts unveiled its report highlighting the problems that many states will face going forward.

Pew said many state retirement systems “are on an unsustainable course, coming up short on their investment targets and having failed to set aside enough money to fund the pension promises made to public employees.”

Pew’s report analyzed the state pension funding gap for fiscal year 2016, the most recent year for which comprehensive data were available for all 50 states and found that state pension funds cumulatively reported a $1.4 trillion deficit. Pew said this represented a $295 billion jump from 2015 and was 15th straight annual increase in pension debt since 2000. Overall, state plans disclosed assets of $2.6 trillion to cover total pension liabilities of $4 trillion.

“Investment returns that fell short of state assumptions caused a major part of the increase in the funding gap,” Pew said. “The median public pension plan’s investments returned about 1% in 2016, well below the median assumption of 7.5% – a disparity that added about $146 billion to the debt. Assumption changes – primarily states lowering the assumed rate of return used to calculate pension costs – accounted for another $138 billion in increased liabilities.”

Also in mid-April, Janney released a report that showed a survey of 168 municipal bond analysts identified public pension funding as first among the five most important issues facing the municipal bond market today, with 92% of respondents ranking it as a top-five issue.

And late last year, S&P Global Ratings and Moody’s Investors Service detailed the pension problems facing U.S. states.

S&P reported that state pensions’ funded ratios declined in 2016 as a survey revealed a drop in reported median pension funded ratios to 68%.

S&P also said that more states are experiencing some budget pressures related to pensions and other rising costs amid a slow economic recovery. S&P added that while investment returns were up in 2017, long-term pressures on pension funding remain. Total unfunded liabilities across all states increased $22.7 billion or 3.9% in fiscal 2016, according to S&P, with the gain in unfunded OPEB liabilities building upon a trend of rising liabilities reported in the fiscal 2015 survey when they rose 12% to $59.4 billion after stable or declining liability trends in the fiscal 2013 and 2014 surveys.

Moody’s said it was keeping its stable outlook on states for this year, though it said pensions will continue to weigh on state credit profiles due to a legacy of insufficient contributions and a recent history of volatile investment performance.

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Public pensions