In the decade since 2008, when pension funds in the U.S. reported steep investment losses, overall state pension plan funding levels stabilized but have still not fully recovered to pre-recession levels. Although reported levels before the recession were based on actuarial funding and are not fully comparable with today's Governmental Accounting Standards Board (GASB) reporting standards, the average reported pension status across state plans of 70% in fiscal 2017 is well below the average 83% actuarial ratios reported in 2007 (see "Market Declines Will Shake Up U.S. State Pension Funding Stability," published Feb. 26, 2009, on RatingsDirect). Relatively slow economic growth and weak investment returns in select years, adjustments to actuarial assumptions, and maturing pension plan populations have played into reported funded levels that seem stuck in the mud. Furthermore, ongoing stock market volatility in October 2018 raises questions about how some state pension plans are currently positioned to manage through any future market turmoil. In the five years from 2012 to 2017, many of the states' largest pension plans have not changed their target investment allocations in equity, real estate, and alternative asset classes, with a median 70% allocation in these generally more volatile asset classes. However, retiree counts in many plans are growing in relation to new and existing employees, which together with state pension plans' heightened exposure to market volatility and in the context of volatile state revenues and rising fixed costs, raises the stakes for greater potential fiscal stress and credit deterioration in the next recession. (See "When the Credit Cycle Turns, U.S. States May Be Tested In Unprecedented Ways," published, Sept. 17, 2018.)

This year's S&P Global Ratings' annual state pension survey found most state pensions reported slight improvement in funding levels in fiscal 2017 mainly due to solid investment returns as of June 30, 2017 (an average of 12.6% for the states' largest plans). The fiscal 2017 aggregate median reported funded ratio of 69.5% for states was up just slightly compared with 68.0% in fiscal 2016. However, as we predicted in last year's survey, we note more than a third of the states' largest plans lowered their rate of return assumption in 2017, which has played into relatively flat reported funding levels.

According to a report by Wilshire Trust Universe Comparison Service, the median public defined pension plan return was 8.55% as of June 2018, slightly below an average return of 12.4% as of June 2017. We believe solid investment returns as of June 30, 2018, in addition to some states' ongoing actions to adjust contribution levels to improve funding trajectories, will likely lead to stability in reported state pension funding in fiscal 2018. However, we also believe that any improvement could be short-lived if recent market volatility persists and shrinks investment returns.

Demographic Trends And Investment Volatility Could Increase States' Costs

The median fixed costs, including pension, other postemployment benefits (OPEB), and debt service, total about 11% across states. This percentage is relatively manageable, particularly when compared to the average fixed costs of 26% across the largest U.S. cities (see "Pension Costs Will Remain High For Largest U.S. Cities, As Revised Liability Measures Place Upward Pressure On Contributions," published Sept. 5, 2018). However, when mandatory Medicaid costs are included, the median fixed costs for states rise to 31% of budget (see "When the Credit Cycle Turns, U.S. States May Be Tested In Unprecedented Ways," published Sept. 17, 2018). We also see certain trends that are likely to raise states' pension and OPEB costs and competing priorities that could cause budget pressure.

Demographic trends among states with aging populations and minimal growth can deal a double blow to pension costs. Plans with rising numbers of retirees compared to active employees will need to manage assets for liquidity to meet increasing beneficiary payouts or rely more heavily on employer contributions to make up for potential investment losses. A greater proportion of retirees typically indicates a larger pool of assets to fund their benefits, leaving plans more vulnerable to investment swings than ever before. Furthermore, many states set contributions to rise over time with anticipated payroll increases; however, with weaker-than-assumed payroll growth they will likely see higher future costs as plans lower current assumptions to align with experience.

Most states that fund pensions on an actuarial basis use a valuation of assets, which smooths market returns over a number of years to help minimize year-to-year fluctuations in pension costs. However, severe stock market volatility could lead to longer-term strain for state budgets. Even as state plans have been lowering discount rate assumptions, many are often only lowering the embedded inflation assumption while projecting higher real returns and taking on more risk. In the event of a market downturn, reported funding levels could fall substantially, and while subsequent annual increases to employer contributions would be gradual and phased in, state budgetary costs would grow over time, causing credit pressure.

Plan Investment Allocations

We find that targeted investment allocations of the states' largest pension plans in equity, real estate, and alternative investments are relatively high but have remained stable overall in the previous five years. Still, some state plans are vulnerable to equity sell-offs. Using reported plan investment allocations from 2012 to 2017 (found on the Public Plans Database website maintained by the Center for Retirement Research at Boston College or in plan reports), the median proportion of the portfolio target allocation among high-risk assets (equities, real estate, and alternatives including commodities) in the largest pension plans across states was 70% in 2017, unchanged from five years earlier. These targeted allocations are also higher than the average 62% target allocation to high-risk assets by state and local pension plans in 2001.

In chart 1, state plans appearing high in the chart reflect higher relative target asset allocations in the high-risk assets in fiscal 2017 compared with the peer median of 70%. However, some state plans have continued to increase targeted allocations to these more volatile asset categories while others have pulled back. The state plans appearing farther to the right in the chart have seen target allocations migrate to riskier assets compared with five years ago. The size of the bubbles reflects the plan's respective funded ratio and the colors signify the relationship between the plan's actuarial assumed long-term rate of return and the median assumed rate of 7.5% in fiscal 2017. Red bubbles reflect assumed rates of return that are more optimistic than the median, and blue bubbles reflect assumed rates that are more conservative than the median.

We did not characterize targeted investments PPD categorized as hedge funds as high risk, since a hedge strategy is inherently meant to limit volatility; however, there is often limited disclosure for these investments and hedge fund composition could lend to greater asset volatility in certain cases. If hedge funds were included in the high-risk asset grouping, the largest state plans' median allocation rises to 77% in 2017 from 73% in 2012.

Many plans continue to lower these assumptions as reflected in the National Association of State Retirement Administrators 's (NASRA) June 2018 public fund survey*, which finds rate of return assumptions across state public pension plans decline to a median 7.45% and average 7.32% in fiscal 2019. However, as we note in our article, "The Increasing Cost Of Governmental Pensions: Discount Rate And Contribution Practices" (published Sept. 27, 2018) , on average, plans are actually assuming higher real rates of return because nominal rates have not declined at the same pace as the assumed inflation rate--and this leads to greater market volatility risk. Furthermore, demographic trends coupled with volatile asset returns across state plans could intensify eventual pension cost increases and cause credit pressure for states. Those plans with relatively elevated high-risk allocations, optimistic assumed rates, and lower funded ratios are particularly vulnerable.

Chart 1

Demographics And Aging Plans

As a plan matures, fewer active members contribute annually and retirees and beneficiary counts rise. Such a plan generally relies more on its assets and/or employer contributions to maintain funding status. Furthermore, a plan with an aging population will likely need liquid assets to draw on for beneficiary payments. Therefore, in a downturn and assuming a limited ability to significantly adjust benefits, plans with market losses must rely more heavily on increases to employer contributions rather than to active member contributions.

In chart 2, plans that show up the farthest to the left are relatively mature with active member-to-beneficiary ratios that fall below a median of 1.3 across the states' largest plans. As before, state plans found at the top of the chart reflect higher relative target asset allocations in the high-risk assets in fiscal 2017 compared with the peer median of 70%. Plans that are both mature and target risker asset allocations could expose states to higher relative future costs in the event of a market downturn.

In our article, "U.S. States Are Showing Their Age: How Demographics Are Affecting Economic Outlooks," published Sept. 25, 2018, we highlight how demographic and population trends among prime working-age adults correlate with economic outlooks across states. Similarly, weak demographic trends and aging populations in certain states do not support plan assumptions that rely on relatively high payroll growth. In many cases, pension plans must reexamine current average assumed payroll growth rates that exceed rates of inflation. We believe many plans are likely to move to lower these payroll growth assumptions in the future, which will also contribute to higher pension costs for certain states.

Chart 2

Survey Results

Our survey results incorporate reported pension liabilities under GASB Statements 67 and 68. Based on plan information reported through the end of fiscal 2017, our survey reflects a stabilization of reported funded levels across most states compared with the previous year (see chart 3). Overall, growth in market returns that outpaced liability growth marginally improved median funded ratios reported across all states to 69.5% in fiscal 2017 from 68.0% in fiscal 2016.

In addition to the better investment returns, changes to a state's funding trajectory and corresponding fluctuations in the single GASB discount rate will also influence swings in reported funding ratios. For example, Colorado State Division used a much lower 5.26% GASB single discount rate as of Dec. 31, 2016, compared with its 7.5% assumption in the previous year, contributing to a one-year decline in its reported funded level to 42.6% from 56.1%. Of note, in 2018, the Colorado state legislature passed a bill to adjust certain eligibility and benefit increases as well as increase pension contributions to the plan, which we believe will help stabilize the state's funding levels in the near term and that contributed to our revised outlook to stable for the state in June (see our full analysis on Colorado, published June 7, 2018). Swinging in the other direction, Minnesota State Employment Retirement System's stronger investment returns in fiscal 2017 lent to improvement in the fund's single GASB rate to 5.42% in fiscal 2017 from 4.17% in the previous year and boosted its reported funding status to 62.7% from 47.5%. Minnesota's legislature subsequently passed a bill to reduce the plan's assumed rate of return and increase statutory employer and employee contributions to the plan, which we believe should also help stabilize the plan's funding trajectory and funded status. (See "Minnesota's New Pension Bill Is A Positive Step Toward Sustainable Funding," published June 7, 2018.)

Chart 3

Fiscal 2017 State Pension Funded Ratios

Overall reported pension funded ratios across the states vary widely. As illustrated in tables 1 and 2, Wisconsin, South Dakota, New York, and North Carolina continue to rank among the states with the best reported funded ratios in the nation. The largest plans in these states also use actuarial funding, regularly update experience studies, employ reasonable amortization methods, and assume rates of return that are lower than the national median for determining actuarial contributions. Kentucky, New Jersey, and Illinois continue to report GASB-funded ratios under 40%, reflecting a history of pension underfunding that makes assumed rates of return used in actuarial funding targets less relevant, and that has contributed to budgetary pressure in those states and relative credit differentiation, with all three rated among the lowest of the 50 states.

Chart 4

Measuring Minimum Funding Progress

Many states are funding their pensions on an actuarial basis; however, lagged adjustments to required employer and employee contributions or benefits, weak amortization methods, or prolonged periods between experience studies and corresponding assumption changes can significantly influence whether there is a credible path forward to fund a plan's estimated long-term unfunded liability. If the underlying actuarial assumptions are not conservative enough or if the funding strategy is poorly crafted, even actuarially determined contributions could fail to make realistic funding progress toward paying down the long-term liability.

A state's track record and ability to manage long-term pension liabilities in the context of the current investment environment and demographic trends are important components in S&P Global Ratings' analysis of state credit quality. In our view, states that consistently fully fund required contributions on an actuarial basis and use conservative assumptions and methods are more likely to effectively manage their pension liabilities and the associated long-term budgetary costs than states that do not. In addition, states that continue to take the long view when reforming funding policies and change actuarial assumptions on a timely basis to calibrate more conservatively with actual experience are better positioned to mitigate the risks of future long-term budget pressures.

Chart 5 compares total annual plan contributions to certain costs driving the annual change in the net pension liability. We believe there is likely some minimum amount of funding progress if the annual plan contributions cover service cost (the present value of benefits earned by participants in the year), a portion of the annual total interest cost related to pension liabilities unmatched by plan assets, and 1/30th of the beginning net pension liability (see Survey Methodology). The chart reveals that, on the whole, plan contributions for only nine of the states covered these annual costs for the most recently reported year. Many of the states that show strong progress in meeting these annual measures are also those with consistently highest reported funded ratios.

Chart 5 also highlights that even for states that maintain a track record of funding at actuarially determined levels, total plan contributions can still fall short of levels necessary to make progress on paying down the long-term liability. This typically happens when the actuarial assumptions and methods used to calculate actuarially determined contributions are somewhat optimistic and do not align with recent experience.

Accordingly, states that continue to reflect very weak pension funding progress tend to base pension contributions on fixed statutory rates or underfund on an actuarial basis with optimistic assumptions. Those states that demonstrate weak pension funding discipline, thin pension funded ratios, and structural budgetary imbalances have generally experienced deterioration in credit quality in recent years.

Chart 5

Improved Assumptions Are Key To Stable State Pension Funding But Some Plans Remain At Risk In Another Recession

We believe funded ratios should stabilize for states that demonstrate a commitment to funding pension plans and make ongoing proactive changes to align actuarial assumptions with experience. However, current pension plan investment portfolios largely make certain state pension funds vulnerable to market volatility. Significant investment losses for pension funds could make for a rougher road in the next recession, particularly for those states that have struggled to make up for previous pension weakness.

Chart 6

Table 3

*Change in Median and Average Public Pension Plan Investment Return Assumptions, NASRA Public Fund Survey, June 2018

Zoya Alam contributed research to this report.