Some public pension plans around the country have raised concerns about whether they might completely run out of money set aside to fund pension benefits. The reasons for such a scenario vary from poor funding discipline, to investments not meeting target rates of return, to newly negotiated benefits, to demographic changes in membership. Having to fully address obligations on a pay-as-you-go (paygo) basis can add volatility and cost to budgets, just as the credit cycle may be turning. Increasingly, these poorly funded plans are addressing the possibility and repercussions of asset depletion.

This Pension Brief addresses S&P Global Ratings' views on the following questions:

• What could asset depletion mean for pension plans?
• How might asset depletion affect issuer credit ratings?
• How likely is asset depletion and what can be done to avoid it?

Sponsor governments have not typically considered plan contributions tantamount to debt and so, in times of budgetary stress, there has been leniency for pension contributions that provide short-term budgetary relief. The actual benefit payments, on the other hand, must be paid out to the members to avoid reneging on plan obligations, so contributions under paygo funding must be paid each year. Typical plan design puts the responsibility and risk on plan sponsors (the employer and any external contributors such as the state) to fund benefits in excess of a fixed employee contribution.

What Could Asset Depletion Mean For Pension Plans?

To fund benefits, pension plans typically relied on investment returns to supplement contributions; if there are no investments to earn returns, benefit payments must be fully supported by annual contributions. To illustrate what happens at asset depletion, we have provided select examples from around the U.S. of severely funded pension plans, which we define here as under 40% funded. The S&P Global Ratings criteria for rating U.S. state debt incorporates a one-notch rating override for an aggregated pension ratio expected to fall below a 40% threshold and additional overrides as this ratio falls to reflect the extremely weak funding levels.

Chart 1a shows for these plans the combination of contribution inflows and expected asset returns compared to the most recent year's expenditures. Three of these plans fall short in FY18, indicating possible negative cash flow for the upcoming year that would require, barring additional financing, a drawdown of assets for short-term support--but this support diminishes in efficacy as assets are depleted. These plans may be on a direct path to insolvency. The remaining plans may find themselves at the precipice of deterioration in the event of poor market returns or other adverse experience which could end up crowding out other payments from the annual budget.

Chart 1a

Asset depletion scenario

Chart 1b shows how cash flows for these plans would look if they had no assets today. Without assets to earn returns or draw upon when needed, the median sponsor (employer and state) contributions must be increased by 33% to cover median expenditures. While Pittsburgh would not see a contribution increase, contributions for New Jersey Teachers and Chicago Municipal Employees would more than double just to fund benefit payments for the year.

Chart 1b

How Might Asset Depletion Affect Ratings?

There are multiple places within S&P Global Ratings' states and local government ratings methodologies where we could reflect the effects of asset depletion. We have a negative view of the existence or high probability of escalated fixed costs, which is more likely as plan funding shifts from investment earnings to contributions. Management may be viewed as poor if there is an impression of a lack of budgetary control indicated by dwindling assets and also if there are excessively high fixed costs. We may view the fund balance to be at risk due to the inherent volatility of paygo funding and the weakened ability to cut costs, which would adversely affect our view of the government's budgetary flexibility. It's important to note that the ratings impact is applied incrementally as the plan asset position transitions downward. In addition to negative management, liability and budgetary implications of weak pension funding, our states rating methodology includes direct rating notch adjustments for extremely poor aggregate pension funding levels below thresholds of 40%, 20%, and 10%. (See "Local Government Pension And Other Postemployment Benefits Analysis: A Closer Look," published Nov. 8, 2017 on RatingsDirect, for more details on local government adjustments.

For our sample of eight plans, chart 2 shows the effect on the budget of asset depletion. Budget is defined as total governmental fund expenditures for cities and budgetary basis general fund expenditures for states and is taken as reported in financial disclosures.

Chart 2

Poorly funded pensions do not necessarily imply poor ratings, particularly if the plan is a relatively small part of the budget. For local governments that we rate, approximately 3% of credits have primary pension plans in our database that are under 40% funded. Based on the weak funding, the majority (82%) of these credits receive a negative adjustment to our assessment of their debt and liabilities. For those credits without a debt score adjustment, we might believe the risk of stress is minimal, even though plan funding level is poor, because current annual postretirement payments are very low as a percent of budget. The median postretirement (pension plus OPEB) carrying charge for these plans is a manageable 5.4% of expenditures with the highest at 8%. It is far more typical however, that a poorly funded pension plan would be substantial enough to stress the budget if not managed.

How Likely Is Asset Depletion And How Can Plans Avoid It?

S&P Global Ratings has recently raised the likelihood of recession in the next 12 months to 30%-35%, from 25%-30% last quarter. Market returns over the past decade have been particularly volatile, and this may be especially alarming to plans that are already at a severely low funding level. Prior underfunding of necessary contributions is what led these plans to their current predicament. Continued underfunding increases the likelihood of a possible asset depletion, particularly in a recession.

We are seeing methodical changes being made to funding discipline around the country, whether by a reduction to the assumed market return or a more prudent amortization methodology. While we do not see widespread asset depletion as a foregone conclusion, it is also not impossible.

Chart 3

Actions Taken To Date

Pittsburgh

While more may be needed, Pittsburgh has recently made improvements to funding discipline, including a reduction to the amortization period and a reduced discount rate, which results in increased annual contributions. The city has also dedicated future parking tax revenues beginning in 2018 and allocated a $220 million above otherwise required pension payments for the next five years, though this is being used to reduce annual contributions, which delays plan funding.

New Jersey

The state continues to ramp up annual payments toward 100% of the actuarially determined contribution (ADC) for FY 2023 by budgeting 70% of the ADC for FY 2020, excluding dedicated lottery fund contributions. Contributing below the ADC continues to defer costs into the future.

Chicago

In 2017, the city started a five-year ramp-up to increased ADC and has dedicated funding sources for this period. However, the ADC is defined to reach 90% funding after 40 years, which defers costs and adds risk. New hires in the Municipal plan will contribute more while receiving no planned cost-of-living adjustments during retirement, which may help, but only in the long term.

Related Research

• U.S. Business Cycle Barometer: Recession Risk Rises, Aug. 15, 2019
• Pension Brief: Are Asset Transfers A Gimmick Or A Sound Fiscal Strategy?, Feb. 19, 2019
• The Increasing Cost Of Governmental Pensions: Discount Rate And Contribution Practices, Sept. 27, 2018
• Pension Obligation Bonds' Credit Impact On U.S. State And Local Government Issuers, Dec. 6, 2017
• Local Government Pension And Other Postemployment Benefits Analysis: A Closer Look, Nov. 8, 2017