Despite investment gains in 2018, U.S. states have made relatively slow progress since the Great Recession in improving funded ratios, with S&P Global Ratings' most recent survey data indicating that the average weighted pension status across state plans was 72.5% compared with 83% in 2007. However, looking at the funded ratios alone falls short of understanding whether or not states have made progress toward improving the overall pension funding picture. Indeed, poor investment returns in select years and maturing pension plan populations have stunted state funding progress. Also, in the years immediately following the Great Recession, many states had reduced plan contributions as a short-term means of balancing budgets, resulting in funding setbacks from which many have yet to recover.

However, in recent years, many states have made conservative changes to actuarial methods and assumptions that, while hindering actuarial funding ratios, show a more realistic assessment of market risk tolerance for states, thus better enabling them to make funding progress. We have also witnessed that many states have learned lessons from funding discipline mistakes over the past ten years and better understand sources of pension liability and costs, and have therefore demonstrated a commitment to actuarially based funding. In this sense, states may be better prepared heading into the next recession despite weaker funded ratios. Yet, in our view, despite some progress, many plans' current contributions, discount rate assumptions, and investment allocations still fall short of fully mitigating the market volatility that increasingly appears to lie ahead.

Average State Funding Levels Plateau With Notable Exceptions

This year's S&P Global Ratings' annual state pension survey found most state pensions reported slight improvement in funding levels in fiscal 2018, mainly due to solid investment returns as of June 30, 2018 (a median of 8.9% for the states' largest plans). The fiscal 2018 aggregate median reported funded ratio of 72.5% for states was up just slightly compared with 69.5% in fiscal 2017. However, we note that nearly half of the states' largest plans lowered their rate of return assumption in 2018 to reduce market volatility risk, and this has played into relatively flat reported funding levels.

Chart 1

In addition to investment returns, changes to a state's funding trajectory and corresponding fluctuations in the single Governmental Accounting Standards Board (GASB) discount rate also influenced swings in reported funding ratios. Minnesota and Kentucky led states in funding gains because they increased their discount rates or trimmed benefits, such as maximum cost-of-living adjustments. We expect that due to reforms, Colorado will be a leader among states in funding gains for fiscal 2019. All three states no longer assume a crossover date for their largest plan following reforms that moved the states to funding closer to actuarially determined contributions (ADCs). (See "Minnesota's New Pension Bill Is A Positive Step Toward Sustainable Funding," published June 7, 2018, on RatingsDirect and "Colorado SB 18-200 Outlines A Path Toward Pension Funding; Is It Enough?" published May 21, 2018.)

Since the close of state fiscal year 2018, plans measured as of December 2018 fared worse due to the steep fall late in the year; poor investment returns had resulted in an average 5% decline in funded ratios. According to Callan, the median public pension annualized investment returns for period ended Dec. 31, 2018 was negative 4.1%. The median rate of return for the four states (Colorado, Ohio, Utah, Wyoming) whose largest plan was measured as of December was negative 3.1%.

According to a report by Wilshire Trust Universe Comparison Service, the median public defined pension plan return was 6.79% as of June 30, 2019, slightly below an average return of 8.4% as of June 2018. We believe slightly weaker investment returns relative to a median assumed rate of return of 7.25% and continued movement toward lower discount rate assumptions, despite some states' ongoing actions to adjust contribution levels to improve funding trajectories, will likely lead to somewhat weaker reported state pension funded ratios in fiscal 2019.

Chart 2

Overall reported pension funded ratios across the states vary widely. As illustrated in tables 1 and 2, Wisconsin, South Dakota, and New York 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 near 40%, reflecting a history of pension underfunding that makes assumed rates of return used in actuarial funding targets less relevant, which has contributed to budgetary pressure in those states and relative credit differentiation, with all three rated among the lowest of the 50 states.

Table 1

Table 2

Many States Continue With Pension Reforms, Avoiding Backward Measures

In 2018, 18 states lowered their assumed rate of return for their largest plans while 15 did so for their second-largest plans. On average, largest plan downward revisions were marginal, at just 0.24%. We understand that modest revisions largely reflect the year-to-year affordability of related necessary increases in ADCs rather than actuarial recommendations. The lower assumed rates of return reduce states' exposure to market volatility, minimizing swings in required contributions with investment returns, and providing for faster funding progress.

Connecticut, Illinois, Kansas, and Oregon all contemplated extensions of pension plan amortizations to provide budgetary relief, but only Connecticut implemented such an extension. Following an unexpected revenue bump in April, Illinois' governor announced that he would no longer pursue a seven-year pension amortization extension as part of fiscal 2020 gap-closing measures. If enacted, we would have viewed the extension of the pension plans' amortization as significantly weakening the state's pension liabilities and boosting costs. It would have compounded the state's negative amortization and increased both interest costs and the plans' vulnerability to a market correction. Connecticut pushed out the amortization of its state teacher plan by 17 years, but at the same time, it significantly lowered its rates of return from 8.0% to 6.9% and revised its amortization basis to level dollar from an escalating level 3.25% of payroll method. In aggregate, we believe the resulting drop in annual contributions will be relatively minor, and therefore the measures did not weaken the rating.

Illinois, New Jersey, and Connecticut have incorporated or are considering asset transfers as a means to improve pension funded ratios and lower required contributions. The way that these solutions are valued and influence funding discipline can have varying effects on the overall health of a pension system and long-term fiscal sustainability. To the degree that they are based on unsubstantiated valuations, create liquidity concerns, or otherwise undermine long-term funding progress, we would view them as a negative credit factor. On the flip side, if these states resist overvaluing assets and sell them to deliver cash to the pension system or use future revenue to supplement pension contributions and accelerate funding progress, the transfer could lead to a consistent paydown of the unfunded liability and stabilize contributions. (For more information on our views of asset transfer and recognition of future revenue streams, please refer to "Pension Brief: Are Pension Asset Transfers A Gimmick Or Sound Fiscal Strategy?" published Feb. 19, 2019.)

Most States Still Fall Short Of Minimum Funding Progress Despite Reforms

Despite the above-mentioned widespread efforts to improve funding discipline, many states are failing to make meaningful progress on their aggregate pension liabilities. Many are funding their pensions on an actuarial basis; however, if the underlying actuarial assumptions are not conservative enough or if the funding strategy is poorly crafted, even ADCs could fail to make realistic funding progress toward paying down the long-term liability.

Chart 3 compares total annual plan contributions to certain costs generating the annual change in the net pension liability (NPL). 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 1/30 of the beginning NPL (see "Survey Methodology" below). The chart reveals that, on the whole, plan contributions for only eight of the states covered these annual costs for the most recently reported year, down from nine the previous year. Many of the states that show strong progress in meeting these annual measures are also those with the consistently highest reported funded ratios.

Looking at another metric, static funding, which measures whether or not a state meets just current service and interest costs, 60% of states fail to meet this threshold. This means that that even for those 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 ADCs are somewhat optimistic and do not align with recent experience.

Chart 3

Despite Improved Assumptions, Plans Remain Vulnerable To Market Volatility

In our view, assumed rates of return should not only align with the expected realistic performance of the target asset portfolio, but should also reflect prudent and informed decision-making on how much market volatility and liquidity risk or budgetary stress a state can absorb. Higher risk typically means exposure to greater volatility. In the event of a market correction, a drop in asset values would necessitate an escalation in required contributions. Despite widespread state efforts to continue to ratchet down assumed rates of return, most plans retain rates that exceed what we view as a sustainable rate based on likely market volatility. In our view, based on current market conditions of the expected asset return of an average plan in the U.S., a sustainable discount rate for the typical plan is 6.5%.

In Chart 4, the assumed rates of return for the 50 states' largest plans are represented on the vertical axis around a median of 7.25%, well above 6.5%. Plans at the top of the chart have higher assumed returns, and consequently, a greater acceptance of market volatility risk within their target portfolio.

Chart 4

Demographics Influence The Funded Ratio And Budgetary Vulnerability

States with mature plans and elevated discount rates that still have low funded ratios may warrant additional attention with regard to budgetary vulnerability.

In chart 4, the active-to-beneficiary ratio is represented on the horizontal axis around a median of 1.32. As the proportion of benefits that are accrued increases for mature plans (seen on the left side of the chart), there is less flexibility to reduce costs via a plan freeze. Additionally, as a plan matures, there are reduced plan inflows as fewer active members contribute annually, and this is compounded by increased outflows for a greater number of retirees and beneficiaries. There is greater strain on employers, as well as asset returns, to maintain plan funding, particularly if the avoidance of intergenerational inequity is desired. Increased liquidity needs, along with reduced capacity for market volatility, could push mature plans toward lower assumed returns.

The funded ratio is represented in chart 4 by color. A mature plan with a high active-to-beneficiary ratio might elect to reduce market risk by incorporating a safer target portfolio and corresponding lower assumed return. A lower assumed return correlates to a lower discount rate, and therefore, a lower funded ratio.

An additional note with regard to demographics has to do with funding discipline. Plans that incorporate assumed payroll growth in their amortization methodology have a built-in deferral of contributions that is intended to be a stable percentage of the budget. However, assumed payroll growth is typically around 1% higher than assumed inflation and this may not be attainable indefinitely. Every year that payroll growth is not realized leads to a contribution shortfall from expectations and adds unfunded liabilities that further add to already-accelerating contributions. We have seen amortization methods reduce such risk of acceleration in states such as Kentucky and Connecticut and expect this trend to continue.

Pension Costs Remain Affordable For Most States, With Notable Exceptions

Fixed costs remain affordable for most states. According to S&P Global Ratings' 2018 survey of state budgets, the median pension contribution as a share of general fund expenditures was 6% of expenditures, with contributions ranging from as low as 1% of expenditures to 18%. However, when accounting for debt and other postemployment benefit (OPEB) expenses, costs rise to a median of 11.5%. Across states, median pension liability per capita is $1,126, and when combined with net OPEB and debt liabilities, increases to a moderate $2,741 per capita. While the extreme outliers rightly get attention, it is worth pointing out that many states retain modest liabilities. However, we acknowledge that, when coupled with rising Medicaid costs (which average about 19% of general fund expenditures), other competing priorities, and slow or declining revenues, even modest growth in pension contributions can lead to budgetary pressure. Notably, the states with the highest pension costs also tend to have higher overall fixed costs, giving them less flexibility to address rising contributions. Please refer to "When The Credit Cycle Turns, U.S. States May Be Tested In Unprecedented Ways" (published Sept. 17, 2018) for more data on states' fixed costs.

Chart 5

Policy Decisions, Not Markets, Will Likely Pose Greatest Future Risks

Despite weaker funded ratios than in 2007 and assumed rates of return that, in our view, still fall short of sufficiently mitigating market volatility, we do not anticipate the next recession will lead to a pension crisis or acute budgetary stress. A majority of plans retain sufficient assets to withstand a market shock, and when smoothed over the remaining amortization period, contribution increases are likely to require difficult budgetary choices but remain affordable. In our view, actions to reduce annual contributions, whether shorting ADCs, extending amortization periods, or poorly executed asset transfers/pension obligation bonds, are more likely to lead to budgetary stress and downward rating revisions than weak pension investment returns in a typical recession.

Table 3

Related Research

• Market Declines Will Shake Up U.S. State Pension Funding Stability, published Feb. 26, 2009
• Pension Brief: Credit Effects Of Municipal Pension Plans Approaching Asset Depletion, published Sept. 5, 2019
• Pension Brief: Are Asset Transfers A Gimmick Or A Sound Fiscal Strategy?, published Feb. 19, 2019
• When The Credit Cycle Turns, U.S. States May Be Tested In Unprecedented Ways, published Sept. 17, 2018.