Leading up to the current economic downturn, state governments steadily improved their pension funding discipline while continuing progress toward reducing risk over the past year. S&P Global Ratings continued to observe states adopt more conservative actuarial assumptions and methods or direct resources into pension plans above required contributions. Meanwhile, most states neglected to leverage the expansion for meaningful progress toward improving the fiscal health of their other post-employment benefit (OPEB) plans, choosing to direct limited surplus revenues to other priorities. We view the specter of new fiscal pressures brought on by the COVID-19 induced recession and the abrupt end of one of the longest economic expansions in U.S. history a risk to future pension and OPEB funding improvements.

In our opinion, the onset of the sudden-stop recession increases the potential that states may fall back on their pension funding discipline improvements, or move away from pre-funding OPEB liabilities, in an effort to ease budgetary pressures. However, S&P Global Ratings does not expect extensive pension or OPEB reforms to occur in fiscal 2021 due to more immediate challenges facing state governments and the upending of regular legislative sessions. Widening budget gaps this year are more likely to result in reduced contributions, extending amortizations, and other actions that may slow the pace of pre-funding these liabilities.

Looking forward to next year's results, increasing market volatility and uncertainty surrounding the global economy may result in lower funded ratios. Maintaining contribution sufficiency, particularly during challenging budget cycles, is also a key consideration of future plan funding. Despite the S&P 500's strong recovery at June 30, following a steep decline earlier this year, public pension plan investment returns are likely to close below their expected return assumptions. Overall, progress on future plan funding is unlikely during what we expect to be an unprecedented period of economic uncertainty.

Results Of Annual Survey Of State Pension And OPEB Funding For Fiscal 2019

Overall, states' pension and OPEB funding remained mostly unchanged in fiscal 2019. State action toward addressing retirement liabilities continues to focus more on pension funding, leaving OPEB liabilities significantly underfunded.

Despite little movement in pension funded ratios, states have made progress in improving funding discipline, which should positively affect funded levels in the future if maintained. Conservative changes to actuarial assumptions that may reduce funded ratios show a more realistic assessment of market risk tolerance for individual states, thus better enabling them to make funding progress. States that have proactively reduced pension plan discount rates, increased liquidity, and adopted other conservative assumptions should be in a better position than the last recession to manage contribution volatility. This stands in contrast to state OPEB or retiree health care plans where little progress has been made by states toward benefit reforms or significantly increasing contributions in an attempt to pre-fund these liabilities.

Pension funding survey results show slight dip in funded ratios.

S&P Global Ratings annual state pension survey found most state pension systems reported a slight dip in funded levels in fiscal 2019, mainly due to weaker investment returns as of June 30, 2019 (a median of 5.9% for the states' largest plans). The fiscal 2019 aggregate median reported funded ratio of 70.9% for states was down slightly compared with 72.5% for states in fiscal 2018, and an improvement from 69.5% in fiscal 2017 (see table at end for state-by-state details).

Chart 1

Despite the slight decline in funded ratios, states continued to make progress on improving funding discipline as more conservative assumptions decrease contribution volatility and can improve plan liquidity. Two notable reforms recognized in reporting this year include Colorado's recent legislation that increased budget allocations to its plan and improved the state's aggregate pension funded ratio to 56% from 44% the year before. However, the state's fiscal 2021 budget adjustments included a one-year suspension of its direct annual allocation of $225 million (or 2% of annual expenditures) from the general fund to reduce pension liabilities. Connecticut's reporting also shows a lowered assumed rate of return on its Teachers' Retirement System (8% to 6.9%), now in line with its State Employees' Retirement System. The state also plans to reduce contribution deferrals by moving to a level dollar amortization beginning with the June 30, 2024, valuation.

The discount rates used to measure funded ratios around the country average approximately 7.2%, but we expect pension plans across the sector will continue to reduce their discount rates to reflect changing macroeconomic conditions and risk tolerance, a trend we have observed over the past decade. As part of these changing macroeconomic conditions S&P Global Ratings recently decreased its discount rate guideline to 6.0% from 6.5% (see "Assessing U.S. Public Finance Pension And Other Post Employment Obligations For GO Debt, Local Governments GO Ratings, And State Ratings," updated July 21, 2020, and the corresponding "Credit FAQ: Pension And OPEB Guidance In U.S. Public Finance," July 21, 2020. Built on foundations of inflation, liquidity risk, and market risk, our guideline was updated for two primary reasons: the underlying long-term inflation assumption decreased to 2.4% from 2.6%; and updated market conditions reflect generally lower returns for a given level of risk. While future reductions in plan discount rates are expected to lower corresponding funded ratios and increase cost, overall funding discipline is expected to improve while limiting risk exposure if annual contribution increases keep pace with these changes.

For more information on efforts states have made to improve pension funding discipline prior to the onset of the recession, see "U.S. State Pension Reforms Partly Mitigate the Effects of the Next Recession,"Sept. 26, 2019.

OPEB funding survey results show modest growth in retiree health liabilities

S&P Global Ratings' latest survey found that U.S. states continue to sharply underfund their OPEB plans as reported aggregate unfunded liabilities ticked upward slightly in fiscal 2019. Across the 48 states that report a liability for retiree medical benefits, the aggregate proportionate share of the net OPEB liability (NOL) rose by 0.9% to $529 billion. Among the states with funded ratios below 40%, 29 states were below 10% funded with 13 states having no prefunding at all.

Chart 2

We expect annual OPEB costs to increase absent meaningful efforts to pre-fund or reduce the liabilities. In recent years, few states have pursued and implemented OPEB reforms (see "U.S. States Are Slow To Reform OPEBs As Decline In Liabilities Masks Increased Risk," Dec. 3, 2019). While we expect this lack of action to continue in the near term for most states, we note some severely stressed states could choose to pursue actions that provide immediate budgetary relief as they face mounting fiscal pressures resulting from the COVID-19 pandemic. Because the size of these unfunded liabilities varies greatly among states, progress toward reducing them is more pressing for some than others.

Risks Of Pension And OPEB Affordability For States

S&P Global Ratings considers pension and OPEB affordability a key credit risk for U.S. state credit quality. We factor this into our analysis by considering contribution direction and sufficiency. Specifically, we consider two funding metrics:

• Static funding: An amount that if contributed every year, would neither reduce nor improve the funded ratio; and
• Minimum funding progress: An amount that includes an addition to static funding that we consider enough to achieve full funding over a reasonable time.

Chart 3 compares total annual plan contributions to certain costs generating the annual change in the net pension liability (NPL). The chart reveals that, on the whole, plan contributions for 15 states covered our minimum funding progress guideline for the most recently reported year, compared to eight the previous year (an improvement from 16% of states to 30%). Many of the states that consistently show strong progress in meeting this metric are also those with the consistently highest reported funded ratios.

Looking at static funding, 48% of states met the threshold this year, up from 40% the prior year. 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 methods used to calculate actuarially determined contributions assume growth in payroll over a long amortization.

Chart 3

Most states continue to fund their OPEB liabilities on a pay-as-you-go (paygo) basis in which annual funding is equal to the benefits distributed; assets are not set aside in advance to pay benefits in the future. Our survey found that combined annual plan contributions do not cover static funding for nearly 80% of the states surveyed. By not meeting static funding levels, these states will likely report escalating unfunded OPEB liabilities in future years if reform efforts are not implemented. Of the 9 states that reached static funding levels, five (10.4% of the states surveyed) met our minimum funding progress guideline.

Chart 4 illustrates these results by comparing total annual plan contributions to certain costs causing the annual change in the NOL. These results are in contrast to funding for state pension plans where total annual plan contributions for 40% of state plans met static funding and 16% of plans met minimum funding progress. In our view, the strict legal requirements for funding many pension plans, which do not exist for most OPEB plans, are largely responsible for this funding differential.

Chart 4

In our survey results, we expect some variation from year to year to reflect improved disclosure across the sector. As Governmental Accounting Standards Board (GASB) statements 74 and 75 have been implemented over the past two years by states and other plan sponsors for OPEB reporting, improved disclosure has increased our ability to assess the proportionate share of OPEB liabilities applicable to each state.

Sudden-Stop Recession Presents New Challenges For State Pension And OPEB Funding

Pension plan sponsors and administrators are likely entering into a period of fiscal stress. To alleviate budgetary pressures, adjustments to reduce pension plan costs and contribution increases are likely to be considered (see "Pension Brief: The Future of U.S. Public Pensions after the Sudden-Stop Recession," May 6, 2020). Should market returns remain below past peaks, the effect of poor returns will result in an increase in employer contributions or a movement to riskier assets. Furthermore, states that have been funding their unfunded OPEB liabilities above paygo contributions may choose to divert these additional funds to their pension plans or other priorities--if practicable--given stronger legal requirements to fund pension plans.

Prior to the start of 2020, the Federal Reserve lowered the federal funds rate three times, the first time it had done so since 2008, following a period of increases during 2015-2018. In response to the sudden shutdown of the national economy to mitigate the spread of COVID-19, the Federal Reserve reduced rates to near zero, where they are likely to remain for some time. As interest rates remain low, so do bond yields, making safer investment options less attractive for pension funds needing to meet targeted returns.

Chart 5

Increasing asset allocations into equities presents its own risk. Despite the S&P 500's strong recovery following a steep decline earlier this year, consumer confidence is likely to be tapered for some time as a prolonged economic recovery ensues and consumer behaviors change (see "Economic Research: The U.S. Faces A Longer And Slower Climb From The Bottom," June 25, 2020). Health and safety concerns are likely to remain a drag on recovery until a vaccine or viable treatment option is developed. Such risks will likely result in segments of the economy or regions of the country shuttering for a time, negatively affecting corporate performance and equity pricing.

Interest rate volatility will also affect OPEB liabilities. Generally, state plans have applied a discount rate based on a municipal bond rate due to a general lack of interest-earning assets and GASB methodology. In last year's survey, we noted a drop in liabilities primarily due to an increase in the discount rate rather than improved funding or OPEB reforms. In this new economic environment, lower rates over time are likely to increase the size of OPEB liabilities and related costs for states. Discount rate movement based on a conservative municipal bond rate is considered to be within reasonable volatility expectations and we don't consider it to be a fundamental change in the funded status of the plans. 

Culling Of State Employee Payrolls Will Weaken Plan Demographics And Increase Costs

Similar to the last recession, state governments have started to reduce headcount in an effort to find budgetary relief. State employment rolls (excluding education) peaked in April 2008, before reaching their trough in December 2013, a 6.5% decline. Employment improved over the past six years peaking in April 2020 before starting to decline again. However, state government employment remains well below its 2008 peak.

Chart 6

Declining payrolls will negatively affect contributions, as fewer active employees contribute to plan assets. Contributions are particularly affected by payroll if the amortization is built around a growth assumption. The contribution shortfalls are likely to augment liquidity pressures for some plans, particularly those with low funded ratios and already weak demographics (see "Pension Brief: Liquidity Is a Rising Concern for U.S. Public Pensions in down Markets," March 24, 2020). Reduced plan inflows are compounded by increased outflows for a greater number of retirees and beneficiaries. The result is greater strain on employers, as well as asset returns, to maintain plan funding. Increased liquidity needs, along with reduced capacity for market volatility, could push mature plans (those with lower active to beneficiary ratios) toward lower assumed returns in an effort to increase contributions.

States generally have more options to address rising OPEB costs if they become unaffordable because they typically have a stronger legal ability to modify these benefits. For example, states may repeal benefits for Medicare-eligible retirees to generate cost savings. (For more on retiree health care offerings by state governments, see "Retiree Medical Benefits Generate Unique Cost Drivers And Risks For U.S. States," published Sept. 17, 2019.) However, waiting until costs become unaffordable to take action is not fiscally prudent over the long term, in our view, especially given practical limitations to plan adjustments. Even if there is legal flexibility, there may be other obstacles to reducing benefits and associated costs (see "OPEB Brief: Risks Weigh On Credit Even Where There Is Legal Flexibility," published May 22, 2019).

Pension And OPEB Funding Discipline Faces Uncertainty Post-Recession

In our view, the current sudden-stop recession was spurred by an extraordinary event and will require extraordinary measures in the near term to keep state budgets balanced (see "U.S. States Mid-Year Sector View: States Will Continue To Be Tested In Unprecedented Ways," July 13, 2020). Similar to the years following the last recession, we expect state governments to take action to ease budgetary stress. For pension plans, we expect states will consider extending amortization periods, benefit design changes, early retirement incentive programs, and other structural changes to reduce costs. The most direct form of alleviating pension costs is to pay less than what is required or issue debt to fund recurring contributions, both of which are actions that S&P Global Ratings views negatively when determining if a budget is structurally balanced.

For OPEBs, S&P Global Ratings believes it is crucial for states to prudently manage plan fiscal health ahead of a tipping point where rising retiree medical benefits costs themselves lead to budgetary stress. While we recognize it will likely be difficult to divert scarce resources to unfunded retiree health care liabilities during the current recession, we believe that, on the whole, continued lack of funding OPEB obligations indicates poor plan management, which exposes state governments to rising unfunded liabilities, fixed costs, and budgetary pressure over time. States contributing more than a paygo amount toward these obligations are likely to reduce contributions for budgetary relief. If legally permissible, benefit design changes may also be considered to reduce annual costs.

In the current fiscal year, we consider extensive pension and OPEB reforms unlikely. Any major changes to retirement benefits typically involve a substantial amount of legislative time and stakeholder engagement. Many legislative sessions were upended or shortened by the pandemic and the more immediate issues facing state governments will likely result in reforms being pushed off. Fiscal 2022 budgets are more likely to reflect a need for reform as immediate budgetary pressures abate and states look to address a prolonged economic recovery and softer revenue growth.

Related Research

• Guidance: Assessing U.S. Public Finance Pension and Other Post Employment Obligations for GO Debt, Local Governments GO Ratings, and State Ratings, Oct. 7. 2019 (updated July 21, 2020)
• U.S. States Mid-Year Sector View: States Will Continue To Be Tested In Unprecedented Ways, July 13, 2020
• Pension Brief: The Future Of U.S. Public Pensions After The Sudden-Stop Recession, May 6, 2020
• Pension Brief: Liquidity Is A Rising Concern For U.S. Public Pensions In Down Markets, March 24, 2020
• Five U.S. State And Local Government Pension And OPEB Trends To Watch For In 2020 And Beyond, Jan. 21, 2020
• U.S. States Are Slow To Reform OPEBs As Decline In Liabilities Masks Increased Risk, Dec. 3, 2019
• U.S. State Pension Reforms Partly Mitigate The Effects Of The Next Recession, Sept. 26, 2019
• Retiree Medical Benefits Generate Unique Cost Drivers And Risks For U.S. States, Sept. 17, 2019
• OPEB Brief: Risks Weigh On Credit Even Where There Is Legal Flexibility, May 22, 2019