The COVID-19 pandemic created uncertainty across U.S. states' budgetary landscapes in fiscal 2020, disrupting progress made in the preceding economic expansion to fund retiree pension and medical benefits. As revenue forecasts plummeted, states scrambled to manage their budgets with lower-than-anticipated resources. Most states, in a financial pinch, prioritized contributions to pension plans over other postemployment benefits (OPEB) plans, given the typically stronger legal protections for pension benefits. While some uncertainty persists, pandemic-driven budgetary challenges have generally settled in 2021 thanks to significant federal aid, vaccine rollout, and an uptick in economic activity.

S&P Global Ratings anticipates this return to stability will allow states to refocus attention on addressing their growing unfunded retirement liabilities. We expect states' reduced appetite for risk over the past decade will continue, translating into further reductions in the discount rate for pensions over time. Although we expect most states will continue to direct limited resources to priorities other than OPEBs, those with large unfunded retiree medical liabilities could face more pressure to act as the budgetary impact increases. In our view, contribution volatility poses greater risk to states with high fixed costs and limited budgetary flexibility.

Fiscal 2020 Annual Survey Results Of State Pension And OPEB Funding

Overall, in fiscal 2020, states' pension funded levels declined slightly and retiree health care liabilities continued to grow.

Pension funded levels decreased slightly in fiscal 2020 due to the pandemic-induced recession, with expected improvement in fiscal 2021.

S&P Global Ratings' annual state pension survey found most state pension systems reported a slight dip in funded levels in fiscal 2020, mainly due to weaker investment returns as of June 30, 2020, stemming from the pandemic-induced recession. The fiscal 2020 median reported funded ratio of 68.9% for states was down slightly compared with 70.9% in fiscal 2019, and 72.5% in fiscal 2018 (see table for state-by-state details). Despite the slight decline in funded ratios, and in part contributing to them, some states continued to focus on improving funding discipline through more conservative market return assumptions with the intent to decrease contribution volatility. We estimate reported funded levels for many pension plans will improve in fiscal 2021 given generally strong market returns to date.

Chart 1

The OPEB funding survey results show growth in unfunded retiree health care liabilities.

Our survey found that states continued to sharply underfund their OPEB plans as reported aggregate unfunded liabilities ticked upward in fiscal 2020. Across the 48 states that report a liability for retiree medical benefits, the aggregate proportionate share of the net OPEB liability (NOL) rose by 5.2% to $557 billion. Among the states with funded ratios below 40%, 29 were below 10% funded, with 13 states having no prefunding at all.

During the economic expansion preceding the pandemic few states pursued and implemented reforms aimed at reducing growing unfunded OPEB liabilities as they diverted finite resources elsewhere. This trend continued during the pandemic and we expect it will persist even as budgets stabilize because states have historically underfunded their OPEBs. Therefore, we expect annual OPEB costs will increase absent meaningful efforts to prefund or reduce these liabilities. Our credit analysis for states with large unfunded liabilities includes legal and practical flexibility for reducing costs; we typically view states with limited flexibility and no progress toward prefunding to be lacking a meaningful funding plan.

Chart 2

Pension And OPEB Affordability Is A Key Factor In A State's Creditworthiness

We consider pension and OPEB affordability a key credit risk for state credit quality. We factor this view into our analysis by considering contribution direction and sufficiency. In addition to analysis of the actuarial contribution, if one is made, we consider two funding metrics based on contributions made in the previous year:

• Static funding: An amount that if contributed every year, would neither reduce nor improve the funded ratio; and
• Minimum funding progress (MFP): An amount that includes an addition to static funding that we consider reasonable progress for a given year.

Chart 3 compares total annual plan contributions to these metrics for pension plans. The chart reveals that, on the whole, plan contributions for 14 states met or exceeded our minimum funding progress guideline for the most recently reported year, a decline from 15 the previous year. States that consistently show strong progress in meeting our MFP metric are also typically those with the highest funded ratios.

In fiscal 2020, 26 states met the static funding threshold, up from 24 the previous year. 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 for a given year. This typically happens when the methods used to calculate actuarially determined contributions assume significant 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. States in which funding consistently falls below static funding levels will likely report escalating unfunded OPEB liabilities in future years if benefit reforms are not implemented. Of the 10 states that reached static funding levels, seven (15% of the states surveyed) met our MFP guideline, indicating a wide gap between the few states that fund OPEB benefits and the majority that don't.

Chart 4 compares total annual plan contributions to the static funding and MFP metrics above for OPEB plans. OPEB plan funding shows a stark contrast to funding for state pension plans. 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.

While we recognize it will likely be difficult for states to divert scarce resources to unfunded retiree health care liabilities, we believe that, on the whole, a 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 might also be considered to reduce annual costs.

Chart 4

States' Declining Market Risk Tolerance Could Lead To Improved Funding Progress

We expect that states' reduced appetite for market and contribution volatility risks over the past decade will continue, translating into further reductions in the discount rate for pensions over time. Although future reductions in plan discount rates will likely lower corresponding funded ratios and increase cost, we expect overall funding discipline will improve as risk exposure is reduced, for plans that receive contributions based on actuarial recommendations. We believe many plans will choose to pursue incremental discount rate reductions at a pace that allows states budgets to absorb the increase in required contributions. Several states have even tied discount rate reductions to market gains to soften the blow of cost increases; as a result, we anticipate some states might decrease their discount rates to less aggressive levels following high investment returns achieved in fiscal 2021.

We believe this improvement in funding discipline, although it worsens some metrics initially, would positively affect funded levels in the future, if maintained. In our view, changes to actuarial assumptions that might reduce funded ratios generally show a more conservative 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 have better positioned themselves to manage contribution volatility. This stands in contrast to OPEB plans in which states have made little progress toward benefit reforms or contribution increases.

Although Significant Federal Aid For Pandemic Recovery Prohibits Pension Paydown, Plans Benefit Indirectly

On March 11, 2021, the federal government approved unprecedented levels of aid to state governments to quell the far-reaching economic and financial effects of the pandemic. While allocations from the American Rescue Plan Act (ARP) are allowed for a variety of uses including capital projects for water, sewer, and broadband infrastructure, states are expressly prohibited from depositing these dollars into their pension funds. Despite this restriction, we believe state retirement plans still indirectly benefit from the influx of ARP funding since these dollars have provided stability to revenue-pressured budgets and enabled states to continue making full and timely contributions to their pension plans. For more information on states' fiscal 2022 budgets, see "Federal Aid Helps Lift The Cloud Over U.S. State Budgets," published on April 29, 2021, on RatingsDirect.

In our view, federal aid has supported some states with significant fixed costs by increasing those states' budgetary flexibility to offset other pandemic-related operating costs and direct excess general fund resources toward management of long-term liabilities. For example, Connecticut--which we consider to have a high fixed-cost burden--benefitted from better-than projected revenue across all state sources and directed amounts in excess of its 15% statutory budget reserve fund cap to reduce the long-term pension liability in its State Employee Retirement Fund. With ARP and other federal pandemic relief funds expected through the fiscal 2022-2023 biennium, Connecticut projects an operating surplus and could make another supplemental contribution to pay down its unfunded pension liabilities. (For more information on Connecticut's credit profile, see our most recent analysis published May 13, 2021.)

Although utilization patterns will differ across states, ARP dollars may be spent through Dec. 31, 2024. We expect states that choose to use this one-time funding for recurring needs could face a structural challenge when ARP funds are exhausted, thereby pressuring fixed costs such as pensions and further challenging funding progress for OPEBs, which do not typically have the same legal protections.

Related Research

• Federal Aid Helps Lift The Cloud Over U.S. State Budgets, April 29, 2021
• Pension Spotlight: Risk Sharing Dilutes Pension Burden For Five States, April 21, 2021
• State, Local Government, School District, And Charter School Sector Views Revised Back To Stable, March 24, 2021
• Five U.S. State And Local Government Pension And OPEB Trends To Watch For In 2021 And Beyond, Jan. 25, 2021
• 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)
• 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