Chart 1

Credit Fundamentals By Sector

• State of Arizona: We view Arizona's pension liabilities as relatively manageable with combined net pension liabilities as a percent of state personal income at 1.6% for fiscal year end 2020. However, the low aggregate funded ratio at about 67.3%, combined with actuarial assumptions we believe to be aggressive, potentially create conditions for the state's unfunded pension liabilities to rise in future years. Nonetheless, the state consistently fully pays its statutorily required contribution, which is determined periodically on an actuarial basis.
• Local governments: Relatively aggressive market return assumptions, increasing amortization methods, and low funded ratios (particularly in the agent public safety employees' pension plan) contributed to rising costs and budgetary pressures. There has been an increase in pension obligation bond (POB) issuances among issuers throughout the state, many of which have used the proceeds to level out their cost trajectory.
• School districts: School districts absorbed rising pension costs in recent years without significant budgetary pressures, and current carrying charges for most school districts remain moderate relative to national peers. However, pension costs are expected to continue rising, which could result in increasingly difficult budget decisions to maintain operational balance.

Forward Looking View Reflects Reduced Risk For All Major Plans

Effective fiscal 2021, both the ASRS and PSPRS boards have adopted various updated actuarial valuation assumptions. S&P Global Ratings considers these changes a credit positive for local governments. Highlights of upcoming assumption changes include:

• ASRS lowered its discount rate to 7.0% from 7.5%, which we believe reduces market risk, although risk is still viewed as elevated as it remains above our guideline.
• ASRS reduced its amortization period to 20 years from the prior 30-year period, improving funding progress.
• PSPRS, CORP, and EORP reduced assumed payroll growth assumptions to 3.0%, 2.5%, and 2.0%, respectively, which reduces contribution deferrals.

Additionally, the state's $1 billion investment toward its PSPRS and CORP liabilities could have an indirect positive impact on local governments. Given the added liquidity, we believe this could allow for increased allocation to return-seeking investments.

Plan Summaries

Arizona has four statutorily established pension plans, the largest of which are the Public Safety Personnel Retirement System (PSPRS) and the Arizona State Retirement System (ASRS). The PSPRS board of trustees also administers the Correctional Officers Retirement Plan (CORP) and the Elected Officials Retirement Plan (EORP).

• PSPRS: an agent, multiple-employer system that serves firefighters and police employed by the state and subdivisions.
• ASRS: a cost-sharing, multiple-employer plan that benefits state employees, political subdivisions, and public schools.
• CORP: an agent, multiple-employer plan that services corrections employees at the state and county level.
• EORP: a cost-sharing, multiple-employer defined benefit pension plan that provides benefits for elected officials and judges of certain state and local governments.

POB Issuances Gaining Popularity In 2021

We observed an increase in pension financing debt issuances over the last two years among cities, counties, and certain special districts within Arizona, particularly toward the PSPRS plans. POB issuance has been attributed to the low interest rate environment, as well as its usefulness as a means to restructure an escalating payment schedule. State statute limits general obligation bonded indebtedness to a level not to exceed 6% of net assessed full cash property valuation. Consequently, many issuers began issuing revenue bonds or certificates of participation as these do not count against debt limits and do not require voter approval. Additionally, debt service is not counted against the statutory expenditure limitation, unlike payments to PSPRS. Following the passage of Senate Bill 1298 in 2021, fire districts began to join the surge of issuance. The recent legislative change permits fire districts to issue lease-purchase agreements or grant a lien on any or all of its property to pay amounts to PSPRS and other pension accounts.

For more information on our view of POBs and the associated risks and opportunities, please see "Pension Obligation Bond Issuances Continue To Increase In 2021," published Oct. 14, 2021, on Ratings Direct.

PSPRS

While the majority of PSPRS legacy plans are poorly funded, the uptick in cash infusions into the plans and recent reforms are expected to improve overall funding. Based on estimates from recent POB issuances, several employer plans are expected to report very high funded ratios between 95% and 100%. Virtually all tier 3 plans are very well funded with many employers reporting a net pension asset position as of the recent measurement date.

Chart 2

PSPRS has 36,916 total members (18,677 active) and $8.7 billion in assets as of June 30, 2020. Each employer establishes a local board that is responsible for determining membership and benefits eligibility in accordance with statutory provisions. Membership is designated as Tier 1, 2, or 3 based on the employment date, which determines the eligibility for retirement and other benefits.

Tier 1 PSPRS plans offer a deferred retirement option plan, which provides lump-sum payments to eligible members. While notable, we do not consider this feature as a material liquidity risk given that eligible members may only participate for a period up to 60 months, beyond which interest is no longer granted.

PSPRS Continually Reduced Risk

Prior to the 2016 landmark reforms that transformed PSPRS, it was on a path toward insolvency largely due to its Permanent Benefit Increase (PBI) program, lack of prefunding, and poor investment returns relative to the expected rate of return. Furthermore, prior reforms in 2011 did not ultimately improve the health of the plan as the retroactive benefit changes were found unconstitutional by the Arizona Supreme Court and reversed.

The 2016 pension reforms addressed several critical issues with the PSPRS plans that included increasing the retirement age for new employees and a risk-sharing feature that splits employer and employee contribution rates at 50/50. The reforms also introduced a Consumer Price Index-based cost-of-living adjustment (COLA) to retirees, capped at 2% per year, to replace the existing PBI formula that siphoned a portion of extraordinary investment returns from the fund for retiree benefits. The COLA mechanism is pre-funded and actuarially accounted for as part of normal cost determination. While reforms established a more affordable benefit tier to ameliorate rising pension costs, employers will still need to adequately address their legacy plans as we expect costs will continue to rise and remain a source of credit pressure.

Chart 3

Relative to tiers 1 and 2, PSPRS tier 3:

• Introduces a reduced risk defined benefit plan, a hybrid plan, or a defined contribution plan;
• Amortizes liabilities more quickly; and
• Changes the pension benefit multiplier from a static 2.4% to a graded multiplier ranging from 1.5% to 2.5% based on years of service.

Given the recent inception of tier 3, most employers across Arizona do not yet have a significant number of employees participating in the new tier and so have not yet seen meaningful cost savings. We believe that long-term costs and risk for PSPRS will gradually improve over time as new members hired into the tier 3 plan eventually account for the bulk of plan participants.

Finally, recent legislation established a program under Section 115 of the Internal Revenue Code dedicated solely for prefunding defined benefit plan costs, allowing employers participating in PSPRS to elect to participate in the trust to help manage pension costs. The trust is distinctly separate from PSPRS, and assets do not count toward PSPRS funding levels or reduce unfunded pension liabilities, but we acknowledge the indirect effect on minimizing pension risk by offsetting escalating contribution payments in the future.

ASRS

We believe that expected increases in ASRS pension costs and the limited ability for issuers to manage the liability through prefunding due to the cost-sharing nature are likely to present future budgetary challenges for issuers across the state, for many of whom ASRS represents the largest pension liability. The plan's funded ratio has fluctuated over the last four years but decreased overall from its peak of 73.4% in 2018. Overall, we believe the plan's lengthy amortization period defers costs, though we view the closed amortization period and generational longevity assumptions as prudent.

With 619,397 total members (214,810 active) and $40.6 billion in assets as of June 30, 2020, ASRS is the state's largest pension plan. Of its 564 participating employer units, 42% are school districts. In addition to pension benefits, ASRS provides a health insurance premium benefit supplement and long-term disability benefits.

Pension Costs Continue To Rise For ASRS

Pension costs rose in recent years, a trend we expect to continue, particularly given the use of high market return assumptions, increasing legacy amortization costs, and relatively low funded ratios. The vast majority of issuers made their actuarially determined contributions toward the ASRS plan in recent years. The ability to absorb the rising costs varies by issuer, but those with already elevated carrying charges relative to budget will likely face more challenges in maintaining financial balance without cutting services.

Chart 4

CORP And EORP

In general, issuers' CORP and EORP liabilities are relatively small compared to budgets and we believe that the closed plans limit future costs. While we expect costs to rise given overall lower funded ratios and higher market return assumptions of 7.3% on both plans, we do not believe the plans alone pose a significant budgetary pressure. Legislation passed in 2013 effectively closed EORP to new members and created the Elected Officials Defined Contribution Retirement System for eligible employees hired after Dec. 31, 2013. Additionally, in 2018, the electorate passed Proposition 125 for the CORP and EORP plans, which is expected to reduce future liabilities by replacing a PBI formula with a capped COLA, (similar to the PSPRS discussion above) and placing all new CORP hires in a defined-contribution plan.

Other Post-Employment Benefits (OPEB)

Retiree health care, or OPEB, costs and unfunded liabilities generally reflect a much smaller portion of issuer budgets. The majority of issuers in the state fund their OPEB costs on a pay-as-you-go basis, which generally results in rapidly growing unfunded OPEB liabilities, although many issuers have opted to prefund an OPEB trust, which helps to mitigate contribution volatility and escalation. In our view, the legal ability within Arizona to alter their health care benefits provides more flexibility than those of pensions.

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