Key Takeaways
- Pension funding in the U.S. public finance sector improved after very strong market returns in 2021, although a decrease in contributions could negate some of this progress.
- High inflation could affect pensions long term but is unlikely to lead to significant short-term changes to liability or costs.
- Pension obligation bonds (POBs) will likely continue to increase if bond rates remain low, but anticipated rate hikes could disrupt issuance plans.
- Demographic impacts from the COVID-19 pandemic could be felt for some time, but despite increased mortality from the coronavirus, we expect limited pension funding relief.
- Environmental, social, and governance (ESG) considerations, including contribution and benefit reforms, will continue to affect pension management.
Market Returns Provide Some Relief, But Funding Challenges Remain
Public pension system funded ratios generally improved in fiscal 2021, often significantly, with market returns of near 30%, but S&P Global Ratings notes that large unfunded pension liabilities remain a significant pressure point for states and local governments around the country. Over the past 20 years, public pension assets added risk to their asset portfolios as inflation declined and managers sought yield, and we expect this trend will continue. We are also beginning to see new avenues of risk and yield-seeking through the addition of alternative investments, or investment vehicles such as cryptocurrencies, to the asset mix. Countering this trend, pension plans across the county are slowly adopting lower assumed returns, with the average falling to 7.1% in 2021 from 8.0% in 2001. We also expect this trend will continue as plan sponsors slowly adjust to higher expected contributions as a cost associated with reduced budgetary volatility. Chart 1 shows the abnormally positive 2021 returns as well as the slow but steady decrease in assumed returns. The chart also highlights the general volatility of year-over-year returns that can lead to contribution jumps for plan sponsors.
Chart 1
Increasing Inflation Could Affect Pension Costs
The U.S. Consumer Price Index (CPI) reached 7% in December 2021, as reported by the Bureau of Labor Statistics. Periodic market swings have limited effect on long-term actuarial assumptions, as shown in chart 2 by contrasting CPI with the long-term U.S. treasury rate and surveyed U.S. public pension inflation assumptions. Given the limited effect of short-term inflation on liabilities and annual costs, we do not expect a significant change in the credit implications of local government issuers with regard to pensions. However, if inflation remains significantly above trends, this could shift underlying actuarial assumptions in a way that affects pension liabilities and issuer creditworthiness.
Chart 2
POBs Will Continue To Increase If Interest Rates Remain Low
POB and OPEB obligation bond (OOB) issuance has been accelerating in the U.S. for the past few years and is expected to continue if interest rates are low. However, low rates might be coming to an end because of inflation pressures, along with expected Federal Reserve quantitative tightening and interest rate hikes. In the meantime, a perception of the end of low interest rates could accelerate POB issuance. Aside from any arbitrage plays, we expect POBs will continue to be used as budget stabilizers for volatile or rapidly increasing amortizations.
S&P Global Ratings discusses its views on risks and opportunities associated with POBs in "Pension Obligation Bond Issuances Continue To Increase In 2021," published Oct. 14, 2021).
Chart 3
A Demographic Impact Caused By The Pandemic, While Generally Limited, Could Be Felt For Some Time
Mortality rates have been unusually high
The Center for Disease Control and Prevention measured a decline in life expectancy in 2020 of nearly two years, and this trend is expected to continue in 2021 as the COVID-19 pandemic lingers. Such a reduction to the actuarial assumption of life expectancy typically leads to expected savings for pension plans, particularly given the apparent disproportionate effect on older people who are more likely to be receiving benefits. However, a large change to the actuarial assumption is not expected since pandemic mortality levels are not likely to continue indefinitely. We expect actuaries to include all information about the pandemic, including eventual recovery and ongoing medical advancements, when recommending mortality assumptions and therefore the pandemic effects are likely to be somewhat muted regarding assumed life expectancy.
Payroll growth could be slower than expected
The National Association of State Retirement Administrators reports that, since February 2020, states and local governments have shed nearly 944,000 jobs (4.7%). Pensions that amortize their unfunded liabilities using a level percent-of-payroll methodology base contributions on an assumption of increasing payroll growth that is based in part on hiring. Therefore, this could lead to more deferred contributions than expected and slower funding progress, ultimately leading to increased cost growth, relative to the current baseline, in future years.
Delayed and early retirement
According to the Society of Actuaries, individuals who reach retirement age with less savings than planned could try to delay retirement. Others, however, might cite health or exposure concerns as a reason to retire early. There appears to much demographic volatility in the job market at all ages and we expect this uncertainty will continue in 2022.
ESG Considerations Will Continue To Influence Pension Management
ESG factors overlap credit rating analysis for pension and OPEB through a review of forward-looking plan governance and risk management (see "ESG Brief: ESG Pension And OPEB Analysis In U.S. Public Finance," published Oct. 7, 2021). In the intersection of ESG and credit analysis, we expect to continue to see management proactively addressing cost deferrals by updating assumptions and methods as well as instituting benefit reforms aimed at reducing long-term pension costs, including hybrid models that share risk among employees, employers, pensioners, and states. (See "Pension Spotlight: Risk Sharing Dilutes Pension Burden For Five States," published April 21, 2021.)
Related Research
- Outlook For U.S. Local Governments: Risks Remain Despite Support From Stimulus, Jan. 5, 2022
- Outlook For U.S. States: Federal Funds Fuel Spending; Will Inflation Impede The Impact? Jan. 4, 2022
- Pension Obligation Bond Issuances Continue To Increase In 2021, Oct. 14, 2021
- ESG Brief: ESG Pension And OPEB Analysis In U.S. Public Finance, Oct. 7, 2021
- Pension Spotlight: Risk Sharing Dilutes Pension Burden For Five States, April 21, 2021
This report does not constitute a rating action.
| Primary Credit Analyst: | Todd D Kanaster, ASA, FCA, MAAA, Centennial + 1 (303) 721 4490; Todd.Kanaster@spglobal.com |
| Secondary Contacts: | Geoffrey E Buswick, Boston + 1 (617) 530 8311; geoffrey.buswick@spglobal.com |
| Jane H Ridley, Centennial + 1 (303) 721 4487; jane.ridley@spglobal.com | |
| Christian Richards, Washington D.C. + 1 (617) 530 8325; christian.richards@spglobal.com |
No content (including ratings, credit-related analyses and data, valuations, model, software, or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced, or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor’s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees, or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness, or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages.
Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P’s opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment, and experience of the user, its management, employees, advisors, and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. Rating-related publications may be published for a variety of reasons that are not necessarily dependent on action by rating committees, including, but not limited to, the publication of a periodic update on a credit rating and related analyses.
To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof.
S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process.
S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.spglobal.com/ratings (free of charge), and www.ratingsdirect.com (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.spglobal.com/usratingsfees.