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Credit Fundamentals by Sector

• State of New Jersey: The state government's pension liabilities are among the highest in the nation and weaken our view of its credit quality. Despite the use of surplus revenue to make an additional pension contribution in fiscal 2022, we expect high costs will remain a financial pressure for the next decade or more. We anticipate that the actuarially determined contribution (ADC) will remain in line with the fiscal 2023 cost of $6.8 billion, of which $5.7 billion is state supported, or a large 11.7% of proposed spending, with the balance supported by dedicated lottery revenues. We view the state's full payment of the pension ADC as a commitment to shrinking its structural deficit. However, we believe the state's ability to continue paying its full ADC relies on continued revenue strength. New Jersey also funds other postemployment benefits (OPEBs), including health care costs, for state employees, teachers, and state proportionate share of OPEBs for state colleges and local governments (LGs). This has led to a significant and growing unfunded liability of $101.6 billion, or $10,938 per capita. Given that the state funds these benefits on a pay-as-you-go basis, we expect continued cost increases and potential contribution volatility due to long-term medical cost trends.
• Local governments: Pension costs for most LGs are high and will likely increase over time due to their increasing amortization schedule. The ability to absorb rising costs can vary significantly, but credit risk is greatest where tax rates are already high, potentially limiting revenue-raising capacity. Municipalities with high pension costs and large unfunded liabilities may face an increasingly difficult budgetary environment as pension costs become an steadily larger portion of fixed costs in LG budgets. LGs must fully fund pension ADCs each year. Most municipalities participate in the New Jersey Public Employees' Retirement System (PERS) and the New Jersey Police and Firemen's Retirement System (PFRS), and they do not have control over funding assumptions or ADC calculations.
• School districts: The state makes on-behalf payments for a large majority of district pension and OPEB costs, so budgetary cost pressure from these is limited. Eligible employees participate in PERS and the New Jersey Teachers' Pension & Annuity Fund (TPAF). District employees also participate in a state-administered OPEB plan, for which the state funds 100% of contributions on the district's behalf. If the state begins to require local contributions for NJTPAF or OPEBs, it could lead to budgetary stress for school districts. We believe this scenario is unlikely in the near term and expect retirement costs to remain low for most school districts.
• Higher education: The state covers pension and OPEB costs on behalf of its public colleges and universities. Most public universities participate in PERS, PFRS, and TPAF. In our view, New Jersey's significantly underfunded defined-benefit pension plans represent a long-term credit risk for the sector because of the possibility that the state could shift pension and OPEB funding responsibility to the colleges and universities.

Plan Overview

New Jersey maintains eight defined-benefit pension plans, two defined-contribution pension plans, and one retiree medical (OPEB) plan. The New Jersey Division of Pension & Benefits (NJDPB) is a division of the state's Department of the Treasury and administers the programs.

Most LGs, school districts, and public universities participate in the following cost-sharing multiple-employer defined-benefit pension plans:

• Public Employees' Retirement System (PERS): Full-time employees of the State of New Jersey or any county, municipality, school district, or public agency.
• Police and Firemen's Retirement System (PFRS): Full-time county and municipal police or firemen and state firemen or officer employees with police powers.
• Teachers' Pension and Annuity Fund (TPAF): Teachers or members of the professional staff.

State Funding Discipline Has Improved Substantially

Despite the state only contributing 80% of the plan's actuarially recommended contribution in fiscal 2021, strong asset returns led pension plan funded ratios to materially improve year over year. The funds returned approximately 28.6%, far outpacing the 7.3% rate of return assumption for the year. This strong revenue environment in fiscal 2022 contributed to the state making its full pension ADC for the first time in 25 years. The governor's budget proposal for fiscal 2023 also includes the full payment of the ADC. However, market underperformance so far in fiscal 2022 will likely reverse a large part of funded ratio gains and could pressure pension contributions due to state budgetary stress (see "Pension Brief: 2022’s Down Markets Reverse 2021’s Unprecedented Gains For U.S. Public Pension Plans," published June 8, 2022, on RatingsDirect).

Most of the unfunded pension liability came from the state historically contributing less than its share of the full ADC. Despite various attempts ramping up payments to meet the full ADC, it did not make its first full ADC until fiscal 2022, with a high of 80% and a low of 0% in the preceding 25 years. If it fully funds the ADC on an ongoing basis, we believe it would make progress toward fully funding its pension obligation and reducing future budgetary strain. New Jersey projects (using its own actuarial assumptions rather than GASB assumptions) that it would achieve a 99% statutory pension funded ratio by 2049, assuming full ADC contributions in future years.

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Budgetary language in the annual Appropriations Act provides the state with flexibility to modify its contributions to pay less than its statutes require. In 2014, the governor reduced New Jersey's pension contribution by $883 million to close a budget gap, so history suggests this could happen again. The state grants statutory authority to the governor to order midyear cuts in pension contributions to make similar cuts in the future. However, procedural changes in 2017 required quarterly state pension payments and monthly payments from dedicated state lottery revenue reduce the possibility of large holdbacks of pension payments at the end of the fiscal year to meet potential annual budget shortfalls.

LGs Weighed Down By State's Historic Underfunding

The New Jersey pension plans' poor overall funded ratios belie strong funding discipline among LGs in the state. State statutes require LGs to pay 100% of their ADC. Despite New Jersey waiving this requirement in times of severe financial distress, such as the Great Recession, most LGs continue to fund at the ADC. Plan shortfalls are less pronounced the larger the share of the ADC for which LGs are responsible, such that PFRS has stronger funding than either PERS or TPAF.

Assets for PERS and PFRS each reside in their respective plan pools with funds from state and local payors comingled. In calculating ADCs, however, New Jersey uniquely allocates assets and liabilities between LG employers and the state based on contributions, payroll, and withdrawals. This state-share/local-share allocation results in a smaller portion of the plans' unfunded liabilities being attributed to LG employers when calculating the entity's share of the total plan ADC. While this methodology has been the state's practice for decades, it is not governed by statute and could therefore change without new legislation.

We believe that the state could use local-share plan assets to fund its share of pension obligation payments if it exhausts state-share plan assets, which would lead to large and rapid increases in required LG pension contributions. In 2018, we estimated that the hypothetical depletion date for state-share PERS and PFRS assets for would be 2025 if it did not continue its funding ramp-up (see "New Jersey Pension Funding: State Actions Reverberate At The Local Level," published Dec. 12, 2018). However, if the state continues to fully fund its ADC, this scenario becomes increasingly less likely and the worse-case date moves further out.

Nevertheless, if New Jersey resumed its historical practice of underfunding its share of the obligation, it could eventually need to use local-share funds for state purposes, and costs to LGs could therefore increase in a severe stress scenario. We therefore believe LG credit quality is still linked to the state's ability to follow through on its pension funding promises. Additionally, even with improved state funding, pension and OPEB costs will likely remain high for LGs for a long time.

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Municipalities Face Continued Rising Pension Costs Due To Weak Assumptions And Amortization Methods

Pension costs rose for most municipalities in recent years, and we believe costs will continue to increase through 2022 and beyond. While the 30-year level dollar amortization plan should result in slow positive funding progress, the need to close the large unfunded gap will likely still result in higher pension cost increases in the near term for most issuers. The state has also been gradually decreasing the assumed investment rate of return, currently 7.00% (effective for the July 2022–June 2023 fiscal year) from 7.65% in fiscal year 2016. While the use of more conservative return assumptions should be positive for contribution predictability in the future, it has also resulted in higher required contribution increases in the short term. Additionally, this assumed return and discount rate is still higher than our 6% guideline, which indicates acceptance of a high level or market and contribution volatility.

Municipalities whose pension costs form a large part of their budgets face increased stress to absorb increasing pension costs. The median pension expense for LGs made up 7.3% of governmental expenditures in 2020 in New Jersey, compared with 5.1% nationally. Other high fixed costs are also prevalent in the state, with the median OPEB contribution at 2.6% of the budget (vs. 0.3% nationally) and the median debt service cost at 9.6% (vs. 8.1%). Approximately 15% of rated New Jersey municipalities have combined fixed costs--combined pension, OPEBs, and debt service--over 30% of expenditures. The state's comparatively high tax rates may worsen budgetary difficulties. Municipalities and counties can exceed the property tax cap for pension costs, but they must be willing to do so. We expect LGs will address the increased costs through a combination of tax increases and reserves. To the extent that reserves deteriorate, or budgets become structurally imbalanced, this could pressure ratings. Furthermore, for municipalities where fixed costs rise to levels we consider very high, this could trigger an 'A' rating level cap.

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Pent-up salary and benefit growth could lead to compounding costs

The state initially paired its 2% cap on LG property tax levy increases with a matching interest arbitration cap when enacted in 2011, effectively limiting contractual salary increases near the 2% mark for most municipalities. That arbitration cap expired in 2017, and most local collective bargaining units have since signed new agreements with higher contractual raises. We also expect that high national inflation could generate higher contractual raises in the short term. With pension benefits tied to salaries, these salary increases will lead to larger ADCs for municipalities with increasing overall salaries. We have observed that it typically takes three fiscal years for the effects of salary increases to be reflected in pension expenses.

Some state lawmakers are calling for a resumption of the automatic cost-of-living increases that were paused in 2011, most recently in Bill S260 of the 2022-2023 legislative session. The State Treasury has estimated this change would increase total required contributions from the state by approximately $2.0 billion and LGs by approximately $1.6 billion, both of which would likely pressure budgets.

In 2018, the state transferred management of the PFRS to a separate board, which can independently set benefit levels and has a higher board representation from employee groups than the other retirement systems. We have said that we would consider it a negative rating factor if the board raised benefit levels (e.g., reinstating a cost-of-living allowance) without commensurate increases in pension contributions.

OPEBs Present A Governance Risk Under Our ESG Credit Factors

Most New Jersey municipalities have large OPEB liabilities and elevated costs. Generous retiree health care benefit plans are common in the state. Issuers have the legal ability to alter OPEB benefits provided subject to negotiations with bargaining agreements, but there are practical hinderances to reducing health care benefits, and changes typically only apply to new employees. Therefore, although some LGs implemented eligibility restrictions or plan phase-outs, effects may not emerge for many years after implementation.

New Jersey does not allow local units to prefund OPEB liabilities, so plans are pay-as-you-go funded, meaning sponsors make annual benefit payments with no plan assets to help offset the burden. This has resulted in escalating and volatile OPEB costs with large liabilities for many issuers, signaling high future costs as well. Despite the state's progress on funding pension expenses, the inability to prefund OPEBs means that costs will likely increase dramatically and unpredictably for LGs. We view the statutory prohibition of OPEB prefunding as a possible credit pressure for New Jersey municipalities, as well as a risk management, culture, and oversight governance risk that we capture under our ESG credit factors as more broadly described in our "ESG Brief: ESG Pension And OPEB Analysis In U.S. Public Finance," published Oct. 7, 2021. The aggregate state OPEB liability increased significantly in fiscal 2021 from $65.5 billion to $101.6 billion in fiscal 2021, in part due to changes in actuarial assumptions and differences between expected and actual census, claims, and premium experiences. New Jersey's pension governance also contributes to our weaker view of governance for the state (see "ESG Credit Indicator Report Card: U.S. States And Territories," published March 31, 2022).

Appendix

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