State retirement plans enjoyed unprecedented asset returns from soaring investment markets in fiscal 2021, substantially improving the metrics reported within S&P Global Ratings' annual survey of state retirement liabilities. We expect this upswing to be short-lived, however, given poor market returns in fiscal 2022 that we believe will erase much of the gains reported in this year's survey. Furthermore, we anticipate market volatility will spur contribution volatility in future years for some state budgets given complex funding formulas that incorporate plan investment performance.

Rather than placing outsized emphasis on volatile market returns, the foundation of S&P Global Ratings' analysis of state retirement liabilities is underpinned by a holistic view of long-term progress to fund these obligations. In our view, the whiplash of recent investment performance will demonstrate how reducing return assumptions might be beneficial to state budgets in the long term. Over the past decade, some states have shown a reduced appetite for risk by lowering the assumed return (and therefore the discount rate). We expect these states will face lower contribution volatility than states that maintained higher return assumptions. As states pivot to absorb potential increased contributions following fiscal 2022 market performance, we expect those with high fixed costs and limited budgetary flexibility will likely face greater budgetary pressures.

Fiscal 2021 Annual Survey Results Of State Pension And OPEB Funding

Most state pension and other postemployment benefit (OPEB) plans reported improved financial metrics in fiscal 2021, including boosted funded ratios and reduced liabilities. Notably, several previously well-funded plans are now reportedly overfunded for the first time in recent history.

Pension funded levels increased significantly in fiscal 2021 given extraordinary investment performance

S&P Global Ratings' annual state pension survey found that most state pension systems reported a significant increase in funded levels in fiscal 2021. The median reported funded ratio of 81.2% in fiscal 2021 is up markedly from 68.9% in fiscal 2020 and 70.9% in fiscal 2019, mainly due to extremely strong investment returns rather than plan funding or administration changes that would have a long-term structural effect.

Chart 1

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

Our survey found that funded levels for state OPEBs also ticked upward in fiscal 2021. Across the 48 states that report a liability for retiree medical benefits, the median reported funded ratio of 6.1% in fiscal 2021 was up just slightly from 5.1% in fiscal 2020. Overall, retiree health care benefits are less likely to be affected by swings in investment performance because there are far fewer legal requirements to fund these liabilities; most states fund OPEBs on a pay-as-you-go basis, meaning contributions are paid as costs are incurred, rather than building assets to prefund and take advantage of market returns.

Chart 2

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

We consider pension and OPEB affordability a key factor for state credit quality. We incorporate this into our analysis by considering contribution direction and sufficiency. In addition

to our forward-looking analysis of the actuarial contribution trajectory, if applicable, 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 meaningful progress for a given year.

Chart 3 compares total annual plan contributions to these metrics for pension plans. The chart shows that, on the whole, plan contributions for 16 states met or exceeded our MFP guideline for the most recently reported year, an increase from 14 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 2021, 38 states met the static funding threshold, up from 26 the previous year due in part to contributions increasing as unfunded interest costs shrank. 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 to accrue returns and help offset future costs. Our survey found that combined annual plan contributions do not cover static funding for just over 75% 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 11 states that reached static funding levels, seven (14.9% 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 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.

Notably, West Virginia exceed its actuarially determined contribution by $95 million even before an additional $30 million in prefunding was applied pursuant to an established funding law. Utah's employer contributions are based on payroll and are consistently strong.

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, and exposes state governments to rising unfunded liabilities, fixed costs, and budgetary pressure over time. In the past, states contributing more than a paygo amount toward these obligations have reduced contributions for budgetary relief. In states where legally permissible, benefit design changes have also been considered to reduce annual costs.

Chart 4

Volatile Markets Could Lead To Volatile Contributions And Budgetary Instability For Some States

S&P Global Ratings anticipates strong returns in fiscal 2021, in combination with a poor market in fiscal 2022, could lead to contribution volatility in future years for some states given complex pension funding models where market returns influence a large part of the plans' inflows and funding amounts.

Abnormally strong investment returns reported for fiscal 2021 have heavily affected reported financial metrics for state pension plans, which typically hold more assets than OPEB plans given the stricter funding requirements for pensions.

Chart 5 below demonstrates just how significantly these market gains affected reported financial metrics for select major state plans. Market returns in fiscal 2021 for the five plans included were, on average, 19.5% higher than assumed returns. For comparison, the average return for these five plans during the five fiscal years prior--which include the economic expansion leading up to the COVID-19 pandemic--was 0.1% lower than assumed returns. The large jumps in assets in fiscal 2021 consequently lowered reported net pension liabilities by an average of 16.8% and increased reported funded ratios by an average of 25.0%.

A variety of factors influence year-over-year changes to pension plan financial statements. Notably, the New Jersey Teachers' Pension Annuity funded ratio additionally improved due to actuarial recognition of the state's higher proportion of pension actuarially determined contributions in fiscal 2021. Nevertheless, we believe abnormally high investment returns strongly contributed to changes reported for plans in fiscal 2021.

Chart 5

Meanwhile, we expect funding gains reported in this year's survey will be short-lived given poor market returns in fiscal 2022. Specifically, Wilshire Advisors estimates that through June 30, 2022, asset values dropped 13.4%.

Overall, S&P Global Ratings believes market returns in fiscal 2022 will likely lead to increased contributions in future years, which could lead to unanticipated new budget pressure. State legislatures might not be preparing to meet this challenge, since lagged financial reporting indicates retirement funds are in better shape than they are. For more information on the impact of market returns on USPF issuers, see "Pension Brief: 2022’s Down Markets Reverse 2021’s Unprecedented Gains For U.S. Public Pension Plans," published June 8, 2022, on RatingsDirect.

The Potential For A Recession Could Keep Retirement Plan Reforms On The Back Burner

While reforming growing retirement liabilities gained traction in the economic expansion leading up to the pandemic, states quickly shifted priorities as the coronavirus spread and revenues fell. For many states, this meant forgoing actions to structurally improve pension and OPEB plans, which often incurs a fiscal impact, in order to focus on budget stability. As vaccines were deployed and the economy began to recover, states began realizing surplus revenues in fiscal 2022. Many chose to translate excess funds into tax reforms for their fiscal 2023 budgets due in part to a low appetite for retirement liability reforms; the most recently available financial reporting during 2022 legislative sessions showed substantial funding gains in fiscal 2021. (For more on states' fiscal 2023 budgets, see "Slower Growth Ahead: Revenue Surpluses Boost U.S. State Budget Flexibility, For Now," published April 28, 2022.) Most recently, inflation continues to surge and borrowing costs are projected to keep rising--leading S&P Global Economics to assess the risk of recession at 45% (see "U.S. Business Cycle Barometer: The Party's Over," July 27, 2022, for more information on the national economy, and "U.S. Public Finance Mid-Year Outlook: The Heat Is On," July 14, 2022, for state sector insights). In our view, a potential recession could lead to continued deferral on structural funding progress for state pension and OPEB plans. Consequently, we expect annual retirement liability costs will increase in the long term, absent meaningful efforts to prefund or reduce these liabilities.

We believe retirement liability pressure, along with other challenges such as high fixed costs, must continue to be addressed before reaching a point where long-term budgetary flexibility is limited and a state's ability to respond to unexpected events, such as significant economic shocks, is suppressed.

Related Research

• U.S. Business Cycle Barometer: The Party's Over, July 27, 2022
• U.S. Public Finance Mid-Year Outlook: The Heat Is On, July 14, 2022
• Pension Brief: 2022’s Down Markets Reverse 2021’s Unprecedented Gains For U.S. Public Pension Plans, June 8, 2022
• Slower Growth Ahead: Revenue Surpluses Boost U.S. State Budget Flexibility, For Now, April 28, 2022
• 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