Fiscal 2023 Market Pullback Means Funded Ratios Are Likely To Continue Falling

Industry discussions often focus on funded ratios and market returns as snapshot proxies for pension system health and funding adequacy. However, U.S. government pension health is influenced by plan structure, economic conditions, and asset allocations, so there is not one measure that alone can provide a status update. Given this, we take a holistic approach to assessing a pension system's overall strength as well as its effect on credit ratings, especially since so many measures and metrics are considered.

The overall economy plays a meaningful role in our rating process, and S&P Global Economics forecasts, as a baseline, a shallow U.S. recession during 2023. S&P Global Economics' projections call for a 1.1% return for the S&P 500 in 2023. While this projection reflects improvement compared with the decline of about 20% in the S&P 500 in 2022, we expect U.S. public pension-funded ratios to decline further this fiscal year, since they are not meeting their return expectations. After a few years of their missing the target rate of returns, we will be watching closely to see if system administrators pursue additional yield-seeking investments during this ongoing period of reduced economic growth, and will analyze the associated risk of contribution volatility and escalation.

A comparison of U.S. government public pension plans' assumed rate of return with actual pension system median returns (chart 1) shows the abnormally positive median 2021 return and a sharp decline for 2022, following the slow but steady two-decade decrease in average assumed return. The chart also highlights the general volatility of year-over-year returns, which can lead to contribution jumps for plan sponsors. The declining target rate of return--from 8% in 2002 to 7% in 2022--is notable, as we see many plans moving forward with more conservative assumptions.

Chart 1

What Do Changing Investment Assumptions Mean Over Time?

After significant growth in fiscal 2021, public pension system funded ratios reverted to 2020 levels and, given returns so far in fiscal 2023, are generally expected to continue to fall without a drastic upward shift in the market. U.S. pension plans, on average, assume annual asset returns of 7.0%, and if this assumption is not met, it equates to a loss compared with planned inflows that may lead to higher contributions in the future. We estimate that a typical public pension plan will have experienced a return of around negative 1% for the first half of fiscal 2023 (July 1, 2022-Dec. 31, 2022), which equates to a loss for the first half of the year of 4.5%, below the half-year assumption of 3.5% returns (which annualizes to 7.0% returns).

As shown in chart 2, if the rest of the fiscal year matches the 7.0% annual expectation, the typical pension plan can expect its funded ratio to decline by around 3.0% for fiscal 2023. If the rest of the fiscal year continues as it has for the first half, but incorporating the S&P Global Economics baseline outlook for the S&P 500, this means funded ratios are expected to be approximately 4.0% lower as of the June 30, 2023, fiscal year-end. For additional information on this topic, including our methodology, please see "Pension Brief: 2022’s Down Markets Reverse 2021’s Unprecedented Gains For U.S. Public Pension Plans," published June 8, 2022.

Chart 2

Inflation's Impact On Pension Costs

After topping 9.0% in June, the U.S. Consumer Price Index (CPI) fell to 7.1% in December 2022, resulting in minimal change during the calendar year from the 7.0% in December 2021. Though this very high inflation period may be coming to an end, S&P Global Economics forecasts that core CPI will remain high, at 4.7% in calendar 2023, until declining to 2.8% in 2024. This is a meaningfully different inflation environment from the preceding decade, and high inflation can have contrasting effects on different aspects of a pensions plan.

Chart 3

Breaking down the moving pieces and what it means for credit

As liabilities remain high and costs escalate, this could create a cost squeeze for employers and possible budgetary pressure. This effect is due to the contrast between applications of short-term inflation (year-over-year) and a long-term inflation assumption:

• Short-term inflation: Periodic market swings can have a dramatic effect on wages, inflation-linked benefits such as cost-of-living adjustments (COLAs), and health care costs. These can have immediate, direct budgetary implications that affect pension contributions.
• Long-term inflation: Inflation volatility has a limited impact on long-term actuarial assumptions such as the assumed asset return, and therefore also on the discount rate. As such, funded ratios are expected to see minimal direct effects from recent inflation volatility. However, if high inflation is persistent, long-term assumptions may have to be adjusted to reflect the perceptions of a new economic reality, which could lead to higher future costs.

Chart 3 contrasts CPI, the long-term U.S. Treasury rate, and the surveyed average U.S. public pension inflation assumption from the Public Plans Database. Since surveyed inflation more closely reflects the long-term U.S. Treasury rate, we expect there will be a limited impact on funded ratios in the near term even as cost pressures rise from the more volatile CPI. During this economic turbulence, credit analysts will continue to watch for contribution sufficiency and funding discipline to assess the risk of funding deterioration that could lead to budget gaps over time.

Chart 4

Pension contributions may be viewed as an outlet for budgetary stress for some governments

Inflation-adjusted U.S. state revenues are showing some signs of weakness, which could add pressure to state budgets. Given most local governments benefit from state funding, which often slows during a recession, budgetary gaps can start to develop. These gaps could be exacerbated by any wage increases governments have used to entice new workers and/or maintain existing staff in recent years. If states and local governments look to reserves and rainy day funds for an extended period to maintain budgetary stability and keep up with pension costs, it could signal broader credit deterioration. (See further discussions in our state outlook for 2023 and local government outlook for 2023.)

Retiree Health Care Could Warrant Increased Focus

Since most other postemployment benefits (OPEB) plans fund retiree health care benefits on a pay-as-you-go (paygo) basis, year-over-year medical cost inflation has a direct impact on governments' budgets. This means that the current high inflation could lead to rapid OPEB cost increases, along with increases in health care costs for current employees. We note in our 2022 state pension survey that the median OPEB funded ratio was a very low 6.1% as of fiscal 2021; during that time, contributions didn't cover static funding levels for 75% of plans, indicating an expected decline in funded status over time. Since most OPEB plans use a paygo approach rather than prefunding a trust, they are exposed to contribution escalation risk from inflationary increases to medical costs.

As the U.S. continues to recover from the pandemic, there have been lingering effects of COVID-19 for those affected by previous variants, as well as ongoing needs due to newer variants that are less deadly but still significant. While we can't predict the budgetary fallout, pandemic-driven morbidity could lead to escalated retiree health care costs, particularly since the health impact of the virus is often greater among older people.

POB Issuance, Highly Dependent On Interest Rates, Will Likely Remain Low

POB and OPEB obligation bond (OOB) issuance has been accelerating in the U.S. while interest rates have been low, but that shifted when interest rates spiked in 2022. A higher interest rate environment will likely lead to fewer opportunistic POB issuances, although we expect issued POBs will continue to be used as a budget stabilizer for volatile or rapidly increasing amortizations. For additional information on our views on risks and opportunities associated with POBs, including our expectation that returns from issuance over the past five years are unlikely to have met expectations thus far, please see "U.S. Pension Obligation Bond Issuance Recedes In 2022 As Interest Rates Rise," published Oct. 10, 2022.

Chart 5

Reduced Payroll Growth In The Wake Of Economic Uncertainty Defers Escalating Costs

As state and local governments grapple with changes to the labor market, service demands, and waning federal stimulus, short-term and long-term changes to personnel may occur. For governments that see payroll growth slowing, cost pressures could arise, particularly for those that amortize unfunded obligations using a level percentage of payroll assumption. If hiring does not match the payroll growth assumptions, actual contributions will likely fall below expectations and defer compounding costs to future years. This can lead to budgetary stress and negative credit implications. Illustrating this concept, chart 6 shows the 16 states that have seen their average annual growth fall at least 1% behind the average payroll growth assumption used in their largest pension plans. Average annual growth is measured by state and local government wage disbursements over the past three years.

Chart 6

Declines in the labor force participation rate since the onset of the pandemic (chart 7) could also affect employer contributions. This will be particularly notable as more baby boomers reach retirement age, and some who are close to retirement age and left the work force due to health and exposure concerns may not return. If not managed carefully, this shift in demographics and decreasing the active-to-pensioner ratio could lead to contribution escalation, and possibly liquidity risks for employers with large unfunded obligations.

Chart 7