This report does not constitute a rating action.
Key Takeaways
- An inflation-led hike in pension provisions and higher employer contributions from January 2023 will see Sweden's local and regional governments' (LRGs') pension costs almost double to 9% of operating revenue by 2024 versus 5% in 2022.
- In our view, this could reduce the LRG sector's financial flexibility in the short and long terms.
- However, we expect LRGs' operating cash flow will remain robust through 2026, limiting the risk of a material deterioration of the sector's liquidity and debt position.
Swedish LRGs face a steep rise in pension-related costs in 2023-2024. The main reason is that the LRG sector's existing pension liability is adjusted by inflation, forcing all LRGs to increase pension provisions this year and next. In addition, the LRG sector has agreed with the unions on a new pension agreement that, among other things, increases the annual pension contribution LRGs pay per employee.
These developments will weigh on the sector's accrual-based net results over the next one-to-two years, likely leading to deficits among a number of LRGs. Yet LRGs would still need to comply with Sweden's balanced budget requirement in subsequent years, and higher provisions imply larger pension payments in future.
S&P Global Ratings therefore foresees a potential weakening of the sector's financial flexibility. Nevertheless, the increased costs are mainly linked to non-cash items, so we expect operating cash flow to remain strong, supporting the sector's debt and liquidity position. In addition, we anticipate provisions could come down from 2025, once inflation starts to abate.
Inflation Is Behind Most Of The Increase
The LRG sector's pension costs are set to reach at least Swedish krona (SEK) 120 billion in 2024, up more than 80% compared to 2022 (see chart 1). About 75% of the increase relates to higher provisions following an inflation adjustment of the existing pension liability.
Chart 1
Most of the remaining 25% will stem from the new pension agreement that took effect in January 2023. This agreement entails a permanent increase of LRGs' annual pension contributions to 6% of employees' salaries from 4.5%. We forecast pension costs will account for about 9% of the sector's operating revenue in 2024, compared to 5% in 2022.
Sweden's Pension System
Pension benefits earned before 1998 by employees of Swedish LRGs go to a defined-benefit scheme, which the LRGs record as an off-balance-sheet liability. Since 1998, the LRG sector has gradually moved into a defined contribution scheme through various reforms, with the purpose of decreasing the sector's relatively large liability related to the defined-benefit scheme and improve the predictability of the sector's pension costs. The new agreement in 2023 is a continuation of this development. At some point after 2050, all pensions will be in a defined contribution scheme and the pension liability will no longer increase (Source: Swedish Association of Local Authorities and Regions; SALAR).
The Cost Will Be Higher For Regions Than For Municipalities
Pension costs, as a share of revenue, are somewhat higher for Swedish regions than for the municipalities. This is because, in relative terms, the regions have a larger share of employees with high salaries eligible for defined-benefit schemes, resulting in a considerably larger pension liability. Therefore, the impact on the regions' bottom-line results from rising pension costs will be greater. We note that 17 of Sweden's 21 regions have planned for operating deficits in their budgets for 2023, compared to only 48 of the 290 municipalities.
In addition, compared, with the municipalities, the regions have a larger share of employees that will potentially transition to defined contribution schemes via the new agreement. As such, we estimate the impact on the regions' operating cash flow will be somewhat larger (see chart 2). We estimate the regions' operating cash flow will reduce by about 1.2 percentage points compared to about 0.5 percentage points for the municipalities.
Chart 2
The new pension agreement will also increase the share of employees being covered by a defined contribution scheme, where contributions are paid immediately. We estimate that, as a result, the LRG sector's cash pension costs will average 4.5% of operating revenue in 2023-2025, up from 3.2% on average over the past two years. All other things being equal, this will shave only 0.8 percentage points off the operating margin, which we estimate at a healthy 8.6% for the sector in 2022.
Regulatory Deficits Should Be Manageable
We think several LRGs will cover potential regulatory deficits in the coming two years with accumulated surpluses. Sweden's Municipal Act states, however, that LRGs need to narrow deficits toward the balanced budget requirement within three years. In addition, the need for LRGs to pay larger pension payments in the future implies less funds available to meet other expenditure items, such as welfare.
Still, we consider that some LRGs are likely to cite extraordinary circumstances ("Synnerliga skäl") as a reason for going into deficit. According to the Municipal Act, under certain circumstances, an LRG is not obliged to restore the deficit within the three-year timeframe. Although this can relieve pressure on fiscal flexibility in the near term, unaddressed deficits will weigh on LRGs' solvency, which is already weak, especially for the regions, and may require tough prioritizations in future budgets.
LRGs' Credit Strength Allows Ample Capacity For Cost Absorption
Among the 24 LRGs we rate in Sweden, we have noted various approaches to manage pension-related issues in the coming two years. In our assessment of their management, we reflect each LRG's ability to balance its budget and comply with regulatory requirements. However, we regard the sectorwide inflation-related pension cost pressures as temporary. Consequently, we will not generally consider potential budget deficits in 2023 and 2024 to be a negative factor in our assessment of management, unless we observe performance that deviates materially from peers'.
We think the LRGs have the capacity to absorb the impact of higher pension costs, since their underlying cash generation (mainly from tax revenue) is strong (see charts 3 and 4). Our ratings in the sector range from 'AA+' to 'AAA' and all carry stable or positive outlooks. In addition, the existing pension liability will be paid out over several decades, and the increased provisions mainly imply higher pension payments in the distant future. The LRGs will also address these additional expenses in their regular budget processes, taking into consideration the balanced budget requirement and internal surplus targets.
Despite weaker bottom-line performance, cash generation remains strong
Chart 3
Chart 4
What's more, we forecast pension costs to decrease from 2025, when inflation is expected to normalize. This will reduce the amount of annual pension provisions compared with the previous year and, other things equal, support a recovery of the sector's performance and balanced budget compliance. Therefore, we foresee an only limited impact on liquidity in the short to medium term, supporting what we view as robust operating balances through 2024.
Related Criteria
| Primary Credit Analyst: | Erik A Karlsson, Stockholm + 46(0)84405924; erik.karlsson@spglobal.com |
| Secondary Contacts: | Carl Nyrerod, Stockholm + 46 84 40 5919; carl.nyrerod@spglobal.com |
| Linus Bladlund, Stockholm + 46-8-440-5356; linus.bladlund@spglobal.com | |
| Additional Contact: | Sovereign and IPF EMEA; SOVIPF@spglobal.com |
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