Chart 1

Credit Fundamentals By Sector

• Commonwealth of Massachusetts: Pensions remain a credit risk. In our opinion, pension funding discipline has been poor, and the commonwealth's reported aggregate pension funded ratios remain relatively low, measured with elevated assumed rates of return despite recent shifts to incrementally more conservative assumptions. The commonwealth contributes on a statutory basis, ramping up to fully amortize the unfunded liabilities by 2036 by increasing contributions 9.63% annually through 2028, declining to 4% annually from 2029 to 2036. We believe this could lead to unanticipated cost increases and pressure future budgets.
• Local governments: While we expect pension costs will rise for almost all local governments, issuers' ability to absorb these costs varies across the commonwealth. We consider the five largest county-level plans to be comparably poorly funded. In high-growth areas around Boston with large, expanding tax bases, local governments will likely be able to support rising costs. However, municipalities with limited tax base growth, little revenue-raising flexibility under Proposition 2 ½ limits, or comparatively lower income and wealth metrics, will likely experience budgetary pressure due to rising costs.
• School districts: Most school districts are departments of their respective municipalities, with operations accounted for in the municipality's general funds. In some instances, communities participate in regional school districts. These districts do not have revenue-raising ability; instead, they rely on assessments to member municipalities to provide the bulk of annual revenue. However, for most school employees, the commonwealth recognizes the liability and pays pension costs on behalf of the districts, resulting in minimal pension pressure on annual budgets.
• Other sectors: S&P Global Ratings maintains ratings on various issuers that also participate in cost-sharing multiple-employer plans, including not-for-profit health care providers and public universities. These entities either participate in the commonwealth plans, or other public plans that are well funded and have minimal credit risk.

Pension Plan Breakdown

This report focuses on the State Employees' Retirement System (MSERS), Massachusetts Teachers' Retirement System (MTRS), and the five-largest regional pension systems by total liability. For data on these plans, including the number of years until each is scheduled to be fully funded as well as planned annual contribution increases, please see Tables 1 and 2 in the Appendix.

Commonwealth's Plan Contributions Will Significantly Increase Through 2036

Poor funding discipline, back-loaded amortization, and high discount rates impede progress

The commonwealth's reported aggregate pension funded ratios remain relatively low, and we consider its pension funding discipline in recent years to be weak; it calculates its contribution by setting funding targets based on percentage increases to contributions rather than adjusting increases to keep level amortization of the liability. This translates into a back-loaded amortization of the liability. In 2023 (its most recent triennial funding schedule reset), Massachusetts updated its planned pension contributions to increase 9.63% annually through 2028, before declining to 4.00% through 2036, when it projects its unfunded pension liabilities will be fully amortized.

Furthermore, the commonwealth continues to establish its contribution levels on a three-year lagged budgetary basis, although actuarial valuations are conducted annually. We believe this policy limits the commonwealth's flexibility to adjust contribution levels when actuarial assumptions miss actual experience, such as missed investment returns, or when the actuarial assumptions themselves have been changed, such as when the assumed rates of return were lowered.

The commonwealth has incrementally lowered its discount rate during the last several years, most recently to 7.00% from 7.15% in fiscal 2021, to reduce its future contribution volatility related to market risk. However, the discount rate remains above our 6.0% guideline, meaning we believe there still may be excessive contribution volatility risk. While the commonwealth will continue to adjust its funding discipline and actuarial assumptions, which should lead to both contribution growth and smoothing volatility over time, current economic conditions are significantly pressuring both its revenue sources and its ability to meet the increasingly onerous funding plan.

Mandated Funding Deadline For Local Government Plans May Increasingly Squeeze Municipality Budgets

Escalating, aggressive contribution rates to meet 2040 deadline may not be sustainable, which would only compound future costs

We consider the five largest county-level plans to be comparably poorly funded. In 2010, Massachusetts required all pension plans to adopt a funding schedule that leads to full funding by 2040. This is the third funding schedule deadline imposed by the commonwealth; previous deadlines were in 2028 (adopted in 1988) and 2030 (2009) and were set or extended following recessions. Although S&P Global Economics now views a recession in the next year as less likely than it appeared in 2023, we believe Massachusetts could again extend the deadline if economic conditions worsen during the next several years. While this would likely mean near-term pension contributions would stabilize and remain more affordable, it would also put a higher price tag on municipalities' future pension costs.

As the 2040 deadline approaches, the truncated funding schedule is bringing municipalities closer to paying down their unfunded liabilities. However, this progress is due to rapidly escalating contributions that may be difficult within local budgets. At the same time, systems are maintaining contribution growth assumptions that we still consider aggressive with regard to affordability, although plans across the commonwealth have adopted incrementally more conservative growth assumptions in recent years. Expected contribution cost growth could be exacerbated by the ongoing adoption of more conservative assumptions, such as lower discount rates. Alternatively, if plan assumptions are not met, long-term costs would also rise.

Climbing pension costs could pressure credit quality and municipalities' budgets as they comprise a higher percent of total operating expenditures

On a percentage basis, Massachusetts local governments' total planned pension contribution increases are some of the largest in the country--even before considering unplanned increases due to risky assumptions. While we view all of these systems as poorly funded with a strong likelihood of escalating and variable costs, we take an individual view regarding their influence on our ratings on local governments. The true budgetary effect for a given local government will depend on factors such as:

• Local economic conditions, including underlying metrics, such as wealth and income;
• Budget size;
• Number of employees participating in the pension plan; and
• Starting costs as a percentage of expenditures.

Chart 2

As demonstrated in Chart 2, we expect contribution costs--on average--to outpace local governments' budgetary growth in the coming years. Chart 2 reflects the adopted funding schedule for each individual plan, including both normal costs and amortization of unfunded liabilities. Our assumed 3.6% local budgetary growth, or the average change in municipalities' general fund expenditures between 2017 and 2022 on a budgetary basis, reflects data from Massachusetts' Division of Local Services (DLS).

In some instances, the difference between pension contributions and budgetary growth will be substantial. For example, in the Worcester Regional Retirement System:

• Its adopted 9.95% annual contribution increases are highly likely to substantially outpace the budgetary growth of participating municipalities.
• A participating municipality's total plan contributions in 2036 will be 231% of its 2024 contributions, according to the current funding schedule.

Using those metrics and the assumed 3.6% annual budgetary growth, a municipality participating in the Worcester system with an 8% pension carrying charge in 2024 could expect its annual pension contributions in 2036 to comprise more than 12% of its total operating expenditures. And if local government budget growth stagnates during the next decade, those pension costs would account for an even larger portion of expenditures.

Chart 3

For information on other regional plans, please see charts 4-7, in the Appendix. In all cases, the majority of contribution increases are driven by escalating amortization of the unfunded liability.

Rising pension carrying charges may be especially difficult for communities with limited legal flexibility to raise property taxes, which comprise the majority of operating revenue for most cities and towns in the commonwealth. In fiscal 2024, DLS data indicate that more than half of municipal property tax levies (183 of 351) exceeded 99% of the maximum permitted levy under Proposition 2½, a commonwealth law that sets a levy limit for each community, raises it by 2.5% annually, and adjusts for growth from new development. These communities could experience budgetary pressure because of their limited flexibility to increase property taxes without voters approving higher taxes.

We believe municipalities with forward-looking financial management teams; large, diverse, and expanding tax bases; and revenue-raising flexibility are better positioned to address pension cost growth. As pension costs escalate ahead of the 2040 deadline, local governments may struggle to make their required contributions as the rising costs increasingly crowd out discretionary spending items and account for a larger share of the budget. Ultimately, we believe rising pension costs could pressure credit quality if local governments defer their capital plans and operational investments due to stagnant or declining reserve levels or rising debt and fixed costs--especially if revenue growth also slowed due to economic conditions.

High discount rates may limit current cost increases, but could lead to contribution volatility

While the Barnstable, Middlesex, Worcester, and commonwealth plans have adopted incrementally more conservative assumptions over the last few years, each of the spotlighted systems still has a discount rate well above our 6% guideline, meaning assets are assumed to take on added risk to provide plan funding--and there do not appear to be significant risk-sharing, budgetary, or demographic features that indicate local budgets could tolerate the additional risk. The regional systems use aggressive assumptions that limit their expected cost increases (see Appendix for more information). For example, the Plymouth County Retirement System uses a 7.875% discount rate, one of the highest in the nation, and while other systems are more conservative, their rates remain elevated.

Other Postemployment Benefits Are Often Overlooked

Focusing solely on pensions leaves another liability growing in their shadow

OPEBs in Massachusetts are provided on a single-employer basis by the commonwealth or local government. Governments have the authority to prefund the liability in an irrevocable trust fund, but funded ratios and discipline vary widely, with affluent tax bases or strong management teams more likely to have made material funding progress. A common theme among many local governments in the commonwealth is that management teams expect to begin prefunding OPEBs only after their pension system is fully funded. We do not view this alone as a credible plan to addressing the liability.

Although pension plans have adopted funding schedules, we believe these remain fluid and subject to change. Should the commonwealth permit pension plans to push their funding schedules past the current 2040 deadline, we believe many will do so to minimize short-term cost escalations, allowing OPEB liabilities to keep rising. Furthermore, as pension plans become funded, we believe local governments may prioritize other, likely deferred, capital and operational needs at the expense of funding OPEB liabilities.

While there is legal flexibility to lower OPEB costs by reducing retiree health care benefits, local governments have generally only done so for future retirees to date, indicating a possible lack of practical flexibility for containing rising OPEB costs. We believe it is unlikely that local governments will eliminate or materially alter these benefits.

The Commonwealth of Massachusetts has a sizable OPEB liability, but we believe management has made good funding progress in reducing it by putting money aside in an OPEB trust fund. As of June 30, 2023, Massachusetts' retirement trust had a $14.2 billion net OPEB liability.

Disclosure And Financial Reporting

The commonwealth and larger county systems readily publish financial and GASB 67 and 68 statements on their websites, however the smaller county systems generally do not. None of the pension plans with a single participating local government publish publicly available stand-alone financial reports or GASB statements. While the commonwealth retirement website publishes an annual one-page snapshot for each system, the reports do not provide sufficient information to assess funding progress metrics. When data limitations apply, we rely on available information in issuer audits when ascertaining pension risks at the issuer level.

Appendix

Table 1

Table 2

Chart 4

Chart 5

Chart 6

Chart 7