State Pension Underfunding and Contribution Decisions Hurt Credit Quality

The “State of the States” report is Conning’s proprietary ranking of the U.S. states by credit quality.

Among its findings are that state credit quality in general continues to decline; state tax revenue growth is sluggish; high legacy costs, low oil prices and slow economic growth continue to entangle many states; and strong economic performance underpins the rankings for top states.

But the report also says, in aggregate, state pension funds have a funded ratio of around 75%, which is relatively unchanged from last year, but there is a wide dispersion. Some states have fully funded plans while others have huge unfunded obligations, created by years of underfunding, plan changes and poor investment performance. In response to required higher pension contributions, many states are choosing to not fund their entire annual contribution, while other states are extending the time to reach fully funded status.

Conning says the credit implication of these actions is to make this liability even greater. “Current and future taxpayers are paying for the choices of prior administrations to extend generous benefits and/or not properly fund their plans,” the report says.

In order to measure this obligation on a relative basis, Conning looks at each state’s Net Pension Liability (NPL) as compared to its population. The NPLs are obtained from each state’s most recently available Comprehensive Annual Financial Report (CAFR)—either FY 2015 or 2016. “While actuarial assumptions under GASB 68 may be different for each state and reporting dates are not uniform, this indicator provides a useful assessment of each state’s total fixed-cost burden by per capita income, the report says. It includes a listing of states with very low or even negative NPLs, as well as states with high NPLs per capita.

Conning notes that one cause of large unfunded liabilities is lower-than-expected investment returns. Up until a few years ago, most plans had assumed investment returns averaging 8%. In recent years, these assumed investment returns have been coming down. The nation’s two largest public-sector pension funds, California’s public employee pension plan (CalPERS) and teachers retirement plan (CalSTRS) recently cut their assumed investment returns. Lower discount rates mean that states are expected to make higher contributions for plan participants.

Local governments are typically required to make 100% of their annual contributions to their pension plans, and large pension contributions were a factor in several recent California city bankruptcy filings. Measuring a local government’s fixed-cost burden is an important part of Conning’s credit analysis, and it raises a red flag when fixed costs (debt service, pension contributions and other post-retirement benefits [OPEB]) exceed 20% of annual General Fund expenditures.