Municipal DB Plans Face Increased Cost Pressures

Since the Great Recession, municipal defined benefit (DB) plans have taken center stage as one of the key sources of long-term credit risk in what has historically been a remarkably stable, low-risk asset class, S&P Global Ratings notes.

The 2008 financial crisis and subsequent economic downturn led to steep declines in asset values for U.S. municipal pension funds, followed by a period of inconsistent and often below-target investment performance. S&P Global Ratings believes these issues have frequently been exacerbated by underfunding, where many municipalities continue to contribute less than actuarially recommended rates to their pension funds and where states have often failed to update statutory formulas in a timely manner to better align with actuarial recommendations.

In this year’s annual survey of the 15 largest American cities, S&P Global Ratings continues to see a mixed picture in terms of where the largest cities stand with respect to their pension and other post-employment benefit (OPEB) liabilities. Primary fixed costs are generally high and in many cases poised to rise considerably in the coming years due to poor pension funding levels, actuarial assumptions and methods that defer meaningful funding progress into the future, and movement toward the adoption of more conservative actuarial assumptions that revise funding levels downward and require higher employer contributions. S&P Global Ratings expects that cities with poorly funded pension plans will continue to struggle with cost pressures. On the other hand, it continues to observe many cities that are proactively addressing their pension and OPEB liabilities through meaningful reforms that, though often more costly in the short term, will better position them in the long run to meet their obligations without impairing their fiscal health.

According to the survey report, pension, OPEB, and debt service spending is high among the 15 largest U.S. cities, exceeding 25% of governmental expenditures on average in the most recent fiscal year. S&P Global Ratings expects spending on pensions and OPEBs to continue to rise well into the future for the largest U.S. cities, as many pension plans are poorly funded or employ funding practices that defer costs into the future. Further, it expects that changing demographics—an increasing number of retirees relative to active employees—along with rapidly rising medical costs will create greater cost pressure from government OPEB plans.

Beginning in fiscal 2017, Government Accounting Standards Board (GASB) Statements Nos. 74 and 75 required more uniform reporting standards and greater transparency around OPEB liabilities. At the median, OPEB costs represented only 1.3% of expenditures among the 15 largest cities in fiscal 2018, though this only measures actual contributions. S&P Global Ratings finds that most OPEB plans are funded on a pay-as-you-go basis, where the sponsoring government is paying for benefits directly from its operating budget. These municipalities are not prefunding the plans by accumulating assets in a trust to earn investment income that will be available to cover future benefit payments.

“The common use of pay-as-you-go financing for OPEBs exposes cities to cost acceleration and volatility. We expect that OPEB spending will be a more significant cost pressure in the future than in the past as Baby Boomers continue to reach retirement age, as longevity improves, and as rising medical costs continue to outpace general price inflation,” the report says. The firm notes that many states allow for greater flexibility to reduce OPEB liabilities by directly cutting benefits, changing eligibility and vesting requirements, or shifting costs onto employees, but these types of measures represent cuts to total employee compensation and to that end may be politically contentious.

DB plans are sensitive to funding setbacks if they realize investment losses or if investment returns fall below the rate of return assumption, as they are heavily dependent on investment earnings to pay for future benefits. S&P Global Ratings says this sensitivity is worth underscoring at this moment given that the U.S. is currently well into what is now the longest economic expansion since World War II and economists are forecasting a 30% to 35% chance of a recession in the next 12 months. In addition to placing funding levels at risk, recessions and accompanying market volatility can place upward pressure on required contributions through the remainder of the plan funding horizon. The effects on the near-term budget will depend on the severity of investment shortfall in a market downturn scenario, the length and the severity of the recession, and its effects on revenue performance, as well as plan-specific characteristics. In general, the report says, cities with more aggressive target investment allocations and aging demographics are at the greatest risk.

Two other key factors S&P Global Ratings attributes to slow funding progress include contribution practices that are not actuarially based or that otherwise defer funding progress and an ongoing movement toward pension reform, one component of which has been the adoption of more conservative liability measures that result in weaker funding levels. In particular, the firm has seen a clear trend across the sector toward lowering investment rate of return assumptions in light of a generally more bearish assessment of long-term economic growth and expectations for weaker market returns.

Most of the 15 largest cities in its survey have reduced their return assumptions for at least one of their pension plans within the last few years. S&P Global Ratings views the move to more realistic actuarial assumptions, particularly more conservative rate of return assumptions, favorably, though it will also result in rising plan contributions. It says the costs of unrealistic assumptions are much greater in the long run, particularly if aggressive assumptions result in systematic underfunding that is allowed to compound over many years, generating a much larger problem down the road.

For the the cities’ largest pension plans, the survey found funding levels were more or less stable from 2016 to 2018, on average improving by 5.4% over the three-year period. Plan funding practices, investment performance, and, in the case of Houston, the issuance of pension obligation bonds (POBs) are key factors that S&P Global Ratings attributes to the largest year-over-year changes. The average and median funded ratios for the 15 cities’ largest pension plans were 66% and 70% in fiscal 2018, respectively.