States Have Made Progress in Partly Mitigating Funding Risk

Despite investment gains in 2018, U.S. states have made relatively slow progress since the Great Recession in improving funded ratios, with S&P Global Ratings’ most recent survey data indicating that the average weighted pension status across state plans was 72.5% compared with 83% in 2007.

However, the agency says looking at the funded ratios alone falls short of understanding whether or not states have made progress toward improving the overall pension funding picture.

In recent years, many states have made conservative changes to actuarial methods and assumptions that, while hindering actuarial funding ratios, show a more realistic assessment of market risk tolerance for states, thus better enabling them to make funding progress. S&P Global says it has also witnessed that many states have learned lessons from funding discipline mistakes over the past ten years and better understand sources of pension liability and costs, and have therefore demonstrated a commitment to actuarially based funding.

In this sense, states may be better prepared heading into the next recession despite weaker funded ratios, yet according to the agency, many plans’ current contributions, discount rate assumptions, and investment allocations still fall short of fully mitigating the market volatility that increasingly appears to lie ahead.

According to S&P Global’s report, Minnesota and Kentucky led states in funding gains because they increased their discount rates or trimmed benefits, such as maximum cost-of-living adjustments. The agency expects that due to reforms, Colorado will be a leader among states in funding gains for fiscal 2019. It notes that all three states no longer assume a crossover date for their largest plan following reforms that moved the states to funding closer to actuarially determined contributions (ADCs).

Wisconsin, South Dakota, and New York continue to rank among the states with the best reported funded ratios in the nation. The largest plans in these states also use actuarial funding, regularly update experience studies, employ reasonable amortization methods, and assume rates of return that are lower than the national median for determining actuarial contributions.

In 2018, 18 states lowered their assumed rate of return for their largest plans while 15 did so for their second-largest plans. On average, largest plan downward revisions were marginal, at just 0.24%, S&P Global found. The lower assumed rates of return reduce states’ exposure to market volatility, minimizing swings in required contributions with investment returns, and providing for faster funding progress.

Illinois, New Jersey, and Connecticut have incorporated or are considering asset transfers as a means to improve pension funded ratios and lower required contributions, according to the report. The way that these solutions are valued and influence funding discipline can have varying effects on the overall health of a pension system and long-term fiscal sustainability. S&P Global says that to the degree they are based on unsubstantiated valuations, create liquidity concerns, or otherwise undermine long-term funding progress, it would view them as a negative credit factor. However, it notes that if these states resist overvaluing assets and sell them to deliver cash to the pension system or use future revenue to supplement pension contributions and accelerate funding progress, the transfer could lead to a consistent paydown of the unfunded liability and stabilize contributions.

Not enough?

Despite their efforts to improve funding discipline, many states are failing to make meaningful progress on their aggregate pension liabilities. Many are funding their pensions on an actuarial basis; however, if the underlying actuarial assumptions are not conservative enough or if the funding strategy is poorly crafted, even ADCs could fail to make realistic funding progress toward paying down the long-term liability, S&P Global says.

The agency believes there is likely some minimum amount of funding progress if the annual plan contributions cover service cost (the present value of benefits earned by participants in the year), a portion of the annual total interest cost related to pension liabilities unmatched by plan assets, and 1/30 of the beginning net pension liability (NPL).

Looking at static funding, which measures whether or not a state meets just current service and interest costs, 60% of states fail to meet this threshold. “This means that that even for those that maintain a track record of funding at actuarially determined levels, total plan contributions can still fall short of levels necessary to make progress on paying down the long-term liability. This typically happens when the actuarial assumptions and methods used to calculate ADCs are somewhat optimistic and do not align with recent experience,” the report says.

As for assumed rates of return, S&P Global suggests they should not only align with the expected realistic performance of the target asset portfolio, but should also reflect prudent and informed decision-making on how much market volatility and liquidity risk or budgetary stress a state can absorb. Higher risk typically means exposure to greater volatility. In the event of a market correction, a drop in asset values would necessitate an escalation in required contributions.

Despite widespread state efforts to continue to ratchet down assumed rates of return, most plans retain rates that exceed what S&P Global views as a sustainable rate based on likely market volatility. It suggests a sustainable discount rate for the typical plan is 6.5%.

Demographics

S&P Global notes that states with mature plans and elevated discount rates that still have low funded ratios may warrant additional attention with regard to budgetary vulnerability.

As a plan matures, there are reduced plan inflows as fewer active members contribute annually, and this is compounded by increased outflows for a greater number of retirees and beneficiaries. There is greater strain on employers, as well as asset returns, to maintain plan funding, particularly if the avoidance of intergenerational inequity is desired, the agency says. Increased liquidity needs, along with reduced capacity for market volatility, could push mature plans toward lower assumed returns.

“A mature plan with a high active-to-beneficiary ratio might elect to reduce market risk by incorporating a safer target portfolio and corresponding lower assumed return. A lower assumed return correlates to a lower discount rate, and therefore, a lower funded ratio,” the report says.

S&P Global notes that plans that incorporate assumed payroll growth in their amortization methodology have a built-in deferral of contributions that is intended to be a stable percentage of the budget. However, every year that payroll growth is not realized leads to a contribution shortfall from expectations and adds unfunded liabilities that further add to already-accelerating contributions. The agency has seen amortization methods reduce such risk of acceleration in states such as Kentucky and Connecticut and expects this trend to continue.

S&P Global concludes that it does not anticipate the next recession will lead to a pension crisis or acute budgetary stress. A majority of plans retain sufficient assets to withstand a market shock, and when smoothed over the remaining amortization period, contribution increases are likely to require difficult budgetary choices but remain affordable. In the agency’s view, actions to reduce annual contributions, whether shorting ADCs, extending amortization periods, or poorly executed asset transfers/pension obligation bonds, are more likely to lead to budgetary stress and downward rating revisions than weak pension investment returns in a typical recession.