Pension funded ratios improve but reliance on riskier assets poses threats

Bonds

While pension funded ratios for states and other municipal issuers have improved in the last five years, measures of pension safety have deteriorated, analysts say.

The condition of pensions is still the “elephant in the room” for municipal bonds, said HilltopSecurities Managing Director Tom Kozlik. Supporting pensions absorbs a large percentage of government spending. “That’s why investors should continue to care and follow this,” he said.

“Pension funding levels are very much still a leading credit variable for investors to consider when allocating investment dollars into the municipal bond market,” Kozlik said. For municipal governments whose “funding levels are less than optimal, the funding dilemma is very much an issue that needs to be dealt with today.”

Fitch Ratings head of U.S. State Ratings Eric Kim said many states have better funded pension systems compared to pre-COVID levels.

Median pension funding levels rose to 73.6% in fiscal 2022 from 69.5% in fiscal 2017, according to S&P Global Ratings. Fitch Ratings head of U.S. State Ratings Eric Kim said states took action to address their pension underfunding during COVID period, and they continue to contribute more than they did before the pandemic.

“States with the most substantial credit pressure from pensions have budgets featuring their strongest contributions in over a decade,” according to a Moody’s Investors Service report lead authored by Senior Credit Officer Thomas Aaron.

However, in an S&P Global Ratings report released a few weeks ago, Director Todd Kanaster said, “Even as assumed real return (total market return less inflation) modestly fell over the past five years, we see a possible increase of market risk within already risky target portfolios given increasing private equity and other opaque alternative investments.”

pension plans are shifting to riskier asset classes, with the percent of investments in these sorts of assets going from 26% in 2002 to 39% in 2017 to 51% in 2022, according to Kanaster.

Earlier this month, Fitch Ratings Senior Directors Douglas Offerman and Sarah Repucci said “recent [investment] market gyrations underscore the vulnerability of pensions to market shocks.”

As Baby Boomers age, many working in government retire each year, Kanaster said. Budget pressures mean many of these openings have gone unfilled in recent years, leaving fewer employees paying into public pensions. The ratio of active employees to pensioners has plunged from 225% in 2008 to about 115% in 2022.

A positive has been the higher prevailing interest rates of the last year or two, which helped pension fund investment returns, Kozlik said, but these could decline soon, pressuring returns.

High inflation also hurt pensions by increasing costs, Kanaster said.

“We are at a time when rising expenditure demand for spending initiatives such as new or upgraded infrastructure, weather-related spending, and spending for cybersecurity, among other expenditure demands, could compete with the funds needed to fully and accurately fund annual pension payments,” Kozlik said.

In their January report, Moody’s analysts profiled the pension and other post-employment benefit (OPEB) risks for the 50 states. They said 25 states have medium levels of risk, and five — Hawaii, Illinois, Kentucky, Mississippi, and New Jersey — have high levels.

Kim said that while Illinois is making its statutory required payments to its pension system this is short of its actuarial requirements. If this shortfall continues, it will be a problem over the long term.

“State and local governments are generally most affected by the ongoing need to fund defined benefit public pension plans,” Kozlik said. “There are some quasi-governmental agencies that also need to fund defined benefit public pension plans.”

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