Fitch Considers Pension Funding in Government Credit Ratings

December 16, 2010 (PLANSPONSOR.com) – Fitch Ratings said the analysis of long-term obligations, including pensions, is an important part of its rating review for state and local government credits, and it has downgraded a number of credits due in part to pension funding issues.

Fitch noted it will “continue to take such action as warranted.” However, given wide variations in the financial condition of, and management approach to, individual plans, blanket conclusions are problematic, and Fitch said it is important to evaluate them individually.  

According to a press release, in analyzing state and local government pension obligations and the impact on overall credit quality, key factors that Fitch reviews include the size of the resource base from which funding is derived, the amount of the government’s budget needed to make pension payments, and officials’ willingness and ability to make hard choices to bring assets and liabilities into better balance. These factors are not positive for all governments, and more will see rating declines as options become even more limited as time passes.   

Specific examples of the wide variations in pension situations include North Carolina’s Teachers’ and State Employees’ Retirement System, which was funded at 95.9% as of December 31, 2009, down from 104.9% two years earlier due to market losses, but nonetheless very well funded. The state and other member governments have a demonstrated commitment to fully funding their ARC. In contrast, the State of Illinois’ five retirement systems combined had a funded ratio of 50.6% as of June 30, 2009, down from 63.6% two years earlier. The state had consistently underfunded its ARCs even prior to the market downturn and the state’s fiscal crisis. This poor funding history is one among a number of reasons that Illinois’ credit rating, at ‘A’, is among the lowest of the states’, the press release said.  

Fitch noted the systems that pose the greatest risks are those with significant unfunded liabilities for which the government’s annual payments have been significantly less than an actuarially-determined ARC over multiple years. Plans with relatively low funded ratios prior to the market downturn — below 70% — will likely be in a weak position as market losses are fully reflected. However, for some plans that appear relatively poorly funded, ARC payments continue to be made and the government is on a path to 100% funding over a reasonable period of time (e.g. 20 years) without undue financial pressure. In other cases, the funded level is high but the ARC is growing to a nearly-unsustainable proportion of overall resources, crowding out spending for essential operating purposes or forcing tax increases on an already stressed base.   

Fitch said it agrees that given the recent market downturn and prospects for lower returns going forward the average 8% discount rate assumption for public pension funds is likely optimistic, and to enhance its analytical efforts, it is in the process of estimating the size of plans’ liabilities under various alternative discount rate assumptions. Such adjustments will clearly reduce estimated funded ratios and raise contributions for most plans and make the dimensions of the problem more pronounced. They will also allow Fitch to compare liabilities among plans on a more equivalent basis, pending expected pension accounting revisions by the Governmental Accounting Standards Board (GASB).   

Although a pressing need remains to set many pension systems on a more sustainable footing, what Fitch has observed over a long period of time is generally responsible financial management actions by state and local governments, and Fitch said it believes officials will work in the near term to improve funded ratios.  

The agency will provide additional, more detailed, commentary on U.S. state and local pension issues in the coming weeks, including a more detailed analysis of current public pension accounting and GASB’s proposed changes, to be followed by a revised framework for enhancing the analysis of pension liabilities.   

Additional information is available at www.fitchratings.com.

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