Unfunded pensions for state and local governments were once expected by some to sink the whole market. That never happened. Instead, unfunded pension liabilities are in their best condition in nearly a decade, according to Pew Charitable Trusts, and are less of a financial burden on many state and local governments. The improvement in pension liabilities supports the case that credit quality in the muni market has improved and is strong overall.
How do pensions work?
The state or local governments that provide pensions must contribute and invest funds to pay for future benefits. The employees usually must contribute, as well. Future benefits are based on a variety of factors such as projected retirement dates, growth in salaries and life expectancies.
Municipal pension plans vary in terms of funding levels, annual expenses, and the ability and willingness to fully fund their plans. If the value of a plan’s assets falls, or the future retirement benefits promised become more expensive, the municipality generally must contribute more. Those costs compete with other costs, such as other public services or debt payments. Large payments to pensions can take funds away from payments to other resources—such as keeping the municipality operating, or making payments to bondholders. If pension expenses become too burdensome, the municipality risks defaulting on its bonds.
Each plan has a different “funded ratio,” which offers a snapshot of the amount of future assets available to meet projected future needs.
Most state and local government plans haven’t set aside all the assets required to meet 100% of the needs of future retirees, as the map below shows, which isn’t an immediate concern in our view. A ratio of 80% is generally considered as a well-funded plan. Some plans are better funded than others. However, state pension plans are in much better shape today due to increased contributions and strong market gains. The improvement in state pensions has helped improve the credit conditions of many states.
Mind the pension-funded gap
Source: S&P Capital IQ, as of September 20, 2021.
A few points to keep in mind:
- Pension expenses are manageable for most municipalities.The good news is that in general, states have the financial resources to make payments to both their pension plans and bondholders. However, as shown in the chart below, the amount of each state's revenues that go toward fixed costs, including pensions, varies. For example, Connecticut spent 28% of the revenue it generated on debt service, other post-employment benefits (OPEBs) like health care in retirement, and pension contributions in fiscal year 2020. The remaining revenue went toward other things like operations and state-run programs. This compares to North Dakota, which only spent 1.1% of the revenue it generated on similar fixed costs.
Payments on debt account for a low portion of governmental revenues for many states