Public pensions, which have attracted increased attention over the past year, play an integral role in a government’s overall finances and credit quality, according to Rachel Barkley, a municipal credit analyst with Morningstar and author of a recently released report entitled, The State of State Pension Plans 2013: A Deep Dive into Shortfalls and Surpluses.

Not only do state pension plans represent a state’s financial obligations, but they are also often structured as umbrella plans covering employees of a state’s myriad local government bodies, she says in the report. While some states have been able to manage their pension systems relatively well, the majority of states are experiencing significant budgetary pressure as a result of unfunded pension liabilities. In the interview that follows, Barkley shares her insights and additional findings from this year’s report.

MuniNet: Is it fair to point the finger at unfunded pension liabilities as the catalyst for the fiscal challenges that state and local governments are facing? 

Barkley: State and local governments have been under considerable budgetary pressure for years, with revenues declining precipitously during the recent recession. At the same time, expenses – including labor and post-employment benefit costs – have been on the rise. People are living longer; therefore, more and more people are eligible to collect pension benefits. Combined, these factors have created a “perfect storm.” To various degrees, unfunded pension liabilities have become a critical pressure point for many states, resulting in an additional layer of fiscal stress. State pension systems didn’t necessarily create the financial problems, but they certainly exacerbated financial hardships in many cases.

“Public pensions, which have attracted increased attention over the past year, play an integral role in a government’s overall finances and credit quality.”

We definitely saw marked difficulties during the recent recession, precipitating a significant decline – often over 20 percent over the course of one year – in the market value of many pension systems. Despite the fact that revenue was constrained, many states had to increase the level of contributions to their pension fund to compensate for the substantial drop in asset value. This scenario put a squeeze on other funding needs.

MuniNet: What measures are used to evaluate the condition of state pension systems?

Barkley: In the Morningstar study, we examined two key measures of the fiscal solvency and management of state pension systems: the funded ratio and the unfunded actuarial accrued liability (UAAL) per capita. The funded ratio is calculated by dividing the pension plan’s assets by its liabilities. This calculation reflects the plan’s ability to meet its obligations. Our study found that, in aggregate, state pension plans are 72.6% funded.

The UAAL – or, in simpler terms, unfunded liability – per capita serves as a broad measure of the pension burdens on residents. This ratio does not imply that every resident in the state needs to grab their checkbook tomorrow; rather, it serves as a yardstick in the same way that a state’s debt-per-capita ratio does, bearing in mind that state pensions are structured in multi-year plans, meaning that payouts will be made over the course of time, rather than in one lump sum.  Our study found the average UAAL per capita to be approximately $2,600.

Pension systems with an unfunded ratio of 80% or greater and/or an UAAL per capita under $1,500 are considered “strong.” While these two measures often run in tandem, the Morningstar study found several notable exceptions where the rankings based on these data points do not match. Puerto Rico, for example, has the lowest funded ratio (11.2%), while Alaska (whose funded ratio is 59.2%) has the highest UAAL per capita (greater than $10,000, compared to Puerto Rico’s $8,900 per capita). This disparity reinforces the need to take both ratios into consideration in the fiscal analysis of state pension systems.

MuniNet: “Pension Reform” seems to be a new buzz phrase… Can you provide any examples of states that have proposed – or taken – actions that, in your opinion, could realistically benefit the state’s economy? 

Barkley: Pension reform itself is a very broad umbrella, encompassing a wide range of actions. In most cases, reform involves pension benefits for new employees and/or for current employees covering future work. The vast majority of states have implemented some type of pension reform in recent years in the form of increased employee contributions and/or adjusted formula calculations of benefits. Even Illinois, which has been struggling to pass current pension reform legislation, was able to pass some level of reform in prior years.

Kentucky approved a three-pronged pension reform legislation earlier this year, a) requiring that the state begin to fully fund the annual required contribution by the year 2015; b) creating a defined-contribution plan for new employees; and c) mandating that any cost-of-living (COLA) adjustments be pre-funded going forward. Although Kentucky’s low funded ratio (47%) and high unfunded liability (around $5,000 per capita) are still an issue, these reforms show that the state is taking action to make its pension system more tenable.

Colorado has made some revisions to benefits in recent years, including lowering the COLA and changing retirement requirements, driven by the system’s poor funded ratio and high unfunded liability per capita. PERA, the Colorado state pension system, is currently 61.2% funded as a whole with a $4,819 UAAL per capita. The State Division of the system fares even worse from a funded ratio stand point at 57.7%. However, absent significant additional pension reform, a considerable increase in employer contributions will be required over time to have the fund remain fiscally solvent. This could potentially have a negative impact on the state’s credit quality in the medium to long term.

MuniNet: How might pension reform affect state employees on the flip side of the equation who might be forced to take a financial hit because of changes in benefits? 

Barkley: Indeed, the effect on state and local government employees can be a thorny issue; what may be best for a state’s fiscal health and credit quality could have a negative impact on government employees who suffer a reduction in benefits. Currently, 48 states offer some type of statutory protective provision to prevent the government from having to impair or reduce pension benefits.

“Pension reform itself is a very broad umbrella, encompassing a wide range of actions. In most cases, reform involves pension benefits for new employees and/or for current employees covering future work.”

MuniNet: States struggling with unfunded pension liabilities are getting a lot of press these days. If we shift the focus to states on the other side of the spectrum, who are these states and what are they doing right/well?

Barkley: While there has been a lot of media attention on state and local governments that are experiencing challenges related to pension funding, our report found that the fiscal health of state pension plans varies widely from state to state. Despite economic challenges, many states have exceptionally strong plans, based on their high funded levels and low UAAL per capita ratios. Wisconsin leads the nation with a 99.9% funded ratio and UAAL of $18 per capita. Washington and North Carolina come in at number two and three among states, respectively, with funded ratios of 98.1% and 93.9% and UAALs per capita of $160 and $415.

In our analysis of state pension plans, we found one common element among states that appear to have a firm grasp on managing their pension liabilities: They do not hinder pension solvency in times of fiscal stress. Unlike states that are allowed to “kick the can” down the road, leaving greater liabilities for the future in hopes of better times, these states are required by law to pay the full contribution regardless of their economic or financial condition.

We were also able to identify several other “best practices” associated with strong state pension systems. In general, states that are managing their pension liabilities well:

  • consistently pay the annual required contribution (ARC);
  • tend to have realistic assumptions about their expenses over the medium and long term, thereby avoiding unexpected “surprises;”
  • enact pension reform as needed, creating new tiers of employee benefits, to address pension funding needs on an ongoing basis; and
  • make periodic changes to benefits, such as cost-of-living adjustments, rather than one-time adjustments.