S&P Presents Guidelines for Funding Pension and OPEB Plans
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Commentary

S&P Presents Guidelines for Funding Pension and OPEB Plans

Unfunded pension liabilities are taking on a larger role in S&P's credit ratings determinations. This is bad news for cities and states with perpetual pension problems.

At a January 2020 meeting of the governing board of the Arizona Public Safety Personnel Retirement System, a representative from ratings agency Standard and Poor’s (S&P) presented their global ratings guidelines for financing pension and other post-employment benefit (OPEB) plans. Included in this presentation was a robust discussion around setting actuarial assumptions and amortization methods, as well as a look at how public pension systems and OPEBs are affecting some large cities’ finances.

Readers of the Pension Integrity Project at Reason Foundation’s work should find many of S&P’s guidelines familiar. For pension system actuarial assumptions, S&P prescribes a funding goal of 100 percent, a discount rate of 6.5 percent, and actual contributions to match the minimum needed to keep the plan fully funded moving forward. For amortization methods, S&P prescribes a closed period of no more than 20 years to pay off debt on a level-dollar basis, and that the payroll growth assumption be less than the sum of 1 percent plus long-term inflation.

Funding Goal of 100 Percent

Meeting a 100 percent-funded target ensures that the dollars being contributed by today’s employees, employers, and taxpayers are being used to prefund the retirement benefits of today’s workers. This concept is commonly referred to as intergenerational equity. Falling short of 100 percent funding forces future taxpayers to foot the bill for the poor planning and execution of today’s pension and OPEB plans. Falling short of that 100 percent target also makes it even more crucial to set an accurate and low-risk expected rate of return on assets. Setting an unrealistically high return rate will unfairly shift costs to future taxpayers, who will be required to foot the cost of today’s benefits.

In short, a 100 percent funding goal means that any pension debt on the books must be paid down as soon as possible.

Discount Rate of 6.5 Percent

The discount rate is used to determine the present value of already-promised pension benefits, determining how much is needed today to pay for the plan members’ benefits in the future. The higher the discount rate, the lower the present value of earned pension benefits will be. The lower the present value of earned pension benefits is, the less the plan sponsors and employees will need to pay in contribution rates for those earned benefits. Most public sector pension plans set their discount rate to match their assumed investment return rate. With the national average assumed rate sitting over 7 percent, you can see that S&P would view a substantial lowering of discount rate assumptions positively.

S&P also highlighted those states who have mature plans with elevated discount rates and low funded ratios. These plans are given more attention when setting ratings, due to their budgetary vulnerability to be able to pay for these benefits in the future.

20-Year Closed Level-Dollar Amortization and Capped Payroll Growth at Less Than 1 Percent Plus Long-Term Inflation

A closed amortization schedule means that the plan has a particular year that any added unfunded actuarial liability (UAL) will be paid off. After each year’s payment to the UAL, the schedule moves one year closer to its end date. This is in contrast to “open” amortization approaches that essentially refinance pension debt each year, ultimately never paying it off.

The intergenerational equity concept mentioned above is a key component in S&P’s guidelines for a maximum 20-year amortization period. This means that any new pension debt must be paid off no further than 20 years out from the year the debt was added. This is lower than the more-common 30-year policy currently used by most public pension plans (though we would generally prefer debt schedules no greater than 15 years to match the typical average service life of an employee).

Level-dollar amortization means the plan expects to pay the same dollar amount each year of the schedule, rather than being tied to a level percentage of payroll, which relies on a salary growth assumption. Level-percent amortization policies lead to plans paying less in the early years of a schedule due to assumed increases in plan payroll each and every year. Level-dollar policies—as prescribed by S&P—avoid backloading payments, establish more stable budget requirements, save employers a great deal in overall costs, and generally make for public pension systems that are more resilient to unpredictable market factors.

Conclusion

S&P shared some cautionary anecdotes that should catch the attention of every pension plan sponsor, especially considering the current economic downturn that we’re facing due to the coronavirus pandemic. Currently, only nine states meet S&P’s minimum funding guidelines, and 58 percent of states are moving backward by either not paying the full freight for their pensions or not making significant progress on eliminating their pension debt.

In addition, unfunded pension liabilities are taking on a larger role in S&P credit ratings. Previously, debt represented 10 percent of the overall credit rating, with pensions being just 3.33 percent. Now that more information is known about the budget impacts of pensions, that pension percentage has grown to expanded beyond debt and has moved into their budget and management category. Lastly, it should be noted that the worst-rated S&P states all have pension plans that are less than 50 percent funded, highlighting the emerging importance that S&P places on pension debt.

This emerging importance should be at the forefront of all policymakers’ and pension managers’ minds as we move into a different economic climate. Perpetually underfunding or failing to make funding progress will likely keep states and localities behind their peers on their credit ratings, costing them millions of dollars in additional interest costs that must be paid on the bonds that they often rely on to finance infrastructure and other public projects.