Pension liabilities as a credit factor.

• Author: Young, Parry

The following article is reprinted, with permission, from Standard & Poor's CreditWeek Municipal, April 6, 1998.

Pension liabilities continue to represent a significant credit factor for state and local governments, despite very real progress made in funding these liabilities over the past two decades, and particularly in recent years. The Public Pension Coordinating Council's recent survey found that funding levels for U.S. public funds increased in 1996 to 87.4 percent, up from 83.9 percent in 1994, compared with 50 percent in the mid-1970s. The total unfunded actuarial accrued liability stood at a sizable $167 billion in spite of this improvement. While all 1997 data are not available, analysts anticipate further gains in funding based on the strong investment returns for the year, especially in equities.

Standard & Poor's views pension obligations as long-term liabilities that should be managed in a way that will not adversely affect the sponsor's ability to make debt service payments. Although various debt instruments may have a lien position that is senior to pension obligations, benefit payments carry with them a political reality that adds to any legal protections. Because of the improvements in funding levels, the status of pension systems for many states tends to be a generally neutral credit factor and, in certain cases, even a positive one. For some states, however, the relative low level of funding or slow funding progress remain an ongoing rating concern.

While debt levels are usually more predictable due to long-term capital plans, pension liabilities can be more volatile. It is important to consistently monitor a retirement system's funding trend, as well as the reasons for any deviation from plan, because even a well-funded plan can fall victim to unanticipated changes. Pension assets are not the only variable that can grow at double-digit rates. Actuarial liabilities have been known to leap 30 percent, or even 50 percent, from one valuation to the next, resulting in sharp declines in funding levels. Such large liability increases may be fueled by new accounting rules, updated demographic assumptions, or other factors outside of the control of the pension system and the sponsor. The higher contribution requirements that result from these new unfunded liabilities could make any preexisting fiscal stress more acute, especially if the hike was unexpected. A mitigating factor to liability growth is the fact that for newer...