The relationship between municipal credit ratings and pensions is simple, and pension health has become a critical factor in determining states’ credit ratings. The funding rate of pension plans is indicative of a state’s long-term ability to manage general finances responsibly. For municipal issuers, credit rating is arguably the most important element when determining financing costs. Since the Great Recession, rating agencies have used pension funding as a dominant factor in their rating methodology.
Borrowing costs are typically higher for issuers with a history of financial stress related to debt repayment and revenue streams. Of course, state and local governments have varying pension funding levels and liabilities, some healthier than others. A portion of payroll taxes primarily funds the liabilities. The higher the liabilities, the more likely they will affect credit evaluations. Furthermore, pensions affect state and local government budgets because many states redirect general fund revenue receipts to the programs.
Pension liabilities have been growing for the past several decades. Across America, approximately 5,500 state and local pensions are responsible for overseeing retirement benefits of 21 million Americans, representing trillions of dollars. A Tax Foundation report on US State Pensions, based on 2019 data from The Pew Charitable Trust, ranked all 50 states according to their funding rate. Many states are significantly underfunded, which will play a role in their credit rating and subsequent cost of debt financing. Before the COVID-19 pandemic, poor economic conditions and low investment returns impacted the health of pension plans. With some market participants predicting anemic returns for the next decade, pension funding could put more pressure on state and local government finances in the future.
While pension plans are vital to state and local government employees’ retirement incomes, they are only one factor to consider when evaluating a state’s economic health. Inadequate pension funding does not necessarily mean a state will have issues meeting debt payment obligations. However, the increased consideration rating agencies are putting on pension liabilities has put the spotlight on their funding. Pension plans have been reformed in recent years to reduce the financial burden on state and local governments. While pension reformation is occurring and future changes to contributions and recipient benefits remain unknown, pensions will continue to play a prominent role in state health.