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      1. Pension Obligation Funding Overview

        The gap between the promises states have made for public employees’ retirement benefits and the money they have set aside to pay these bills was at least $1.38 trillion in fiscal year 2010, according to a Pew Center for the States 2012 analysis. More than $757 Billion of this shortfall is based on unfunded pension obligations, while $627 billion is for retiree healthcare.

        For pensions, the report lists Connecticut, Illinois, Kentucky, and Rhode Island as the worst among the states, with funding levels under 55 percent. In a January 2013 update to their earlier state study, Pew indicates cities are also struggling to keep up. Overall, the cities they surveyed had enough money to cover 74 percent of their pension obligations in fiscal year 2009, compared with 78 percent for states.

        For healthcare as of fiscal 2010, Pew says states have put away only 5% of their expected future payment requirements. Seventeen states had put aside no money, while Alaska and Arizona had put aside the greatest portion at nearly 50%. Pension benefits generally have greater legal protection to beneficiaries as compared to healthcare benefits.

        These underfunded obligations have become a critical issue for investors assessing credit strength of their municipal bond holdings. Since municipalities are not required to fund/fully fund their pension obligations every year and since pensions are so long-term in nature, it is often difficult to see the impact of short-term underfunding. Due to the power of compounding, and the substantial amounts involved in pensions, the long-term problems could eventually grow to be very large. Fitch Ratings believes that the vast majority of governments will withstand the substantial pressures they face from their pension obligations, although for many governments this will mean taking difficult steps to adjust contributions and/or benefits to ensure adequate pension funding.

        The good news is that since 2010, the majority of cities and states have put changes in place to better manage their retirement bills, but there is more work to be done to get back on solid fiscal footing. Weak pension financial disclosure has also made it more difficult to grasp the situation in the past, but reforms are being implemented that should help.

        In another study “Are State Public Pensions Sustainable?”, Joshua D. Rauh, from the Kellogg School of Management at Northwestern University projected how long state governments can continue to run their employee pension programs before the funds run out of money. He modeled 3 different state contribution scenarios and assumed investment returns of 6%, 8% and 10% for each of the 3 scenarios. Additionally, he assumed an average inflation rate of 3%.

        Scenario 1: States contributions are only in the amount of new liabilities. The results: If investment returns average 6%, existing funds would in aggregate run out in 2024, if 8% funds would run out in 2028, and if 10% they would extend through the 2040s. Rauh notes that a 10% return is quite unlikely.

        Scenario 2: States contribute an additional $50 billion per year during 2010-2020. Aggregate state contributions in 2008 were $99 billion, so $50 billion represents more than a 50% increase. If investment returns average 6%, funds would run out in 2028. If returns average 8%, they would run out in 2037. If returns average 10%, state pension funds would be overfunded.

        Scenario 3 indicates that states contribute an additional $75 billion per year, 2010-2020. If investment returns average 6%, existing funds would run out in 2030. If returns average 8%, these contributions would funds would last through 2045. If returns average 10%, state pension funds will be overfunded.

        In sum, under the baseline assumption of 8% annual asset returns, states need to contribute $75 billion each year over the next 10 years in order to avoid a significant chance of having to draw on resources outside their pension funds just to meet benefits that have already been promised.

        In addition to looking at the “aggregate” state contributions, the report identifies when each state will run out of funds given an 8% return on their assets and that they use future contributions to fund new benefits in full. To see individual states, please see the attached table, “When Might State Pension Funds Run Dry?” To the extent that pension program benefits are reduced or contributions by employees are increased, funding life would extend. While this as an outcome is uncertain, and changes will be difficult to affect, dialogue on this topic is growing.

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