For many public sector entities, unfunded pension obligations are a meaningful component of total long-term liabilities. Since Governmental Accounting Standards Board Statement 68 (GASB 681) was introduced in 2014, unfunded pension obligations (or “net pension liabilities”) have been included on state and local government balance sheets as a liability, similar to any other long-term debt. Due to the magnitude of these obligations and the level of discretion allowed in both pension assumption setting and defining and/or adhering to funding policies, unfunded pension obligations are receiving increased scrutiny from multiple stakeholders, including plan participants, taxpayers, public policy groups, and credit rating agencies. The question becomes, how do pension plans influence credit ratings and consequently borrowing costs for public entities?
This paper provides perspective on the relationship between an entity’s approach to managing its pension plan and its credit rating. We highlight the value that credit rating agencies place on adequate funding, proper assumptions, and sound governance. Specifically, we find that a strong approach to pension management can impact taxpayers via reduced borrowing costs for state and local entities. We conclude this paper with specific actions that can be taken by plan sponsors to positively influence credit ratings.
Pension Impact on State and Local Credit Ratings
We interviewed the Big Three rating agencies (Fitch Ratings [Fitch], Moody’s Investor Services [Moody’s], and Standard & Poor’s Financial Services [S&P]) to better understand the impact pension obligations have on their state and local bond ratings, and subsequently, borrowing costs. Recent white papers and rating methodology updates published by the Big Three further emphasize the attention owed to thoughtful and appropriate pension plan management. However, this information is often buried in lengthy documents and is not easily digestible by public pension plan stakeholders. Our goal is to summarize this information to help stakeholders understand the impact pensions have on credit ratings and, as a result, make more informed decisions.
Each agency organizes its rating framework in four or five broad factors, as summarized in Chart 1. Public pension liabilities are generally compartmentalized within the debt and liability factors noted in the chart. An important distinction is that Moody’s and S&P assign specific weightings to each factor, while Fitch does not in an effort to tailor its ratings to issuer-specific circumstances. Both Moody’s and S&P assign a 20% weight to the broad debt and liability factors, as shown in Chart 1.
While each agency has a unique rating methodology, we find consistency across the firms with regard to the inclusion of both the current and future state of pension liabilities and plan management. Agencies are not just looking at where these plans stand today; they are also looking at the expected future trajectory of the plan based on how it is being managed.
The current state is captured across agencies as a net pension liability measurement at a snapshot in time. A key difference in the current state metric used across the agencies is the adjustment to the state or local government reported liability. This is an important point, as some of the adjustments made have a significant impact on the net pension liabilities that the credit rating agencies consider, as opposed to what is reported on the entity’s balance sheet and/or used for planning and budgeting purposes. At one end of the spectrum is the adjustment Moody’s makes to the net pension liability. The metric that is incorporated into the credit rating is adjusted to use a market discount rate (currently, 3%–4%), similar to the pension liability measures reported in corporate sector financial statements. By contrast, the median discount rate used by public plan sponsors in determining their funding contribution is 7.5%,3 reflecting the expected long-term rate of return on assets, and resulting in a much lower reported liability. For example, for a pension plan with a 12-year liability duration, a 1% decrease in the discount rate would result in a 12% increase to the plan liability. Fitch also uses an adjusted net pension liability figure, using a static 6.0% discount rate for liabilities that are calculated at a higher discount level by the plan sponsor. These adjustments highlight the agencies’ focus on the potential economic impact unfunded pension obligations may have on a state or local government’s financial stability, as well as allow for easier comparison across entities. On the opposite end of the spectrum, S&P does not make any direct adjustments to the liability figures reported by the localities.
The forward-looking view of pension obligations has received increased attention and also has a direct influence on the overall credit rating. In assessing pension obligations, the Big Three consider factors such as the following:
- Are policies in place to adequately fund future obligations? For example, are contributions at least enough to “tread water” to keep pace with liability growth and new benefit accruals?
- Have entities been making their full actuarially determined contributions (ADCs) in past years?
- How will unfunded pension liabilities impact future budgets?
- Are methods and assumptions, such as amortization periods and discount rates, realistic?
These forward-looking factors contribute to a meaningful portion of the overall pension impact on credit ratings. For example, S&P equally weights its “Pension Liability Metric” (current state) and the “Pension Funding Discipline” (future state) into its pension score. There are also additional factors S&P considers that have the ability to improve or degrade the Pension Funding Discipline score by one point (on a scale of 1 to 4). Furthermore, after S&P determines the indicative credit rating from its scoring framework, there is the potential for overriding factors to further reduce the indicative rating by one notch. One of the six overriding factors is a high level of expected future liabilities, which may eventually lower the expected funded ratio to below a certain threshold and negatively impact the overall credit rating.
Both Moody’s and Fitch also directly consider pension plan management and governance into their credit ratings. Moody’s analysts are able to adjust the rating placement of the pension metric to reflect the additional factors listed in Table 1 and can also make below-the-line notching adjustments to reflect these factors. Fitch’s methodology takes a less standardized approach, with the ultimate rating reflecting both issuer-specific quantitative and qualitative factors, which include governance and plan management.
Table 1 provides detail on the pension plan inputs, both current state and future state, that each agency factors into its overall credit rating within the debt and liability factors.
Most of a pension plan’s influence on credit ratings is captured within the debt and liability factor as described in Table 1, but pensions also have tangible impacts across other listed factors. For instance, each agency considers the impact of an entity’s past, current, and future funding practices on the state or local budgetary performance. Within Fitch’s Expenditure Framework (one of the key factors in its Credit Rating Factor Framework), Fitch calculates a hypothetical benchmark pension contribution. It reflects an annual payment amount required to amortize the Fitch-adjusted net pension liability on a level dollar basis over a 20-year period at a fixed rate of 5%. This benchmark is then used to highlight outliers where the reported actuarial contribution is insufficient to make progress in lowering the liability and is expected to increase pension budget demands over time.
This will have a negative impact on the overall rating. Conversely, a reported actuarial contribution that is equal to or greater than the Fitch-calculated benchmark will positively impact the credit rating, further emphasizing the importance of appropriate assumption setting and funding policy. Moody’s and S&P also factor in similar considerations that allow for pensions to impact other areas in addition to the dedicated pension weights in Table 1. Pensions may also impact an entity’s Financial Management score (Financial Management carries a weight of 30% for Moody’s and 20% for S&P) and Budgetary Performance score (Budgetary Performance carries a total weight of 20% for S&P).
Pension management is also considered under the Governance and Operating factors (Weights: Moody’s–30%; S&P–20%; Fitch–no specific weighting). Similar pension management aspects impact these factors as well, such as key assumptions used, the adequacy and appropriateness of the policies that are in place, the strategies used to control the costs and fulfill the actuarially determined contributions, and the degree of control plan entities have to make changes to plan management.
The key takeaway is that forward-looking pension plan management—and not solely the current level of an entity’s net pension liability—has a meaningful impact on credit ratings. We anticipate that the attention and impact of pension plan management on credit ratings will not soon fade, especially if pension debt continues to contribute a meaningful portion of an entity’s total debt.
Credit Ratings and Borrowing Costs
So what does this mean for the cost of debt for public entities? As we have shown, pension plans have a direct impact on the ultimate state or local credit rating. It is no surprise, then, that there is a relationship between credit ratings and bond yields—lower credit rated bonds tend to require a higher yield to investors and thus provide less capital to public entities. This leads us to a simple but powerful conclusion: Taxpayers in these jurisdictions are paying higher borrowing costs and could save money through healthier pension plan management.
A Call to Action: Proactive Plan Management Has Real Impact
The current state of pension plans and the anticipated ability of an entity to fully satisfy future benefits directly impact the Big Three’s state and local government credit ratings. And while there are certain pension factors that cannot be controlled, such as capital market returns and beneficiary demographics, there are aspects that entities can control and clear actions that can be taken to directly improve a pension’s impact on its locality’s credit rating. We recommend that plan sponsors consider the following:
- Conduct an actuarial assumption audit to review the reasonability of key assumptions, including salary scale, mortality, retirement rates, and turnover rates.
- Assumptions set to plan-specific expectations will lead to lower contribution volatility, whereas aggressive assumptions may provide short-term relief but may have long-term consequences.
- Consider adjustments to the expected return assumption that are in line with forward-looking expectations for asset returns.
- For plans contributing actuarially determined amounts, failing to achieve target returns will necessitate increases in future contributions and make what was intended to be a smooth, budget-friendly progression of contribution increases far more volatile.
- For plans contributing less than the actuarially determined amounts, the funding gap will widen and become highly volatile as contribution policy will not add enough dollars to replenish losses.
- Review the plan’s funding policy, looking far enough into the future to identify potential pain points.
- Conduct a “tread water”/hurdle rate analysis to ensure that short-term contributions are sufficient to keep pace with the growth of the plan liabilities.
- Consider an asset-liability study to understand the range of potential future outcomes rather than a single deterministic scenario.
Selecting appropriate actuarial assumptions, avoiding excessive risk taking, and developing an adequate funding policy are actions that indicate to the Big Three that a plan sponsor is taking a proactive and realistic approach toward fully funding pensions and properly managing an entity’s total debt profile. While an entity’s debt priorities and revenue framework to service such debt will vary on a case-by-case basis, every jurisdiction has the ability to thoughtfully develop a funding policy and set appropriate assumptions. These initial steps will help pension stakeholders better understand their true economic costs, improve the funding outlook for public pensions, and potentially reduce borrowing costs and further taxpayer burden.
1 See the Appendix for additional information on GASB rules for determining balance sheet liabilities for pensions.
2 Sources: Fitch’s “U.S. Public Finance Tax-Supported Rating Criteria,” May 31, 2017; Moody’s “US States Rating Methodology,” April 17, 2013; and S&P’s “U.S. State Ratings Methodology,” October 17, 2016.
3 NASRA Issue Brief: Public Pension Plan Investment Return Assumptions. Updated February 2017.
4 Sources: Fitch’s “U.S. Public Finance Tax-Supported Rating Criteria,” May 31, 2017; Moody’s “U.S. States Rating Methodology,” April 17, 2013; and S&P’s “U.S. States Ratings Methodology,” October 17, 2016.
5 Fitch does not use a standardized weighting for pension obligations.
6 Source: Barclays Bloomberg Indices as of May 31, 2017.
7 GASB 67 is the companion standard for the pension plan, as opposed to the plan sponsor.
Governmental Accounting Standards Board (GASB) Balance Sheet Entry
Since GASB 687 was adopted for fiscal years beginning after June 15, 2014, pension debt has been reported on the balance sheet. The net pension liability is now disclosed along with the employer’s other long-term obligations. GASB 68 was introduced to provide additional transparency regarding the liabilities and funded status associated with the pension promise made by government entities to their employees. While the net pension liability is similar in concept to the funded status measure used under the prior standards, the method by which the net pension liability is calculated is somewhat different.
The asset value used to calculate the net pension liability under GASB 68 is not permitted to reflect any type of asset smoothing. This market value of asset approach differs both from the prior accounting standard methodology as well as the funding valuation approach. Further, the total pension liability used under the new standards may be significantly different from historical measures of total pension liability due to two key items outlined in the new standard: (1) The cost method used for calculating the total pension liability must be entry age normal (entry age normal cost methods are designed to spread costs evenly over career as a level dollar amount or percentage of pay). (2) The discount rate used for determining the total pension liability must be based on a blended rate that combines the plan trust’s expected return on assets for the time period that the trust is expected to be sufficient to pay for benefit payments, together with a 20-year municipal bond rate index for any remaining payments from the plan. Plans using different cost methods may have seen an increase in liabilities due to the adoption of the entry age normal cost method, which would be further increased by the potentially lower discount rates calculated for poorly funded plans under the blended approach.
The combined effect of removing asset smoothing and potentially increasing liabilities likely resulted in a much larger net pension liability appearing on balance sheets for many public sector employers once GASB 68 was adopted. Further, due to the lack of asset smoothing, it is anticipated that during periods of economic turmoil, the net pension liability will be volatile.
This document has been produced by the Global Investment Management Team, a division of Aon plc, and is appropriate solely for institutional investors. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice, and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice specific to their own personal circumstances. The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. The information contained herein is derived from proprietary and nonproprietary sources deemed by Aon Hewitt to be reliable and are not necessarily all-inclusive.
Aon Hewitt does not guarantee the accuracy or completeness of this information and cannot be held accountable for inaccurate data provided by third parties. Reliance upon information in this material is at the sole discretion of the reader.
This document does not constitute an offer of securities or solicitation of any kind and may not be treated as such (i) in any jurisdiction where such an offer or solicitation is against the law; (ii) to anyone to whom it is unlawful to make such an offer or solicitation; or (iii) if the person making the offer or solicitation is not qualified to do so. If you are unsure as to whether the investment products and services described within this document are suitable for you, we strongly recommend that you seek professional advice from a financial adviser registered in the jurisdiction in which you reside. We have not considered the suitability and/or appropriateness of any investment you may wish to make with us. It is your responsibility to be aware of and to observe all applicable laws and regulations of any relevant jurisdiction, including the one in which you reside.
Aon Hewitt Limited is authorized and regulated by the Financial Conduct Authority. Registered in England & Wales No. 4396810. When distributed in the U.S., Aon Hewitt Investment Consulting, Inc. (AHIC) is a registered investment adviser with the Securities and Exchange Commission (SEC). AHIC is a wholly owned, indirect subsidiary of Aon plc. In Canada, Aon Hewitt Inc. and Aon Hewitt Investment Management Inc. (AHIM) are indirect subsidiaries of Aon plc, a public company trading on the NYSE. Investment advice to Canadian investors is provided through AHIM, a portfolio manager, investment fund manager, and exempt market dealer registered under applicable Canadian securities laws. Regional distribution and contact information is provided below.
About Aon Hewitt Investment Consulting, Inc.
Aon Hewitt Investment Consulting, Inc. (AHIC) is the U.S. investment consulting practice of Aon plc, with headquarters in Chicago, Illinois. AHIC is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940, as amended. AHIC is also registered with the Commodity Futures Trading Commission (CFTC) as a commodity pool operator and commodity trading adviser, and is a member of the National Futures Association (NFA).
Aon plc (NYSE:AON) is a leading global professional services firm providing a broad range of risk, retirement and health solutions. Our 50,000 colleagues in 120 countries empower results for clients by using proprietary data and analytics to deliver insights that reduce volatility and improve performance.
For further information on our capabilities and to learn how we empower results for clients, please visit aon.mediaroom.com.
© 2017 Aon plc