States’ “Weak” Pension Contributions Continue to Hurt Pension Funding, Says Fitch

A new commentary from Fitch Ratings lambasts states for their pension funding practices.

Even as contributions rise, Fitch writes, the sustainability of pension systems is not improving.

Fitch acknowledges that states are paying more in recent years:

Actual pension contributions have risen rapidly in recent years as governments have attempted to stem the erosion of their systems’ funded ratios and catch up with rising ARCs, the contribution benchmark calculated by actuaries as necessary to eliminate the unfunded pension liability over time. The average actual contribution in fiscal 2014 is roughly 89% greater than in 2008, the year the global financial crisis began, while the ARC has risen an average of 72% since then.

But, the credit rating agency contends, it’s not enough:

Actual contributions remain inadequate relative to the ARC. Based on Fitch’s last state pension update, a little more than half of major state-wide systems received an annual contribution in fiscal 2014 at or above their ARC. The remaining systems received lower contributions. A shortfall in actual contributions, relative to the ARC, deprives a system of investable resources, increases its unfunded liability and elevates the future ARC that will be calculated at subsequent funding valuations.

In many cases, a system’s ARC itself is a poor benchmark of contribution adequacy.

[…]

Under a 30-year rolling amortization, the ARC is an inadequate measure of contribution sufficiency because at each successive annual funding valuation the ARC is recalculated based on a new 30-year open period, much like refinancing a home mortgage loan year after year. The resulting ARC is likely to provide a higher degree of contribution stability at a lower cost than if it were calculated based on more conservative, alternative methods, such as a consistently fixed, closed-period amortization, various layered amortization approaches, or even a shorter rolling period, such as over 20-years.

For systems using a 30-year rolling amortization, the resulting ARC may too low to cover the cost of new benefits each year plus the accrued interest on the pre-existing unfunded liability — hence the unfunded liability can rise each year, even when the full ARC is paid and other assumptions are achieved. Many governments using 30-year rolling amortization while consistently paying their full ARC each year have still seen their funded ratios languish well below prerecession levels.