Downgrades Loom for US States

Cash-strapped US statesand cities face the prospect of downgrades after Fitch Ratings changed the way it analyses their burgeoning pension bills.

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In a report published on Thursday, Fitch warns the new approach could lead to “limited negative rating action”, particularly for local governments with big wage bills. The changes to the way it assesses pension liabilities come amid growing concern over the scale of municipal debt problems and the effect on state and city finances of generous, unfunded public sector pension schemesthat will run for many years.

Sharp falls in equities and other risky assets during the financial crisis reduced the funding levels of nearly all these pension plans, increasing the pressure on states and local governments when they have even less cash because of dwindling tax revenues to make up the shortfall. Revenues have tumbled while spending has been rising.

“The key questions are whether states and local governments are funding their pensions, how much it is taking up of their general fund and concern about the crowding out of spending for other needs,” said Laura Porter at Fitch.

The rating agency, which used data from 2009, said there was cause for near-term concern about “a number of” pension plans and pointed to the “considerable pressure that these obligations will place on many government budgets”. The greatest risk would come at the local level since labor-related costs were a higher percentage of local government budgets, Fitch said.

In Miami, Florida, a quarter of the city’s operating budget pays for pensions. Among states, Illinois stands outfor setting aside 12 percent of its budget for its chronically underfunded pension.

In valuing pension liabilities in its credit analysis of states and local governments, the rating agency will now assume a return on assets of 7 percent, lower than the average return of 8 percent used by most pension plans. That translates to an increase in the average plan liability of 11 percent.

Using the 7 percent rate does not shift any plans from being adequately funded, which Fitch considers to be assets equal to 70 percent of liabilities, to “weak”, or under 60 percent. However, plans in Montana, Hawaii, Vermont and New Jersey are among those whose funding ratios fall under 60 percent using Fitch’s assumptions.

The Illinois State Employees Retirement System is the weakest at 37 percent, compared with 44 percent using its reported 8.5 percent assumed rate of return.

A hypothetical 6 percent assumption, however, would drag plans in Nevada, Massachusetts and Minnesota from adequately funded to weak ratios.

For state-run plans that also cover local workers, Fitch said it is difficult to assess how much of the liability is the obligation of the local government because plans typically do not provide this breakdown. That can overstate states’ obligation and understate what local governments owe.