Updated with correction Oct. 3, 2011
Last summer's downgrade of the U.S. government's credit rating and the potential for large cuts in federal funding to states could have a trickle-down effect on the public pension plans of states that are depending on federal spending.
Before Aug. 5, when Standard & Poor's downgraded the U.S. government rating to AA+ from AAA as the government came close to hitting its borrowing ceiling, Moody's Investors Service on July 19 looked at 15 states reliant on federal funds that could also be at risk for a downgrade if the federal government's rating slipped. Of those states, five — Maryland, New Mexico, South Carolina, Tennessee and Virginia — garnered a “negative outlook” designation that keeps them under review for possible downgrade as well.
What could happen to a state's pension calculations if the state itself suffered a downgrade?
“That's a reasonable question to ask, particularly when a material portion of a state's workforce, including their benefits, is covered with federal dollars,” said Douglas Offerman, senior director of public finance for Fitch Ratings, New York. “It's another thing to keep in mind for stresses that public plans face in the future, too.”
A September report from Fitch notes that despite the uncertainty there is “limited immediate risk.”
S&P isn't revisiting states' ratings until state-specific details emerge from federal budget talks, Robin Prunty, managing director with the state and local governments group, said in an interview.
Right now, all eyes are on the congressional supercommittee charged with identifying at least $1.2 trillion in spending cuts before Thanksgiving. At risk are across-the-board cuts in money sent to states for everything from Medicaid to roads. In recent years, those federal dollars have given all 50 states and local governments roughly $500 billion annually, which averages out to one-third of states' budgets, according to the Pew Center on the States in Washington.
“The fact that there are going to be more cuts introduces a lot of uncertainty for states,” said Sarah Emmans, Pew research manager.
That uncertainty translates into more headaches for state pension funds. “The pressure from the federal level comes at a time when states are already dealing with pension funding pressures,” Ted Hampton, vice president and senior analyst in Moody's public finance group in New York, said in an interview. “Most states have the option of not fully contributing to their pension plans to offset budget pressure, and it's one of the main reasons for this degree of underfunding that we've seen in the public sector,” which Moody's views as a credit negative, he said.
“States have notable strengths, including balanced budget requirements, sovereign taxing authority and affordable state debt, even when pension liabilities are included,” said Mr. Hampton. As they prepare for federal spending cuts, he said, “the bigger question now is how do states draw on these strengths?”
The five states on Moody's watch list, which still have their AAA ratings but with a negative outlook, fall on either side of the one-third average for the federal share of state budgets. In New Mexico, South Carolina and Tennessee, where the shares were 38%, 39%, and 36%, respectively, as of fiscal year 2009, the main factors were Medicaid spending, federal procurement contracts and a high proportion of federal employees living in those states.
The proportion of citizens who are federal workers is a big concern for Maryland and Virginia, which rank Nos. 3 and 4 in the country in that category, respectively. In federal procurement as a percentage of state gross domestic product, Virginia tops the list at 20%, compared to the national average of 3.8%.
But credit outlooks of the five states are tempered by less reliance on other federal dollars and good fiscal management.